Opinion
No. 88-2007.
Heard April 5, 1989.
Decided June 12, 1989. As Amended June 15, 1989.
Geoffrey J. O'Connor, for petitioners, appellants.
Teresa E. McLaughlin, Tax Div., Dept. of Justice, with whom James I.K. Knapp, Acting Asst. Atty. Gen., Gary R. Allen and Gilbert S. Rothenberg, Tax Div., Dept. of Justice, Washington, D.C., were on brief for respondent, appellee.
Appeal from the United States Tax Court.
Appellants, Walter and Renee Juda (Juda), appeal the Tax Court's determination that they are not entitled to capital gains treatment under 26 U.S.C. § 1235 for certain transactions involving the transfer of patents. We affirm with one minor modification.
This section reads in pertinent part:
(a) General. — A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 6 months, 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.
(b) "Holder" defined. — For purposes of this section, the term "holder" means —
(1) any individual whose efforts created such property, or
(2) any other individual who has acquired his interest in such property in exchange for consideration in money or money's worth paid to such creator prior to actual reduction to practice of the invention covered by the patent, if such individual is neither —(A) the employer of such creator, nor
(B) related to such creator (within the meaning of subsection (d)).
The appropriate holding time for capital asset treatment varied during the years relevant to this case from six months to one year; these changes are not, however, pertinent to this case. The Internal Revenue Service's regulations on § 1235 are set forth at 26 CFR §§ 1.1235-1, -2.
Juda has not appealed the Tax Court's ruling on two other issues involving the deductibility of fees and interest expenses.
FACTS
Our review of the facts found by the Tax Court is "only for the presence of clear error." Estate of Todisco v. Commissioner, 757 F.2d 1, 4 (1st Cir. 1985); see also Dennis v. Commissioner, 473 F.2d 274, 281-83 (5th Cir. 1973). We have reviewed the record in this case and found no clear error. We present only a synopsis of the facts; the full facts can be found in the Tax Court's opinion which will be published at 90 T.C. 1263.
Walter Juda is a limited partner in Cambridge Research and Development Group (Cambridge); his wife, Renee Juda, is a party to the suit only because they filed joint tax returns. Although the total deficiencies involved are less than $2,500, this is a test case involving Cambridge and its limited partners. Our decision, therefore, will impact on a number of other individuals.
Cambridge is a limited partnership formed in 1966 to own and develop products and ideas. Walter Juda joined as a limited partner in 1972. Originally, Cambridge licensed patent rights for inventions to corporations which were to develop and exploit the inventions commercially. Because of its dissatisfaction with the corporations' commercial development of the inventions, Cambridge changed its mode of operation. Starting in 1974, its modus operandi was as follows. Cambridge would first reach an agreement with the inventor regarding patent rights. Then, Cambridge would find an entrepreneur who was willing to be a general partner in a limited partnership involving that one invention. Cambridge would help the entrepreneur locate limited partners and capital. Finally, Cambridge would sell to the limited partnership the patent rights it had obtained from the inventor.
From 1974 to 1985, Cambridge organized individual limited partnerships around numerous inventions, three of which are relevant to this case: (1) the Fire Drill, a hydraulically-operated fire extinguisher; (2) the Gold Crown Discriminator, a device to enhance the functioning of hearing aids; and (3) the Cardiac Contraction Imager, which gives enhanced heart information from a routine chest x-ray. The contracts regarding the Gold Crown Discriminator and Cardiac Contraction Imager are not identical to the Fire Drill contracts, but they are, in relevant parts, essentially the same. Indeed, the parties have not argued that the differences are legally significant and the Tax Court did not distinguish between the contracts in its opinion. We, therefore, will not set forth the facts pertinent to the Gold Crown Discriminator and the Cardiac Contraction Imager. It is sufficient to say that they followed the same pattern as the Fire Drill. Although our focus is on the Fire Drill, its range encompasses the other two inventions.
We realize that the Tax Court made a factual distinction among the three inventions regarding the date of reduction to practice. Given our ultimate holding, however, this distinction is irrelevant.
In 1975, John Chatfield, Jr., received a patent for the Fire Drill. On May 13, 1976, Cambridge entered into an agreement with Chatfield concerning the Fire Drill patent. The entire agreement, which is set forth as an appendix to this opinion, can be synopsized as follows:
1. Chatfield transfers to Cambridge "all of the right, title and interest in and to the FIRE DRILL, the PATENT RIGHTS, and the KNOW-HOW to be held and enjoyed by CAMBRIDGE, its successors and assigns, as fully as the same would have been held and enjoyed by INVENTOR if this grant had not been made."
2. "CAMBRIDGE agrees to use its best efforts to aid in the commercialization of the FIRE DRILL such as by consummating a sale of the FIRE DRILL, the PATENT RIGHTS and the KNOW-HOW to the COMPANY." "THE COMPANY" is described as "a business organization such as a limited partnership or corporation who shall purchase all of the right, title, and interest in and to the FIRE DRILL, the PATENT RIGHTS, and the KNOW-HOW for the purpose of thereafter commercializing the FIRE DRILL."
3. "CAMBRIDGE'S liability to pay to INVENTOR the down payment and the purchase price balance payment shall arise only as and when payment to CAMBRIDGE is made by the COMPANY of the amounts negotiated for the down payment and purchase price balance."
4. "Upon execution of the Agreement, CAMBRIDGE shall continue, at its own expense, its exploration and evaluation of the FIRE DRILL and in this regard, shall examine the marketing and manufacturing aspects of the FIRE DRILL and its patent position, and the overall value of the FIRE DRILL as a new product to form the basis of the business of the COMPANY. CAMBRIDGE shall also carry on at its own expense such further technical development of the FIRE DRILL as it deems necessary or appropriate."
5. "CAMBRIDGE shall have the right, upon formation of the COMPANY and the successful consummation of the sale of the FIRE DRILL PATENT RIGHTS and KNOW-HOW to the COMPANY, to recover certain of its out-of-pocket expenses [including those of the activities described in paragraph 4] in connection with the transaction to the extent it is able to do so by negotiation with the COMPANY, and these expenses whether or not recovered from the COMPANY shall not reduce or be deducted from the down payment received from the COMPANY."
6. "CAMBRIDGE shall have the right to terminate this Agreement at any time if, based on its own judgment, the FIRE DRILL does not conform to its standards or criteria for the establishment of a successful venture based on the FIRE DRILL or if, in CAMBRIDGE'S judgment, the formation of the COMPANY will not be successfully completed."
7. "This Agreement shall terminate on December 31, 1976, unless the formation of the COMPANY has taken place on or prior to that date."
8. "If this Agreement is terminated either under paragraphs [6] or [7] above, then CAMBRIDGE shall reassign to INVENTOR all of the rights to the FIRE DRILL, the PATENT RIGHTS and the KNOW-HOW assigned by INVENTOR to CAMBRIDGE, free and clear of any liens or obligations of any nature whatsoever."
On October 1, 1976, Cambridge entered into an agreement with the partners of The American Fire and Industrial Products Company (AMFIRE), a limited partnership, for the sale of Cambridge's rights in the Fire Drill to the partners, who then contributed it to the partnership. In this agreement, Cambridge stated that it owned the patent rights to the Fire Drill and was selling those rights to the partners. The assignments of the patent — from Chatfield to Cambridge and from Cambridge to AMFIRE — were both recorded in the Patent and Trademark Office on November 23, 1976.
Based on the purchase and subsequent sale of the Fire Drill rights, Cambridge's partners, including Juda, treated the gain realized as capital gain under § 1235. The Commissioner of Internal Revenue disagreed and entered a deficiency. The Tax Court agreed with the Commissioner. It held that Cambridge did not "acquire" all substantial rights to the patent, but rather was acting like a broker or a middleman. As an alternative basis for its decision, the Tax Court held that Cambridge had not given "money or money's worth" in exchange for any rights it did acquire. With respect to the Gold Crown Discriminator and Cardiac Contraction Imager, the court held that any rights Cambridge acquired had not been acquired prior to the inventions' reduction to practice. Juda appeals each of these holdings.
While Cambridge itself is not entitled to such tax treatment since it is not an individual, the individual partners are. 26 CFR § 1.1235-2(d)(2).
DISCUSSION
In deciding whether a transferee acquired all substantial rights to a patent, the nomenclature in the agreement is not controlling, rather the entire agreement must be examined to see if in fact all substantial rights were transferred. E.I. du Pont de Nemours Co. v. United States, 432 F.2d 1052, 1055 (3d Cir. 1970) (collecting cases); Oak Mfg. Co. v. United States, 301 F.2d 259, 261-62 (7th Cir. 1962). "[T]he substance of each transaction should be looked to rather than the form in arriving at whether all substantial rights have been transferred." Kirby v. United States, 191 F. Supp. 571, 576 (S.D.Tex. 1960), aff'd, 297 F.2d 466 (5th Cir. 1961); see also Walen v. United States, 273 F.2d 599, 601 (1st Cir. 1959) ("a transaction is to be judged by its substance, and not by verbiage.").
Events subsequent to the execution of the transfer agreement at issue may be examined to determine the nature of what was being transferred. Kirby, 191 F. Supp. at 575-76. The intent of the parties may be a guide in determining the nature of the transfer. Oak Mfg. Co., 301 F.2d at 262. A transfer for less than the full life of the patent is not a transfer of all substantial rights. Wilkerson v. United States, 435 F.2d 845, 846 (3d Cir. 1970) (per curiam); Oak Mfg. Co., 301 F.2d at 263; 26 CFR § 1.1235-2(b)(1)(ii). Finally, we note that "the basic rule in all tax cases [is] that the burden of proof rests on the taxpayer." Estate of Todisco, 757 F.2d at 6. Although we have found no case involving similar facts, and the parties have cited none, we find that the general principles set forth supra amply support the Tax Court's holding.
The fact that the contract between Cambridge and the inventor uses the word "sale" is not controlling. What is controlling is the substance of the arrangement. Cambridge was not obligated to pay for the invention until it had located the end-purchaser and was paid by it. If no buyer could be found, the agreement and "sale" would lapse long before the expiration of the patent. Furthermore, while case law allows contingent payments to fit under the statute, the payment, in each case, was contingent on the amount received for sales or use of the patented product. See, e.g., Robishaw v. United States, 616 F.2d 507, 509, 222 Ct.Cl. 474 (1980) (royalties with respect to articles using the patented devices); Lockhart v. Commissioner, 258 F.2d 343, 349 (3d Cir. 1958) (amount of sales of patented product; case was decided under 26 U.S.C. § 117 prior to the date of applicability of § 1235); First Nat'l Bank of Princeton v. United States, 136 F. Supp. 818, 821-22 (D.N.J. 1955) (same). We have found no case in which the sales price, much less the sale, was contingent upon the resale of the patent rights themselves. Cambridge was not furthering the development of the invention, rather it was agreeing to use its best efforts to find someone else who would. Under such circumstances, Cambridge, though in form a buyer, was in substance a middleman or broker.
Kronner v. United States, 110 F. Supp. 730, 126 Ct.Cl. 156 (1953), a case that appellants describe as having "some strong factual similarities" to the present situation, involves the assignment of patent rights by an inventor to the manufacturer of the product, not the assignment of rights to a party for the sole purpose of resale to someone else.
Events subsequent to the inventor-Cambridge contract bolster our conclusion. The recording of the patent assignments in the Patent and Trademark Office (PTO) from the inventor to Cambridge and from Cambridge to the end-purchaser was done on the same day and long after Cambridge bought the patent rights. Under 35 U.S.C. § 261, patents are "assignable in law by an instrument in writing," but an assignment is void as against subsequent bona fide purchasers unless it is recorded in the PTO within certain time periods. The timing of the recording of the assignments is additional evidence that the agreement between the inventor and Cambridge was not intended as a final sale to Cambridge but was wholly contingent upon a resale to an investor. Furthermore, as per the contract, Cambridge paid for the inventor's patent with part of the money it received from the end-purchaser. The difference between Cambridge's payment to the inventor and Cambridge's payment from the end-purchaser was its profit.
Juda argues that two facts show that Cambridge acquired the patents. First, he points out that under the contract, it was Cambridge that actually paid the inventor and that the contract speaks in terms of sales. This, however, is irrelevant once the substance of the arrangement is examined. Cambridge was merely a conduit for the funds to flow through. It was the end-purchaser who effectuated the congressional purpose of financing the development of inventions, not Cambridge. Second, Juda argues that since Cambridge was the party in control of both the inventor-Cambridge contract and the negotiations with the end-purchaser, it could not be an agent or broker. This recognizes the power of a patent broker; it does not change Cambridge's status to that of a patent holder.
As the Tax Court noted, the record is devoid of any indication "that Cambridge ever intended to exploit the patents in any way other than through a subsequent sale to another company." In this context, it is unnecessary to decide whether Cambridge was in fact the inventor's "agent." It is enough to determine that Juda failed to meet his burden of showing that Cambridge acquired — and, hence, "transfer[red]" — "all substantial rights" to the patents at issue. Given all these considerations, we see no clear error in the Tax Court's finding that Cambridge did not acquire "all substantial rights."
Given this holding, we need not reach the alternative bases given by the Tax Court for its decision.
The Commissioner concedes that the amount of the deficiency for 1977 was incorrectly entered and that it should have been $526, not $546. We, therefore, modify the 1977 deficiency to reflect the correct amount. In all other respects, the opinion of the Tax Court is
Affirmed.