Royalties From Related Party Are Ordinary Income

The Second Circuit Court of Appeals affirmed the Tax Court’s decision that an individual’s receipt of patent royalties was ordinary income, not long-term capital gain, because the payments were made in exchange for patent rights transferred to a related corporation.

Nathaniel Garfield was a limited partner in a partnership that was majority owner of a corporation. In 1969, his general partner, Thomas McSherry, filed a patent application for an expansible fastener and the same day assigned the related patent rights to the partnership. Subsequently, the partnership transferred the patent rights to the corporation, which paid royalties to Garfield and McSherry. The IRS in 2004 notified Garfield of deficiencies in returns for 2000 through 2002 stemming from more than $800,000 in royalties for the three years that it said Garfield erroneously characterized as longterm capital gain.

Garfield pointed to section 1235(a), which provides that a property transfer of all substantial rights to a patent is treated as a sale or exchange of a long-term capital asset. However, the Tax Court rejected this argument because under subsection (d), the treatment is not available if the transfer was between a corporation and a related party— in the case of patent rights, a more-than- 25% owner. Garfield held a 36% interest in the corporation and, before that, the partnership had held a 74% interest.

Alternatively, Garfield argued that the patent was a capital asset and that the royalty payments were long-term capital gains under sections 1221 and 1222. The courts rejected this argument also, on the basis that Garfield did not hold any patent right for more than one year as required. In addition, the courts upheld a 20% substantial underpayment penalty under section 6662(a). The Tax Court said that grounds for an exception for reasonable cause and acting in good faith were not evident where Garfield and his wife “do not contend that they followed, or even sought, the advice of a tax professional.” The Second Circuit upheld the penalty while acknowledging the returns were signed by a law firm.

n Nathaniel H. Garfield v. Commissioner, TC Memo 2006-267, aff’d, 102 AFTR2d 2008-5803 (2d Cir. 2008)

By Jean T. Wells, CPA, J.D., assistant professor of accounting, Howard University, Washington, D.C.