In a recent appellate decision from the Ninth Circuit, a taxpayer/attorney/neurosurgeon/corporate shareholder who helped develop a patented imaging technology was held liable for ordinary income assessments with respect to annual royalty payments related to patent royalty income.
Facts
Dr. Aaron Filler, a licensed attorney and neurosurgeon, contributed to the development of a certain Diffusion Tensor Imaging (“DTI”) technology. DTI involved a magnetic resonance imaging technique that allowed doctors to visualize nerve tissue in the brain. This technology was developed by Dr. Filler together with his colleagues while attending his residency in London in 1992. In 1996, Dr. Filler, together with his colleagues, acquired a patent for DTI (“360 Patent”) and formed a NeuroGrafix, Inc. (“NGI”) in 1998 to hold the patent. Over the next few decades, Dr. Filler filed approximately twenty patent infringement claims against corporate and governmental entities with respect to the 360 Patent and DTI. The Court noted that while many of the cases settled, no such defendant in any of the cases ever stipulated to actual infringement of the 360 Patent and no court ruled in Dr. Filler’s favor.
With respect to his 2014 tax return (amended), Dr. Filler claimed a $1.95 million net operating loss (“NOL”). Dr. Filler argued that the governmental infringement, by the State of California, during the years of 2001 through 2013, resulted in an involuntary conversion, thus causing a loss for Dr. Fuller with respect to his NGI shares. The IRS assessed $661,367 in a notice of deficiency and subsequently assessed accuracy-related penalties in the amount of $122,273. In the preceding Tax Court Case, Dr. Filler argued (1) the NOL should be respected as declared, (2) the characterization of his royalty income should be long-term capital gains, not ordinary income, and (3) the accuracy-related penalty should not apply.
Analysis
NOL Claims
Under Section 165 of the Internal Revenue Code (“Code”), taxpayers are allowed to take a deduction for losses “sustained during a taxable year and not compensated for by insurance or otherwise.” Dr. Filler argued that the patent infringement resulted in losses with respect to his NGI shares. Unfortunately for Dr. Filler, Section 165 applies in a rather specific fashion. Dr. Filler neither sold nor exchanged his shares. Citing to a prior case in the same circuit, the Court stated “diminution in the value” of a capital asset is insufficient to declare a capital loss.[1] Thus notwithstanding any diminution in value or infringement resulting in less income or less value for Dr. Filler, he was not entitled to any such loss under Section 165.
Dr. Filler also argued “involuntary conversion” with respect to California’s alleged infringement. His argument was based on a Fifth Amendment taking by inverse condemnation. In using this argument, he characterized such as a casualty loss in the amount of severance damages to his NGI shares.[2] Notwithstanding his claims, the Court noted that his arguments ultimately failed, as a casualty loss was inapplicable as a matter of law due to the fact Dr. Filler’s NGI shares were “connected with a trade or business.” Further, the Court noted that casualty losses, specifically the “other casualty” provision of Section 165(c)(3), related only to “physical damage or loss of the physical property.”[3] Even more unfortunate for Dr. Filler, the Supreme Court had previously ruled that patent infringement does not constitute a Fifth Amendment taking.[4] In closing, the Court noted that because the record did not support Dr. Filler’s claims, as no court had made a finding of any patent infringement anyway, the Tax Court lacked jurisdiction lacked jurisdiction to adjudicate the issue.
Ordinary Income Characterization of Royalty Income
Dr. Filler argued that Section 1235 applied to characterize his royalty income, relating to the 360 Patent, as long-term capital gains. Section 1235 authorizes capital gains treatment of money received as consideration for the transfer of “all substantial rights to a patent.” Dr Filler also cited to Sections 1222 and 1231, which permit capital gains treatment of proceeds from the sale of capital assets held for more than one year.
Once again, unfortunately for Dr. Filler, none of the cited provisions applied. The Court more or less said “hard no” on Sections 1222 and 1231, as such were “facially inapposite,” as Dr. Filler held the patent for only 14 days and merely served as an intermediary to facilitate transfer for NGI. Section 1235 did not provide relief either as NGI and Dr. Filler were related parties under Section 1235(c) (i.e. a shareholder owning 25% or more of a corporation’s stock). Dr. Filler owned 75% and such was undisputed. Under Section 1235(a), a transfer of all substantial rights to a patent is treated as a sale or exchange of a capital asset held greater than The reasoning here was that Section 1235(c) provides that the general rule under Section 1235(a) does not apply to related parties, such as Dr. Filler and NGI.
Accuracy-Related Penalties
Dr. Filler did not go home losing on all fronts. He did prevail with respect to his accuracy-related penalties. The IRS assessed accuracy related penalties, in the amount of 20%, with respect to his underpayment.[5] However, there was an exception to this penalty where a taxpayer had “reasonable cause for their position and acted in good faith.”[6] Dr. Filler claimed he relied on IRS correspondence (Form 4549), signed by a revenue agent, when claiming his NOL.[7]
While Dr. Filler was found by the Tax Court to have offered no evidence to support his assertion, the Court noted that during oral arguments, counsel for the government did not dispute the fact that Dr. Filler submitted the form to the Tax Court, suggesting that its omission was inadvertent. The Court extended a bit of relief to Dr. Filler on this front, vacating the accuracy-related penalties with respect to the claimed NOL.
Closing
While this case . It does serve as a reminder of a few rules relating to capital assets, losses, and penalties. On its face, the case may not have presented the prettiest of facts, but the case shows that it is worth diving into the facts a bit to see what relief might be found, even if a taxpayer is substantively drawing the short straw. While Dr. Filler did leave with what is not an insubstantial tax bill, he did find some level of relief by his reliance on prior IRS communications in the Form 4549.
[1] See Sunset Fuel Co. v. U.S., 519 F.2d 781, 783 (9th Cir. 1975).
[2] See IRC Section 165(c)(3).
[3] Pulvers v. Comm’r¸ 407 F.2d 838, 838-40 (9th Cir. 1969).
[4] See Schillinger v. U.S., 155 U.S. 163, 168 (1894).
[5] IRC § 6662(b)
[6] IRC § 6664(c)(1)
[7] The case at issue did not directly specify to which year the Form 4549 applied, but it is understood by the author that this Form 4549 related to a prior tax year.
