James Cooper v. Cir

FOR PUBLICATION

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

JAMES C. COOPER; LORELEI M. No. 15-70863

COOPER,

Petitioners-Appellants, Tax Ct. No.

17284-12

v.

COMMISSIONER OF INTERNAL OPINION

REVENUE,

Respondent-Appellee.

Appeal from a Decision of the

United States Tax Court

Argued and Submitted October 4, 2017

Pasadena, California

Filed December 15, 2017

Before: Andrew J. Kleinfeld, Susan P. Graber,

and Morgan Christen, Circuit Judges.

Opinion by Judge Graber;

Partial Concurrence and Partial Dissent by Judge Kleinfeld

2 COOPER V. CIR

SUMMARY*

Tax

The panel affirmed the Tax Court’s decision, after a

bench trial, on a petition for redetermination of federal

income tax deficiencies in which taxpayers sought capital

gains treatment of patent-generated royalties pursuant to

26 U.S.C. § 1235(a).

Taxpayer James Cooper is an engineer and inventor

whose patents generated significant royalties. He and his

wife incorporated and transferred their rights to the patents to

Technology Licensing Corporation (TLC), which was formed

by taxpayers and two other individuals, Walters and Coulter.

If a patent holder, through effective control of the

corporation, retains the right to retrieve ownership of the

patent at will, then there has not been a transfer of all

substantial rights to the patent so as to warrant capital gains

treatment of the royalties under § 1235(a). The panel held that

the Tax Court permissibly concluded that Mr. Cooper did not

transfer “all substantial rights” to the patents to TLC because

Walters and Coulter acted at Mr. Cooper’s direction, did not

exercise independent judgment, and returned patents to Mr.

Cooper when requested for no consideration.

Taxpayers claimed a deduction for a nonbusiness “bad

debt” pursuant to 26 U.S.C. § 166(d)(1)(B), which allows

short-term capital-loss treatment of a loss “where any

nonbusiness debt becomes worthless within the taxable year.”

*

This summary constitutes no part of the opinion of the court. It has

been prepared by court staff for the convenience of the reader.

COOPER V. CIR 3

The panel held that the Tax Court permissibly concluded that

the debt had not become “totally worthless.”

Finally, the panel upheld the Tax Court’s determination

that taxpayers failed to meet their burden of showing that they

actually relied in good faith on their advisers’ judgment so as

to avoid accuracy-related penalties under 26 U.S.C. §§ 6662

and 6664.

Judge Kleinfeld dissented as to Section A of the majority

opinion regarding the royalty payments as capital gains,

joined in Section B as to the bad debt deduction, and

observed that the accuracy penalties discussed under Section

C would need to be revisited if his view on the royalties were

to be accepted. Judge Kleinfeld opined that the better

approach to distinguishing “control” from “mere influence”

over a corporation is the approach set forth in Charlson v.

United States, 525 F.2d 1046 (Ct. Cl. 1975) (per curiam), and

Lee v. United States, 302 F. Supp. 945 (E.D. Wis. 1969): that

“control” means the ability to compel what the transferee

corporation does.

COUNSEL

Richard G. Stack (argued) and Dennis N. Brager, Brager Tax

Law Group P.C., Los Angeles, California, for Petitioners-

Appellants.

Clint A. Carpenter (argued) and Richard Farber, Attorneys,

Tax Division; Caroline D. Ciraolo, Principal Deputy

Assistant Attorney General; United States Department of

Justice, Washington, D.C.; for Respondent-Appellee.

4 COOPER V. CIR

OPINION

GRABER, Circuit Judge:

Petitioners James and Lorelei Cooper are married

taxpayers who challenge the Commissioner of Internal

Revenue’s notice of deficiency for tax years 2006, 2007, and

2008. Mr. Cooper’s patents generated significant royalties

during those years. Petitioners sought capital gains treatment

of those royalties pursuant to 26 U.S.C. § 1235(a) on the

theory that Mr. Cooper had transferred to a corporation “all

substantial rights” to the patents. After a bench trial, the Tax

Court disagreed, finding that Mr. Cooper effectively

controlled the recipient corporation such that he had not

transferred all substantial rights to the patents. The Tax Court

also found that Petitioners could not take a bad debt tax

deduction in 2008 because the debt at issue had not become

worthless during that year, and that Petitioners had not

established reasonable cause to avoid accuracy penalties

arising from their underpayment. Because the Tax Court

accurately applied the law and did not clearly err in its factual

findings, we affirm.

FACTUAL AND PROCEDURAL HISTORY

Mr. Cooper is an engineer and inventor. He is the named

inventor on more than 75 patents in the United States. His

patents are primarily for products and components used in the

transmission of audio and video signals. Petitioners are co-

trustees of a family trust, referred to as the “Cooper Trust.”

In 1983, Petitioners incorporated Pixel Instruments

Corporation (“Pixel”). Mr. Cooper was president, and Ms.

Cooper held various positions, including vice president.

Petitioners wholly owned Pixel until 2006.

COOPER V. CIR 5

In 1988, Mr. Cooper and Pixel entered into a

commercialization agreement with Daniel Leckrone. Mr.

Cooper and Pixel assigned their patents to a licensing

company formed by Leckrone, in exchange for royalty

payments arising from the commercialization of the patents.

The arrangement brought significant tax benefits to

Petitioners. Because Petitioners had transferred “all

substantial rights” to the patents to the licensing company,

26 U.S.C. § 1235(a) permitted Petitioners to treat the

payments from the licensing company as capital gains. But

in 1997, after disputes with Leckrone, Mr. Cooper terminated

the commercialization agreement. All of Mr. Cooper’s patent

rights reverted to his assignee pursuant to a settlement and

arbitration.

Understandably, Petitioners sought to retain the tax

benefits afforded by § 1235 and, to that end, they sought legal

advice from Gordon Baker. Baker advised them that they

could set up a licensing company to which to transfer the

patents, so long as they complied with two requirements that

are relevant here. First, he advised them that, pursuant to

§ 1235(c),1 they could not own 25 percent or more of the

company. Second, he advised them that, regardless of formal

ownership, they could not effectively control the new

company. The prohibition on effective control had been

discussed at length in Charlson v. United States, 525 F.2d

1046, 1053 (Ct. Cl. 1975) (per curiam).

1

Section 1235(c) formerly was labeled § 1235(d). We use the

present-day citation.

6 COOPER V. CIR

Petitioners, joined by Lois Walters and Janet Coulter,

incorporated Technology Licensing Corporation (“TLC”).2

Walters is Ms. Cooper’s sister, and Coulter is a long-time

friend of Ms. Cooper and Walters. During all relevant times,

Coulter and Walters lived in Ohio, and both held full-time

jobs unrelated to TLC. Neither Coulter nor Walters had any

experience in patent licensing or patent commercialization

before their involvement with TLC.

Consistent with Baker’s advice, Petitioners, as co-trustees

of the Cooper Trust, owned only 24% of the TLC stock;

Walters owned 38%; and Coulter owned 38%. Walters was

president and chief financial officer, Ms. Cooper was vice

president, and Coulter was secretary.

In 1997, Mr. Cooper and Pixel entered into agreements

with TLC. Under the TLC agreements, Mr. Cooper and Pixel

transferred to TLC all rights to certain patents, and TLC

agreed to pay Mr. Cooper and Pixel royalty payments using

a formula that relied on percentages of gross and net proceeds

received from licensing the patents. During 2006, 2007, and

2008—the years at issue here—Mr. Cooper received royalty

payments pursuant to the TLC agreements, and Petitioners

treated those payments as capital gains.

During 2008, Petitioners also claimed a deduction on their

2008 tax return for a nonbusiness “bad debt” pursuant to

2

In 2003, Petitioners moved from California to Nevada. They then

incorporated a second Technology Licensing Corporation in that state,

with the same board membership and the same stock ownership. The two

corporations merged in 2004, with the Nevada corporation emerging as

the surviving corporation. We follow the Tax Court’s convention of

referring to both the original corporation and the surviving corporation as

“TLC.”

COOPER V. CIR 7

26 U.S.C. § 166(d)(1)(B), which allows short-term capital-

loss treatment of a loss “where any nonbusiness debt becomes

worthless within the taxable year.” The debt arose from a

working capital promissory note from the Cooper Trust to

Pixel. At the end of 2008, the outstanding balance on the

promissory note was a little more than $2 million, and Mr.

Cooper concluded that Pixel could not pay the outstanding

balance.

The Commissioner issued a notice of deficiency to

Petitioners. Relevant here, the Commissioner disagreed that

the royalty payments from TLC qualified as capital gains; he

disagreed that the Pixel promissory note debt qualified as a

bad debt deduction; and he assessed penalties for those errors.

Petitioners sought review by the Tax Court. After a trial, the

Tax Court agreed with the Commissioner on all three points,

and the court ordered Petitioners to pay deficiencies and

penalties totaling approximately $1.5 million. Petitioners

timely appeal.3 See 26 U.S.C. § 7482(a)(1) (permitting

appeals from the Tax Court to the applicable circuit court).

STANDARDS OF REVIEW

“We review decisions of the Tax Court under the same

standards as civil bench trials in the district court. Therefore,

conclusions of law are reviewed de novo, and questions of

fact are reviewed for clear error.” Johanson v. Comm’r,

541 F.3d 973, 976 (9th Cir. 2008) (internal quotation marks

omitted).

3

The Tax Court ruled in favor of Petitioners on a separate issue; the

Commissioner did not cross-appeal. That ruling therefore is final.

8 COOPER V. CIR

DISCUSSION

“Determinations made by the Commissioner in a notice

of deficiency normally are presumed to be correct, and the

taxpayer bears the burden of proving that those

determinations are erroneous.” Merkel v. Comm’r, 192 F.3d

844, 852 (9th Cir. 1999). The burden shifts back to the

Commissioner in certain circumstances, 26 U.S.C. § 7491(a),

but the Tax Court held that Petitioners have neither asserted

nor proved that they have met those requirements. On appeal,

Petitioners do not challenge the Tax Court’s conclusion that

they bear the burden of proof.

Petitioners challenge the Tax Court’s rulings on (A) the

treatment of royalty payments as capital gains; (B) the

treatment of the Pixel loan as a bad debt; and (C) the

imposition of penalties.

A. Royalty Payments as Capital Gains

The Tax Code generally treats income derived from a

capital asset as ordinary income. By contrast, the Tax Code

generally treats the proceeds from the sale of a capital asset

more favorably, as capital gains. Real property provides a

good example: If a homeowner rents a house, the rents are

ordinary income; but if the homeowner sells the house, the

proceeds from the sale are capital gains. Patents do not fit

neatly within that dichotomy, because patent holders often

sell all substantial rights to a patent in exchange for periodic

payments contingent on the patent’s productivity. But

because that payment arrangement appears so similar to rent,

the Commissioner originally treated the proceeds from such

exchanges as ordinary income—even though the patent

holder had divested all meaningful property rights in the

COOPER V. CIR 9

patent. See Fawick v. Comm’r, 436 F.2d 655, 659–61 (6th

Cir. 1971) (describing this history).

In 1954, Congress responded by enacting 26 U.S.C.

§ 1235. Subsection 1235(a) provides:

A transfer (other than by gift, inheritance,

or devise) of property consisting of all

substantial rights to a patent . . . by any holder

shall be considered the sale or exchange of a

capital asset held for more than 1 year,

regardless of whether or not payments in

consideration of such transfer are–

(1) payable periodically over a period

generally coterminous with the transferee’s

use of the patent, or

(2) contingent on the productivity, use, or

disposition of the property transferred.

Accordingly, if a patent holder transfers “all substantial rights

to a patent,” then the resulting royalty payments are treated as

capital gains, because the patent has been “sold.” By

contrast, if a patent holder retains substantial rights to a patent

and merely licenses the patent, then the resulting payments

are not treated as capital gains, because the patent has not

been “sold.” The key consideration is whether the patent

holder “transfer[red] . . . all substantial rights” to the patent.

Id.

Petitioners urge us, for the first time on appeal, to

determine whether there has been a transfer of all substantial

rights by looking solely to the formal documents, without

10 COOPER V. CIR

regard to the practical realities of the transaction.4 We

decline the invitation. A bedrock principle of tax law—now

and in 1954—is that substance controls over form. See, e.g.,

United States v. Eurodif S.A., 555 U.S. 305, 317–18 (2009)

(“[I]t is well settled that in reading regulatory and taxation

statutes, form should be disregarded for substance and the

emphasis should be on economic reality.” (internal quotation

marks omitted)); Helvering v. F. & R. Lazarus & Co.,

308 U.S. 252, 255 (1939) (“In the field of taxation,

administrators of the laws and the courts are concerned with

substance and realities, and formal written documents are not

rigidly binding.”). Nothing in § 1235 suggests that Congress

intended a different rule to apply here. To the contrary,

considerable legal authority supports our conclusion that,

when determining whether there has been a transfer of all

substantial rights, we must look beyond the bare form of the

transaction.

Acting pursuant to an express statutory delegation,

26 U.S.C. § 7805(a), the Secretary of the Treasury

(“Secretary”) has promulgated regulations concerning the

statutory phrase “all substantial rights to a patent.” 26 C.F.R.

§ 1.1235-2(b). We defer to the Secretary’s regulations. See

Kueneman v. Comm’r, 628 F.2d 1196, 1201 (9th Cir. 1980)

(“The Secretary has broad authority to promulgate reasonable

regulations to implement the revenue laws . . . .”); Comm’r v.

Portland Cement Co. of Utah, 450 U.S. 156, 169 (1981)

(“Treasury Regulations ‘must be sustained unless

unreasonable and plainly inconsistent with the revenue

4

The issue is purely one of law, and the parties have briefed it to us.

We exercise our discretion to reach the issue, despite Petitioners’ failure

to raise it before the Tax Court. Bolker v. Comm’r, 760 F.2d 1039, 1042

(9th Cir. 1985).

COOPER V. CIR 11

statutes.’” (quoting Comm’r v. S. Tex. Lumber Co., 333 U.S.

496, 501 (1948))). The pertinent Treasury Regulation states:

“The circumstances of the whole transaction, rather than the

particular terminology used in the instrument of transfer, shall

be considered in determining whether or not all substantial

rights to a patent are transferred in a transaction.” 26 C.F.R.

§ 1.1235-2(b)(1). That interpretation finds support in the

legislative history, specifically a Senate Finance Committee

report that stated:

It is the intention of your committee to

continue this realistic test, [developed under

prior case law,] whereby the entire

transaction, regardless of formalities, should

be examined in its factual context to

determine whether or not substantially all

rights of the owner in the patent property have

been released to the transferee . . . .

S. Rep. No. 83-1622, at 440 (1954), as reprinted in 1954

U.S.C.C.A.N. 4621, 5083. Not surprisingly, then, we

previously have described the inquiry in practical terms:

“What did the taxpayer actually give up by the transfer; that

is, was there an actual transfer of the monopoly rights in a

patent . . . .” Kueneman, 628 F.2d at 1199 (emphases added

and original emphasis omitted) (quoting Mros v. Comm’r,

493 F.2d 813, 816 (9th Cir. 1974) (per curiam)).

In Charlson, 525 F.2d 1046, the United States Court of

Claims described how the principle applies in a case

involving a transfer of patent rights to a corporation. In that

case, the inventor formally transferred all substantial rights to

certain patents to a corporation that was owned by the

inventor’s close friends and associates. Id. at 1048–49.

12 COOPER V. CIR

Section 1235(c) provides that royalties from a patent transfer

are not taxable as capital gains if the recipient is a “related”

person or entity. The court held that § 1235(c)’s

requirements concerning formal ownership had been met, but

the court “stressed that § 1235[(c)] was not intended to be an

exclusive or exhaustive statement of the impact of control

over a § 1235(a) transaction.” Id. at 1053. It is “clear,” the

court held, “that retention of control by a holder over an

unrelated corporation can defeat capital gains treatment, if the

retention prevents the transfer of ‘all substantial rights.’” Id.

“This is because the holder’s control over the unrelated

transferee . . . places him in essentially the same position as

if all substantial rights had not been transferred.” Id.; see also

id. (describing Congress’ “obvious intent of having a

transferor’s acts speak louder than his words in establishing

whether a sale of a patent has occurred”).

We agree: If a patent holder exercises control over the

recipient corporation such that, in effect, there has not been

a transfer of all substantial rights in the subject patent(s), then

the requirements of § 1235(a) are not met, even if the

documents describing the transfer formally assign all

substantial rights. The key inquiry remains whether, as a

practical matter, the transferor shifted all substantial rights to

the recipient. Mere influence by the patent holder is

insufficient to defeat § 1235(a) treatment, as is control by the

patent holder of aspects of the corporation apart from the

patent rights. A patent holder who formally transfers all

substantial patent rights to a qualifying corporation is entitled

to the benefits of § 1235(a) unless, through effective control

of the corporation, he or she did not effectively transfer all

substantial rights to the patent(s).

COOPER V. CIR 13

Importantly, “[t]he retention of a right to terminate the

transfer at will is the retention of a substantial right for the

purposes of section 1235.” 26 C.F.R. § 1.1235-2(b)(4).

Accordingly, if a patent holder, through effective control of

the corporation, retains the right to retrieve ownership of the

patent at will, then there has not been a transfer of all

substantial rights. Stated differently, if the recipient

corporation stands ready, as a practical matter, to return

ownership of the patent to the patent holder at the holder’s

direction, then there has not been a transfer of all substantial

rights.

Here, the Tax Court found, and we agree, that Petitioners

complied with the formal requirements of § 1235. Mr.

Cooper formally transferred all substantial rights to the

patents to TLC, and Petitioners owned less than 25 percent of

TLC. The Tax Court further found, however, that Mr.

Cooper effectively controlled TLC within the meaning of

Charlson such that, in effect, there had not been a transfer of

all substantial rights to the patents. For the reasons that

follow, we hold that the Tax Court did not clearly err.

The Tax Court found that Walters and Coulter—the two

shareholders other than the Cooper Trust—exercised no

independent judgment and acted at Mr. Cooper’s direction.

“During the years at issue, [Walters’ and Coulter’s] duties as

directors and officers consisted largely of signing checks and

transferring funds as directed by TLC’s accountants and

signing agreements as directed by TLC’s attorneys.”

“[S]ubstantially all of TLC’s decisions regarding licensing,

patent infringement, and patent transfers were made either by

Mr. Cooper or at his direction.” Walters and Coulter “acted

in their capacities as directors and officers of TLC at the

direction of Mr. Cooper. They did not make independent

14 COOPER V. CIR

decisions in accordance with their fiduciary duties to TLC or

act in their best interests as shareholders.”

Those findings strongly suggest that TLC would take

practically any action requested by Mr. Cooper—including

the return of patent rights—without regard to the interests of

TLC’s shareholders and without regard to the personal

interests of Walters and Coulter. But the Tax Court was not

required to speculate as to whether, upon Mr. Cooper’s

request, TLC would return valuable patent rights to Mr.

Cooper; that event in fact occurred. In 2006, upon request,

TLC returned valuable patent rights to Mr. Cooper for no

consideration. Mr. Cooper quickly commercialized the

patents through a separate entity, which received $120,000 in

revenue.

In sum, the Tax Court permissibly concluded that Walters

and Coulter acted at Mr. Cooper’s direction; did not exercise

independent judgment; and, when requested, returned patents

to Mr. Cooper for no consideration. Given that Walters and

Coulter acquiesced, without question or explanation, in the

rescission of the transfer of certain patents, there is no reason

to think that they would have objected to the rescission of any

other transfer of patents. Because the right to retrieve

ownership of the patent is a substantial right, the Tax Court

did not clearly err in ruling that Mr. Cooper did not transfer

“all substantial rights” to the patents.

We respectfully part ways from the dissent’s thoughtful

analysis of this issue and offer the following observations in

response.

For all the reasons described above, the inquiry into

whether there was a transfer of all substantial rights is a

COOPER V. CIR 15

practical one, not merely a formalistic or legalistic one. We

therefore reject the dissent’s suggestion that we must ask

whether, in theory, TLC could have declined to transfer the

patents back to Mr. Cooper; instead, we must ask whether, as

a practical matter, Mr. Cooper retained the ability to retrieve

the patents at will. Similarly, whether Mr. Cooper

hypothetically could have forced TLC to comply with his

wishes on other matters is beside the point.

We recognize that there is a difference between mere

influence and control sufficient to defeat § 1235(a) tax

treatment. Reasonable minds may differ on where a

particular situation lies. Having examined the record

developed at trial in this case, and reviewing for clear error,

we hold only that the Tax Court’s conclusion was a

permissible one. Relatedly, we disagree with the dissent that

the facts of Charlson require a different result here. The

officers of the corporation in Charlson exercised independent

judgment, and the corporation never returned patents to the

inventor without consideration.

Finally, we emphasize that our analysis is limited solely

to the tax consequences of Petitioners’ business

arrangements. Allowing an inventor to have effective control

of the recipient corporation very well may be a smart business

practice in some circumstances. We hold only that, if the

patent holder effectively controls the corporation such that he

or she did not transfer all substantial rights to the patents,

then the tax treatment allowed by § 1235 does not apply.

B. Bad Debt Deduction

We review for clear error the Tax Court’s finding of the

worthlessness of a debt. L.A. Shipbuilding & Drydock Corp.

16 COOPER V. CIR

v. United States, 289 F.2d 222, 228–29 (9th Cir. 1961);

accord Cox v. Comm’r, 68 F.3d 128, 131 (5th Cir. 1995).

The taxpayer bears the burden of proving “that the debt

became worthless within the tax year.” Andrew v. Comm’r,

54 T.C. 239, 244–45 (1970). “The year a debt becomes

worthless is fixed by identifiable events that form the basis of

reasonable grounds for abandoning any hope of recovery.

Petitioner must establish sufficient objective facts from which

worthlessness could be concluded; mere belief of

worthlessness is insufficient.” Aston v. Comm’r, 109 T.C.

400, 415 (1997) (citation omitted). The debt must “become

totally worthless, and no deduction shall be allowed for a

nonbusiness debt which is recoverable in part during the

taxable year.” 26 C.F.R. § 1.166-5(a)(2). A taxpayer need

not have initiated legal action against the debtor, but “he does

have the burden of establishing that such an action, when

considered in the light of objective standards, would in all

probability have been entirely unsuccessful.” Dustin v.

Comm’r, 467 F.2d 47, 48 (9th Cir. 1972) (footnotes omitted).

The Tax Court found that, contrary to Petitioner’s

assertion, the debt on Pixel’s promissory note did not become

“worthless” in July 2008. 26 U.S.C. § 166(d)(1)(B). The

court reasoned:

Pixel had total yearend assets each year

from 2008 through 2012 in excess of

$172,000, including more than $319,000 in

assets in 2011 and 2012. It appears to us that

Pixel remained a going concern well past

2008. . . . Pixel experienced a decline in its

business in 2008, but its gross receipts

increased in 2009. Petitioners as cotrustees of

the Cooper Trust continued to advance funds

COOPER V. CIR 17

to Pixel under the terms of the promissory

note throughout 2008. Indeed, petitioners

advanced $148,255 to Pixel under the terms of

the promissory note between July and

December 2008. We do not find it credible

that petitioners would have advanced nearly

$150,000 to Pixel after July 2008 if they

believed the promissory note had been

rendered worthless in July 2008 . . . . The

evidence shows that Pixel had substantial

assets at the end of the 2008 tax year and that

its gross receipts increased in 2009.

Moreover, at the very least, Pixel was entitled

to an indefinitely continuing annual royalty of

$22,500 and owned rights in several other

patents. . . . Pixel’s liabilities to petitioners

under the terms of the promissory note

comprised substantially all of Pixel’s

liabilities in 2008.

(Formatting omitted.) Those findings are not clearly

erroneous.

In short, Pixel had a steady, if small, income stream, and

it had hundreds of thousands of dollars worth of assets.

Petitioners almost certainly could not have recovered the full

$2 million and change but, considering that they were

essentially the only creditors, they likely could have made a

partial recovery. The Tax Court permissibly concluded that

the debt had not become “totally worthless.” 26 C.F.R.

§ 1.166-5(a)(2).

18 COOPER V. CIR

C. Accuracy Penalties

Title 26 U.S.C. § 6662(a) imposes a 20 percent penalty to

underpayments of tax if any of the conditions in § 6662(b) is

met. Here, the Tax Court found that two conditions were

met: “Negligence or disregard of rules or regulations,” id.

§ 6662(b)(1), and “[a]ny substantial understatement of

income tax,” id. § 6662(b)(2). On appeal, Petitioners do not

challenge those findings.

Section 6664(c) provides a “[r]easonable cause exception

for underpayments”: “No penalty shall be imposed under

section 6662 or 6663 with respect to any portion of an

underpayment if it is shown that there was a reasonable cause

for such portion and that the taxpayer acted in good faith with

respect to such portion.” 26 U.S.C. § 6664(c)(1). Petitioners

assert that they relied in good faith on professional advice.

Reliance on professional advice may

establish reasonable cause and good faith.

Treas. Reg. § 1.6664-4(b)(1). The Tax Court

requires a taxpayer to prove three elements in

order to show that reliance on advice was

reasonable: “(1) The adviser was a competent

professional who had sufficient expertise to

justify reliance, (2) the taxpayer provided

necessary and accurate information to the

adviser, and (3) the taxpayer actually relied in

good faith on the adviser’s judgment.”

Neonatology Assocs., P.A. v. Comm’r,

115 T.C. 43, 99 (2000). Once the

Commissioner produces evidence showing

that an accuracy-related penalty applies, the

COOPER V. CIR 19

burden of proving the existence of reasonable

cause and good faith falls on the taxpayer.

DJB Holding Corp. v. Comm’r, 803 F.3d 1014, 1029–30 (9th

Cir. 2015). Here, the Tax Court held that Petitioners failed to

meet their burden of showing that they actually relied in good

faith on an adviser’s judgment. “Whether the taxpayer acted

with reasonable cause and in good faith is a finding of fact

reviewed for clear error.” Id. at 1022.

1. Royalty Penalty

With respect to the royalty penalty, Petitioners contended

that they relied on the advice of Baker. The Tax Court found:

Mr. Baker testified with respect to the

royalty payments and petitioners’ compliance

with section 1235 that he advised petitioners

that Mr. Cooper could not indirectly control

TLC. Moreover, Mr. Baker did not provide

advice to petitioners before they filed their

Forms 1040 for the years at issue, nor did he

provide advice to petitioners regarding

whether Mr. Cooper controlled TLC

following TLC’s incorporation. Petitioners

did not follow Mr. Baker’s advice to ensure

that Mr. Cooper did not indirectly control

TLC. Consequently, petitioners cannot claim

reliance on the professional advice of Mr.

Baker to negate the section 6662(a) penalty

with respect to their erroneous capital gain

treatment of the royalty payments Mr. Cooper

received during the years at issue.

20 COOPER V. CIR

Those findings are not clearly erroneous, and the Tax

Court’s reasoning is sound. Baker advised Petitioners at the

time they formed TLC that, in order to receive capital gains

treatment, Mr. Cooper could not control TLC indirectly.

Baker also testified specifically that he had no recollection

that he ever advised Petitioners that the way in which they

were operating TLC actually conformed to his advice.

Indeed, there is no evidence that Petitioners ever sought post-

formation advice from anyone about whether their conduct

actually complied with Baker’s advice.

Nor was the penalty inappropriate because of the

allegedly uncertain state of the law. “[A]n honest

misunderstanding of fact or law that is reasonable in light of

all of the facts and circumstances” can excuse an

understatement of tax. 26 C.F.R. § 1.6664-4(b)(1). But there

is patently no honest misunderstanding here: Petitioners’

theory at trial was that Baker advised them to conform with

Charlson such that they did not informally control TLC.

Indeed, they conceded before the Tax Court that Charlson

provided the binding legal rule: Capital gains treatment is

unavailable if the taxpayer informally controls the

corporation. It is only on appeal that they have challenged

the legal standard. Accordingly, whatever merit Petitioners’

argument might have had if they truly had been uncertain

about the validity of Charlson (despite the fact that no court

has questioned its validity), Petitioners cannot benefit from

that purported uncertainty because it was not until this appeal

that they alleged any uncertainty.

COOPER V. CIR 21

2. Bad Debt Penalty

With respect to the bad debt penalty, Petitioners

contended that they relied on the advice of Mitch Mitchell

and Baker. The Tax Court found:

With regard to the bad debt deduction,

petitioners have failed to introduce evidence

regarding what information they provided to

Mr. Baker and Mr. Mitchell to enable them to

determine whether the promissory note was

worthless within the meaning of section 166

in 2008. Petitioners did not call Mr. Mitchell

to testify or otherwise introduce any evidence

regarding Mr. Mitchell’s advice. Similarly,

Mr. Baker did not testify regarding any advice

he may have given to petitioners that would

indicate that it was his opinion that the

promissory note became worthless in 2008.

In short, petitioners have failed to prove that

they received or relied on the professional

advice of Mr. Baker and Mr. Mitchell with

respect to their erroneous section 166 bad debt

deduction in 2008.

Again, there is no clear error. Petitioners have not

rebutted the Tax Court’s finding that Petitioners failed to

prove that “the taxpayer provided necessary and accurate

information to the adviser.” DJB Holding Corp., 803 F.3d at

1030. Mitchell did not testify, and neither Petitioners nor the

Commissioner asked Baker any questions about the bad debt

22 COOPER V. CIR

or about any advice he may have given Petitioners on that

topic.

AFFIRMED.

KLEINFELD, Senior Circuit Judge, concurring in part and

dissenting in part:

I respectfully dissent. My dissent is directed only to

Section A, “Royalty Payments as Capital Gains.” I join in

Section B, “Bad Debt Deduction.” As for Section C,

“Accuracy Penalties,” whether and how the penalties would

apply would need to be revisited if my view on royalties were

to be accepted.

The majority errs because it dilutes the meaning of

“control” from the ability to compel a result to something less

and indeterminate. This puts us at odds with our only sister

circuit to rule on the matter, the Court of Claims in Charlson

v. United States.1 Both Charlson and the Commissioner’s

own regulations show the error of the majority’s approach.

The majority opinion accurately notes that in Charlson,

the corporation to which inventor Lynn Charlson transferred

his patent was owned by his “close friends and associates.”

Actually, they were more than close friends and associates:

three of the shareholders and directors were his employees,

1

525 F.2d 1046 (Ct. Cl. 1975) (per curiam); cf. S. Corp. v. United

States, 690 F.2d 1368, 1370–71 (Fed. Cir. 1982) (en banc) (adopting Court

of Claims opinions as binding precedent).

COOPER V. CIR 23

and the fourth was his personal attorney.2 As such, Charlson

could fire each of them if he disliked how they voted. The

corporation also “frequently sought, received, and followed

the recommendations of Charlson,”3 and Charlson and the

directors were “solicitous of each other’s individual interests

as well as their mutual interests.”4 The Commissioner argued

that the corporation, the directors of which had their

livelihoods subject to Charlson’s preferences, followed his

recommendations, and were solicitous of his personal

interests, was “controlled” by Charlson.5 And Charlson

certainly had more ability to influence than Cooper does.

Cooper cannot fire his sister-in-law and her friend from their

jobs.

Yet Charlson won his case. The Commissioner lost.6

Despite the evidence that the corporation did what Charlson

wanted, the Court of Claims concluded that he did not

“control” the corporation such that the transfer of patent

rights was not genuine. Today’s majority opinion quotes

Charlson’s statement that the “retention of control by a

holder of an unrelated corporation can defeat capital gains

treatment, if the retention prevents the transfer of all

substantial rights.”7 That language marks the boundary of

2

Charlson, 525 F.2d at 1048–49.

3

Id. at 1056.

4

Id. at 1055.

5

Id. at 1052.

6

Id. at 1057.

7

Id. at 1053 (internal quotation marks omitted).

24 COOPER V. CIR

capital gains treatment, but Charlson held that the boundary

was not crossed. Charlson had power over the corporate

directors—far more power than Cooper had over TLC’s

directors—but Charlson did not “control” the directors for the

purposes of § 1235.

The regulations make it clear that even though the

directors in this case are Cooper’s friends and relatives, that

does not amount to control or make TLC a “related” entity.

The regulations are at pains to say that even transferring

patent rights to a corporation controlled by one’s own brother

“is not considered as transferring such rights to a related

person.”8 Since a brother is not a “related person” for

§ 1235(c) purposes, neither is a sister-in-law or a friend of a

sister-in-law.

The majority correctly concedes that “[m]ere influence by

the patent holder is insufficient to defeat § 1235(a)

treatment.” But influence is all Cooper had. His authority

over Walters (his sister-in-law) and Coulter (a friend of

Walters and of Cooper’s wife) was considerably less than

Charlson’s authority over his employees. Cooper’s situation

is more like the one in Lee v. United States, where the transfer

put the taxpayer’s own longtime personal friend in charge.9

Yet in Lee, as in Charlson, the Commissioner lost. Lee held

that the issue of control is whether the taxpayer can “force”

the transferee to do his bidding.10 There is no evidence

whatsoever that Cooper had that power.

8

26 C.F.R. § 1.1235-2(f)(3); see 26 U.S.C. § 1235(c)(2).

9

302 F. Supp. 945, 948 (E.D. Wis. 1969).

10

Id. at 950.

COOPER V. CIR 25

Walters and Coulter, like the directors in Charlson, were

solicitous of Cooper’s and each other’s personal interests.

They did transfer a few patents to Cooper for no

consideration so that he could in turn transfer them to a

corporation in which his children had an interest. But

Walters and Coulter still owned 76% of the new corporation.

(Instead of Cooper and his wife owning 24%, Cooper and his

wife owned 1% and their children owned 23%.) And Cooper

was not the only one who benefitted from TLC. Walters and

Coulter each received $40,000 in director’s fees, and TLC

bought them long-term insurance policies worth $115,406

and $63,089, respectively. Cooper did not receive an

insurance policy.

Although the Commissioner argues that the patent

transfer benefitting Cooper’s children somehow breached a

fiduciary duty to TLC’s shareholders, that argument would

apply equally to the payments made to Walters and Coulter.

And it would be equally irrelevant. All that a breach of

fiduciary duty means is that Walters and Coulter, acting in

their capacity as shareholders, could theoretically sue

themselves in their capacity as directors. That unlikely

possibility does not show control. The core of the

Commissioner’s argument—that the directors knew nothing

about Cooper’s sophisticated inventions and simply followed

his instructions—does not show control. If anything, it shows

that there was no good reason for them to reject Cooper’s

recommendations, because it was his knowledge and skill that

generated millions in revenue, so he did not need control.

In distinguishing control from influence, our focus should

not be merely on whether TLC’s directors did what Cooper

wanted. There was no reason for them to do anything else.

Instead we must ask whether, as a practical matter, they could

26 COOPER V. CIR

have done otherwise. Cooper could have, but did not, set up

the corporation to retain control.

The most obvious way to control a corporation is to own

a majority of its stock. For example, owning 100% of the

stock defeated the tax benefits in the classic sham case

Gregory v. Helvering.11 However, Congress provided that a

patent holder cannot receive capital gains treatment if he

owns 25% or more of the corporation to which he transferred

his patents.12 That is why Cooper and his wife owned only

24% of TLC’s stock.

Minority shareholders may still control a corporation by

controlling its directors’ votes, and there are well-established

means by which Cooper might have done so. Those means

are often used in close corporations to protect minority

shareholders from oppression. One way to retain control is

to write the articles of incorporation to require a super-

majority so that no decision can be made without the minority

shareholders’ consent.13 Another is to establish a voting trust

so that the majority must vote their shares in line with the

minority’s preferences.14 A third means is to use classified

shares with the minority shares controlling the class that

chooses the directors.15 And a fourth is to contractually

obligate the directors to vote consistently with the minority

11

293 U.S. 465, 467–69 (1935).

12

26 U.S.C. § 1235(c)(1); see id. § 267(b)(2).

13

ROBERT C. CLARK, CORPORATE LAW 775 (1986).

14

Id. at 777.

15

Id. at 780.

COOPER V. CIR 27

shareholders’ preferences.16 This list is not exhaustive, of

course. But Cooper did not do any of these things. If he had,

then he would have genuinely controlled TLC, not just

influenced it.

Because Cooper’s inventions generated TLC’s revenue,

Walters and Coulter no doubt thought it was in TLC’s best

interest to accommodate Cooper and keep him productive.

But Cooper could not always count on Walters and Coulter to

do things his way. At some point, he would age out of his

peak productivity, meaning there would be less reason to

listen to him. Moreover, a change in circumstances could

always occur. As Professor Clark wrote in his treatise:

As time passes, the personal relationships

among the major participants in a close

corporation always change in important ways.

One of several participants will retire or die,

leaving a gap in a shareholding or managerial

role that might or might not be filled.

Participants who were once friendly to each

other will accumulate grudges. Some

participants will want to go on to other

ventures. Others will want to bring in new

associates, who may or may not be acceptable

to the others.17

If, for example, a buyout offer could enrich Walters and

Coulter but would end Cooper’s influence over TLC, that

might create conflict between the shareholders. Yet Cooper

16

Id. at 781–83.

17

Id. at 763.

28 COOPER V. CIR

would lack any power to make Walters and Coulter reject the

buyout. They would be multimillionaires and he would lose

his connection to his own inventions.

Because the majority opinion makes “control” a vague

and ambiguous term, it risks eviscerating § 1235 capital gains

treatment when transfers are made to close corporations.

Congress thought it was a good idea to give patent holders a

tax benefit, but the majority’s decision creates so much risk

of litigation that it may be a bad idea to claim the benefit. A

transfer to a corporation directed by the inventor’s employees

and attorney was good enough in Charlson.18 A transfer to a

corporation directed by one’s longtime friend was good

enough in Lee.19 And a transfer to a corporation controlled by

one’s own brother is good enough under the regulations.20

Yet now a transfer to a corporation controlled by one’s sister-

in-law and her friend is not good enough, even if the taxpayer

lacks any means to compel those directors to do his will.

Accordingly, it is not possible to say with confidence what

close corporation arrangement will qualify for capital gains

treatment.

In short, the majority opinion does not say how “control”

is distinct from “mere influence,” so mere influence of some

vague and indeterminate kind prevents capital gains

treatment. “Control” means the taxpayer can make the

transferee corporation do what he wants, while “influence”

means that although the corporation may defer to his

18

525 F.2d at 1048–49, 1057.

19

302 F. Supp. at 948, 950.

20

26 C.F.R. § 1.1235-2(f)(3).

COOPER V. CIR 29

judgment or be persuaded by his view, he cannot make the

corporation do what he wants. The better approach is the one

seen in Charlson and Lee: that “control” means the ability to

compel what the transferee corporation does.