Judges: "Foley, Maurice B."
Attorneys: Ronald J. Cohen and David S. Schwan , for petitioners. Frank J. Jackson and Karen A. Rennie , for respondent.
Filed: Dec. 18, 2006
Latest Update: Dec. 05, 2020
Summary: T.C. Memo. 2006-267 UNITED STATES TAX COURT NATHANIEL H. AND CAROL A. GARFIELD, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 4017-05. Filed December 18, 2006. Ronald J. Cohen and David S. Schwan, for petitioners. Frank J. Jackson and Karen A. Rennie, for respondent. MEMORANDUM FINDINGS OF FACT AND OPINION FOLEY, Judge: The issues for decision are whether income received by petitioners should be treated as ordinary income or long-term capital gain and whether petitioners
Summary: T.C. Memo. 2006-267 UNITED STATES TAX COURT NATHANIEL H. AND CAROL A. GARFIELD, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 4017-05. Filed December 18, 2006. Ronald J. Cohen and David S. Schwan, for petitioners. Frank J. Jackson and Karen A. Rennie, for respondent. MEMORANDUM FINDINGS OF FACT AND OPINION FOLEY, Judge: The issues for decision are whether income received by petitioners should be treated as ordinary income or long-term capital gain and whether petitioners ..
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T.C. Memo. 2006-267
UNITED STATES TAX COURT
NATHANIEL H. AND CAROL A. GARFIELD, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4017-05. Filed December 18, 2006.
Ronald J. Cohen and David S. Schwan, for petitioners.
Frank J. Jackson and Karen A. Rennie, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
FOLEY, Judge: The issues for decision are whether income
received by petitioners should be treated as ordinary income or
long-term capital gain and whether petitioners are liable for the
section 66621 accuracy-related penalty.
1
Unless otherwise indicated, all section references are to
(continued...)
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FINDINGS OF FACT
On June 1, 1969, Nathaniel Garfield and Thomas McSherry
formed McSherry Associates, LP (the partnership), a New York
limited partnership. The purpose of the partnership was to
finance, research, and develop a variety of mechanical patents.
Mr. McSherry, the general partner, had a 51-percent equity
interest, and Mr. Garfield, after making an initial $25,000
contribution, was a limited partner with the remaining 49-percent
equity interest. On July 10, 1969, Thomas McSherry filed an
application with the U.S. Patent Office for his invention, the
expansible fastener. At the time of his application, Mr.
McSherry also recorded an assignment to the partnership of all
patent rights relating to the expansible fastener.
On September 18, 1970, Mr. McSherry and Mr. Garfield
incorporated Mechanical Plastics Corp. (MPC). Upon formation of
the corporation, the partnership owned 74 shares of MPC stock,
and J. Wolfe Golden, another investor, owned the remaining 26
shares. On September 22, 1970, Mr. McSherry signed an employment
agreement with MPC providing him with an annual salary and
royalties relating to his inventions. Also on that date, MPC’s
board of directors held a special meeting at which they executed
1
(...continued)
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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a shareholders’ agreement. The shareholders’ agreement
delineated the shareholders’ rights and restricted the transfer
of company stock.
On October 10, 1970, the partnership and MPC executed an
assignment agreement, which assigned the rights to the expansible
fastener (i.e., for which a patent application was pending) from
the partnership to MPC. In consideration of the transfer of
patent rights, MPC was obligated to make payments to the
partnership of 4 percent of the gross proceeds from the sale of
expansible fasteners.
On October 10, 1970, the partnership dissolved. Thereafter,
Mr. McSherry owned 38 percent, and Mr. Garfield owned 36 percent
of MPC shares. Pursuant to the dissolution agreement, all shares
of MPC owned by the partnership were distributed to Mr. McSherry
and Mr. Garfield. The dissolution agreement further provided
that Mr. McSherry and Mr. Garfield would each receive 50 percent
of MPC’s payments due to the partnership. In addition, the
assignment agreement provided that, upon dissolution of the
partnership, payments relating to the expansible fastener were to
be made directly to Mr. McSherry and Mr. Garfield.
On March 28, 1972, the U.S. Patent Office granted the patent
for the expansible fastener, and, thereafter, Mr. McSherry and
Mr. Garfield began to collect royalty payments from the sales of
the device. From 1978 through 1985, petitioner and Mr. McSherry
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made joint assignments to MPC of the rights relating to various
inventions (i.e., for which patent applications were pending).
Petitioners timely filed their joint Federal income tax
returns relating to 2000, 2001, and 2002. On December 2, 2004,
respondent issued petitioners a notice of deficiency in which he
determined that income reported by petitioners as long-term
capital gain (i.e., in the amounts of $247,977, $224,962, and
$339,560 relating to 2000, 2001, and 2002, respectively) was
ordinary income. Respondent further determined that petitioners
were liable for a section 6662 penalty relating to 2000, 2001,
and 2002.
On March 1, 2005, petitioners, while residing in Purchase,
New York, filed their petition with the Court.
OPINION
Petitioners contend that, pursuant to section 1235, income
reported by petitioners in the amounts of $247,977, $224,962,
and $339,560 relating to 2000, 2001, and 2002, respectively,
qualifies for long-term capital gain treatment. Section 1235(a)
provides that a transfer of property consisting of all
substantial rights to a patent is considered a sale or exchange
of a capital asset held for more than 1 year (i.e., a long-term
capital asset), regardless of how long the transferor actually
held the rights to the patent. Long-term capital gain
treatment, however, is not available pursuant to section 1235 if
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such a transfer is made to a related person as defined in
section 267(b). See sec. 1235(d). For purposes of section
1235, a corporation and an individual owning more than 25
percent of such corporation are related persons. Sec.
267(b)(2).
The patent rights to the expansible fastener were
transferred to the partnership by Mr. McSherry on July 10, 1969,
the same date that he filed an application with the U.S. Patent
Office. On that date, Mr. Garfield was an equity partner in the
partnership but did not hold any patent rights associated with
the expansible fastener. Mr. Garfield transferred all of his
patent rights to MPC after October 10, 1970. On that date, and
thereafter, Mr. Garfield had a 36-percent interest in MPC.
Because Mr. Garfield owned more than 25 percent of the stock of
MPC, he and MPC were related persons. Secs. 267(b)(2),
1235(d)(1). Thus, pursuant to section 1235, royalty payments
from MPC to Mr. Garfield do not qualify for long-term capital
gain treatment. Petitioners contend that Mr. Garfield and Mr.
McSherry signed a forbearance agreement in 1969 that transferred
to the partnership all substantial rights to any patents; that
this transfer qualifies for long-term capital gain treatment
pursuant to section 1235(a); and that upon formation of MPC in
1970, the terms of the purported forbearance agreement carried
over to the shareholders of MPC, thereby qualifying the reported
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income for capital gain treatment pursuant to section 1235. We
reject petitioners’ contentions because there is insufficient
credible evidence to establish the existence of a forbearance
agreement.
Petitioners further contend that if capital gain treatment
is not available pursuant to section 1235, then the payments are
entitled to such treatment pursuant to sections 1221 and 1222.
Section 1.1221-1(c)(1), Income Tax Regs., provides that a patent
may qualify as a capital asset. In order to qualify for long-
term capital gain treatment, however, a taxpayer must hold his
capital asset for the requisite period prior to a sale or
exchange. Sec. 1222(3). At no time during the existence of the
partnership did Mr. Garfield hold a capital asset. Mr. Garfield
and Mr. McSherry did make joint transfers of patent rights to
MPC between 1978 and 1985, but Mr. Garfield did not hold the
patent rights for the requisite period to qualify for long-term
capital gain treatment. Accordingly, we sustain respondent’s
determination.2
Section 6662(a) imposes a penalty equal to 20 percent of
the amount of any underpayment attributable to a substantial
2
Pursuant to sec. 7491(a), petitioners have the burden of
proof unless they introduce credible evidence relating to the
issue that would shift the burden to respondent. Rule 142(a).
Our conclusions, however, are based on a preponderance of the
evidence, and thus the allocation of the burden of proof is
immaterial. See Martin Ice Cream Co. v. Commissioner,
110 T.C.
189, 210 n.16 (1998).
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understatement of income tax. Sec. 6662(b)(2). An
understatement is the amount by which the correct tax exceeds
the tax reported on the return. Sec. 6662(d). The
understatement is substantial if it exceeds the greater of
$5,000 or 10 percent of the tax required to be shown on the
return. Sec. 6662(d)(1)(A)(i) and (ii). Petitioners
erroneously reported income resulting in understatements of tax
of $48,603, $40,497, and $37,442 for 2000, 2001, and 2002,
respectively.
An understatement is reduced by the portion of the
understatement that is attributable to the tax treatment of an
item for which there is substantial authority or with respect to
which there is adequate disclosure and a reasonable basis. See
sec. 6662(d)(2)(B); sec. 1.6662-4(a), Income Tax Regs.
Petitioners did not have substantial authority for their
position, nor did they adequately disclose their position. No
reduction, therefore, is appropriate.
Section 6664(c)(1) provides that no penalty shall be
imposed if a taxpayer demonstrates that there was reasonable
cause for the underpayment and the taxpayer acted in good faith.
The determination of whether a taxpayer acted with reasonable
cause and in good faith depends upon the facts and
circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs.
Petitioners do not contend that they followed, or even sought,
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the advice of a tax professional. We conclude that petitioners
did not act with reasonable cause when they characterized the
royalty payments as long-term capital gains. As a result,
petitioners are liable for the section 6662(a) accuracy-related
penalty.
Contentions we have not addressed are irrelevant, moot, or
meritless.
To reflect the foregoing,
Decision will be entered
for respondent.