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Capital Gain Treatment of Transferred Patents

Capital Gain Treatment of Transferred Patents

By Meredith Lowry and Quincy Jordan

       The U.S. tax code entitles a patent owner to long-term capital gain treatment – regardless of how long the patent is held – when the owner transfers all substantial rights to the patent. Neither the code nor regulations specifically address all instances of when rights are “substantially transferred.” Typically, this isn’t an issue – most patent owners involved in transferring the rights to a patent transfer all substantial rights.  Recently, the United States Tax Court heard a case of first impression regarding a patent owner’s ability to retain control of a patent and the substantial right to terminate the transfer at will. 

In Cooper v. Comm’r, 143 T.C. No. 10 (2014), the Tax Court found that the ability to recognize long-term capital gains under the Internal Revenue Code Sec. 1235 is not applicable if there was essentially no transfer of the patent. This case makes note of the implications that can arise from the movement of patents without relinquishing control of the patent or providing adequate consideration for the transfer of the patent.

In this case, the patent owner, Thomas Cooper, formed Technology Licensing Corp. (“TLC”) with Lois Walters and Janet Coulter, two individuals he “could trust and control.” Cooper did not personally own any shares in the company, instead having his trust own a minority share of the company, and did not serve as a director of the company. Upon formation, Cooper transferred his patents to TLC and received royalty payments as a capital gain. However, neither Coulter nor Walters reviewed the royalty payments that were distributed to Cooper.

During the course of business, Cooper was the main negotiator for TLC agreements without any input by Walters and Coulter.  Cooper additionally had stock restrictions placed on all shares of the company except his shares. In 2006, TLC transferred some patents back to Cooper without any payment or other consideration from Cooper to TLC. Following the transfer, Cooper transferred these patents to Watonga Technology, Inc., a second company primarily owned by Coulter and Walters, in exchange for 55% of all net revenue from the patents.

The Tax Court found that Cooper controlled TLC in all material aspects based upon the lack of patent experience of the directors, the lack of review with his royalty payments, the stock restriction agreement, the lack of consideration given for a patent transfer, and his decisions in substantially all licensing, patent infringement, and patent transfers. As a result of Cooper’s control of TLC, Cooper did not transfer all substantial rights in the subject patents and therefore was not entitled to capital gain treatment. 

        The Cooper case demonstrates the implications and consequences of retaining control – indirect or direct – with a patent. The importance of providing consideration for transactions and for maintaining a separation of powers is going to be a main factual determination after this case for section 1235 determination.

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