One of the cool things about tax planning is that you can do everything as required by the letter of the law, and yet the IRS can still tear the entire thing apart. Did I say cool? I meant terrifying.

To wit: let’s say you are the inventive type, and you’ve dreamed up an idea for a company that makes computers or, failing that,  a computer that makes companies. You rush off to the patent office and stake legal claim to your invention.

If you see start licensing your patent and collecting royalties, the royalties will be treated as ordinary income. You’d prefer not to pay up to 39.6% in federal tax on your hard-earned income, however, so you seek out the advice of a tax professional.

The professional then points you towards Section 1235 of the Code, which provides that if you transfer (i.e., sell or contribute to a corporation or partnership)  ”all substantial rights” to a patent, any payments you receive as consideration for the transfer–whether the payments are made as a lump sum or in a series of payments as the transferee uses the patent–are treated as long-term capital gain.

If that second type of payment sounds a lot like a royalty, it’s because that’s exactly what it is. So if we put this all together, with proper tax planning, you can convert royalty payments generated by a patent from ordinary income to capital gain by first giving up all of your rights to the patent by selling or transferring it to another party, and then have that party make payments to you as it uses the patent.

There’s a catch of course. You can’t just dump the patent into a corporation owned by you and then have the corporation pay you royalties that you report as capital gain. That would be a bit too easy. As a result, Section 1235(d) provides that transfers between “related parties” are not eligible for favorable capital gain treatment. For these purposes, a person is treated as related to a corporation if he owns 25% or more of the corporation’s stock.

So taking that all into consideration, you hatch the following plan: you form a corporation, but take care to take back only 24% of the corporation’s stock in exchange for your contribution of your patent. To fill out the remaining 76% ownership, you find any number of loyal lackeys: friends, in-laws, co-workers, etc… You explain to them that all they have to do is invest a nominal amount in the corporation at its formation in exchange for their stock (an amount which you’ll likely float them behind the scenes) and from there, you’ll handle all of the heavy lifting.

Because the other shareholders are, you know…shareholders, they will vote on all corporate affairs. Because they possess no real skills related to your invention and patent, however, they’ll vote the way you tell them to. And that will be the extent of their involvement in your corporation.

So now, your patent is sitting inside a corporation, and you own only 24% of that corporation’s stock. You have complied with all of the formal requirements of Section 1235 in form, if not in spirit. As a result, when the corporation uses the patent and pays you royalties in the future, you will report the royalties as long-term capital gain.

If you find my example a bit far-fetched, understand that this is exactly what happened in Cooper v. Commissioner, decided yesterday by the Tax Court. In Cooper, the taxpayer, under an identical set of facts to our hypothetical above, certainly shared the sentiment that he had done everything necessary to procure long-term capital gain treatment. The IRS, however, had different ideas.

The Service argued that even though in form, the taxpayer owned only 24% of the corporate stock, because the other shareholders were hand-picked figureheads who served no purpose other than to gobble up 76% of the corporation’s ownership, the taxpayer truly owned all of the corporate stock, and thus he didn’t transfer “all substantial rights” to the patent to an unrelated corporation.

To settle the dispute, the Tax Court was left with an issue of first impression regarding Section 1235: can a shareholder who formally owns only 24% of a corporation’s stock be treated as effectively “controlling” the corporation, denying the ability of the shareholder to convert royalties on a transferred patent into long-term capital gain?

The answer, the court determined, was a resounding yes. In Cooper, just like in our hypothetical, the other shareholders added no skill, no experience, no expertise; instead, they were merely placeholders to permit the taxpayer to keep his interest at 24%. Sure, they voted, but they voted as directed by the taxpayer, and often voted in a manner that an independent thinking shareholder looking out for the best interests of the corporation would not. For example, the majority shareholders in Cooper allowed the corporation to distribute valuable patents to the taxpayer without any consideration, and also willingly signed stock restriction agreements without being compensated.

Based on these facts, the Tax Court concluded that even though in form the taxpayer owned only 24% of the corporation, in substance he controlled the entire entity. As a result, when he transferred the patent to the corporation, he did not give up all substantial rights to the patent because he effectively owned 100% of the patent before and after the transfer. This retention of control, the Tax Court stated, meant the taxpayer failed to meet the requirements of Section 1235, and thus was required to treat the royalty payments received from the corporation as ordinary income.

The lesson, of course, is that when it comes to tax planning, meeting the form of the statute is only half the battle. The IRS can also look through to the substance of the transaction, and undo all of that carefully-considered tax planning.

Follow along on twitter @nittigrittytax

 

This article was written by Tony Nitti from Forbes and was legally licensed through the NewsCred publisher network.