“You Know What I Meant”
In order to determine the income tax consequences of a given transaction, a court must sometimes ascertain the intention of the taxpayers who were parties to the transaction. In making its determination, the court will consider all of the relevant facts and circumstances, including the terms of any written agreement between the parties, the tax returns filed by the parties, the parties’ testimony and actions, and other indicia of intent.
In prior posts, we have discussed situations in which a court had to evaluate whether a transaction constituted a loan or a contribution to capital, a gift or an arm’s-length transfer, compensation or a loan, a sale or a lease, an option or a sale, etc. We have considered the capacity in which one or more parties to a transaction were acting; for example, as a shareholder or as a representative of a corporation, as an employee or as an individual, as a corporate officer or as a parent.
Depending upon the characterization of the transaction, and the identity of the parties, a taxpayer may have to recognize ordinary income or capital gain, or they may have no immediate taxable event at all.
Too often, however, and especially in the context of dealings involving a closely held business, the parties to the transaction – which may include the settlement of a dispute – will fail to set forth their agreement in sufficient detail, including its intended tax treatment.[i]
An unscrupulous party may seek to exploit any ambiguity for its own benefit by taking a position that is inconsistent with the parties’ implicit agreement or understanding, whether from a tax perspective or otherwise.
Alternatively, a taxing authority may rely upon an ambiguity to interpret an agreement and its tax consequences in a way that is inconsistent with a party’s tax return position.
Either way, at least one of the parties risks an economic loss.
A Recent Illustration
Employer provided business-to-business lead generation services for its clients.
Under Taxpayer’s initial employment contract, Employer paid Taxpayer both a salary and a commission. Under the terms of the contract, Taxpayer’s salary was reduced over time, the expectation being that his commissions would represent a greater portion of his pay as he settled into his position. At the same time, Taxpayer’s commission rate also decreased over time, thus creating an incentive for Taxpayer to sign new clients. Taxpayer and Employer later modified his compensation structure, forgoing any salary in favor of straight commission payments.
After being hired, Taxpayer began to design a method by which a business could allocate leads and target marketing efforts more effectively (the “IP”). Taxpayer filed a provisional patent application for the IP; after Employer waived any rights it had in the IP, Taxpayer filed a regular patent application.
Taxpayer used the IP to secure several important accounts for Employer. He was not involved in managing the accounts after he secured them.
A couple of years into their relationship, Taxpayer and Employer signed a broker agreement under which Taxpayer was no longer an employee of Employer but, instead, a broker acting on Employer’s behalf through Taxpayer’s wholly-owned S corporation (“Corp”). Under this agreement, Taxpayer continued to receive a commission from new account billings, but only for three years from the date on which Employer’s work on an account originated.
PC Wants the IP
At some point, Employer’s parent company (“PC”) began to consider a sale of Employer. In preparation for the sale of Employer, PC sought to obtain, and approached Taxpayer about acquiring, the rights to the IP.
As it turned out, Taxpayer needed cash to support another venture, so he was amenable to a transfer. He proposed two options: (1) he would license the IP to PC and receive royalties, which would increase once the patent was awarded; or (2) he would assign all rights in the IP to PC, in exchange for an extension of his commissions[ii] from certain accounts (the “Accounts”).
Taxpayer executed an assignment of the IP to PC. At the same time, Taxpayer and PC executed a written addendum to his commission structure (the “addendum”) that extended the period during which Taxpayer would receive commissions from the Accounts.
The addendum also provided that, in the event PC terminated its relationship with Taxpayer, PC would “pay the equivalent of one month’s commission (based on the average of the most recent 12 months of commissions) for each year of service provided.” Neither party consulted a lawyer in connection with the transfer of the IP or the addendum.
During the taxable year in issue, Taxpayer received commissions from the Accounts, and Employer issued a Form 1099-MISC, Miscellaneous Income, to Corp reporting a payment of nonemployee compensation.
One year later, PC terminated its broker relationship with Corp as it prepared to file for bankruptcy. Taxpayer filed a proof of claim in PC’s bankruptcy case for severance pay.
Taxpayer reported only $400 of long-term capital gain[iii] on his Form 1040, U.S. Individual Income Tax Return for the year in issue. Corp reported over $1.3 million of total income[iv] on its Form 1120S, U.S. Income Tax Return for an S Corporation.
Later, however, Taxpayer and Corp amended their respective returns: Taxpayer reported over $800,000 of long-term capital gains and attributed them to the transfer of the IP; Corp reduced its reported total income by the same amount, on its Form 1120S, which resulted in a loss for the tax year.
The IRS questioned whether the payments to Taxpayer, attributable to the above-referenced addendum, were made in consideration for the transfer of the IP; it asserted that the payments actually represented commissions that were taxable as ordinary income. The IRS issued a notice of deficiency, and Taxpayer petitioned the U.S. Tax Court.
Classification of Income
The question before the Court was whether any of the payments under the addendum were in exchange for Taxpayer’s assignment of the IP, or were owed to Corp under its broker agreement.
The Court began its analysis by reviewing Section 1235 of the Code https://www.law.cornell.edu/uscode/text/26/1235 , which provides that the “transfer * * * of property consisting of all substantial rights to a patent * * * by any holder[v] shall be considered the sale or exchange of a capital asset held for more than 1 year.”[vi] This treatment, the Court observed, applies regardless of whether payments in consideration of the transfer are payable periodically or are contingent on the productivity, use, or disposition of the property. Moreover, the patent need not be in existence at the time of transfer if the requirements of Section 1235 are otherwise met.[vii]
According to the Court, the term “all substantial rights to a patent” means “all rights * * * which are of value at the time the rights to the patent * * * are transferred.”
In determining whether all substantial rights in the IP were transferred, the Court stated that it would consider “[t]he circumstances of the whole transaction, rather than the particular terminology used in the instrument of transfer.”
The Court noted that the IRS did not dispute that the IP was transferred, or that the transfer of the IP met the requirements of Section 1235. However, the IRS disputed that the payments attributable to the addendum were made in consideration for that transfer; without that direct nexus, the payments would not be treated as long-term capital gain under Section 1235.
Turning to the addendum, the Court stated that “[t]he cardinal rule in the interpretation of contracts is to ascertain the mutual intention of the parties.”
It then added that, under applicable State law, the Court would limit the scope of its search to the four corners of the document if its terms were “clear and unambiguous.” Where the terms of the document were unclear or ambiguous, the Court “may consider extrinsic evidence as well as the parties’ interpretation of the contract to explain or clarify the ambiguous language.” The parties’ construction of ambiguous terms in a contract, the Court added, “is entitled to great weight in determining its meaning.”
The Court found that the text of the addendum was susceptible of more than one interpretation.
The IRS’s Position
The IRS contended that the payments under the addendum were not consideration for the IP but, rather, for some other purpose, and that Taxpayer was compensated for the IP – which the IRS argued had little to no value – in some other way. First, the IRS pointed out that there was no reference in the addendum to the transfer, Taxpayer did not retain a security interest in the IP, and the addendum included several provisions that were standard in a commission agreement. Second, the IRS argued that the circumstances surrounding the addendum did not support Taxpayer’s claim; specifically, the IRS asserted that the addendum was executed before Taxpayer’s discussion with PC about transferring the IP. And third, the IRS argued that the form of the transaction did not support Taxpayer’s claim because both PC (on a Form 1099-MISC) and Taxpayer (on his tax return) initially reported the payments as nonemployee compensation to Corp, rather than as consideration for the IP; according to the IRS, Taxpayer should escape the tax consequences of his chosen form.[viii]
The Court Disagrees
The Court acknowledged that there was no explicit reference to the transfer of the IP in the addendum, and the date on the addendum seemed to support the IRS’s contention that the addendum was signed before and, therefore, was independent of the Taxpayer’s discussions about the transfer of the IP.
However, the Court believed that PC’s representative credibly testified that she approached Taxpayer about the transfer of the IP in the year immediately preceding the year in which the addendum was executed. She and Taxpayer also credibly testified that they understood the addendum to be consideration for the rights to the IP. The Court believed it was significant that the parties to the addendum conceived of it in the same way.
The Court turned next to the date the addendum was signed, commenting that it was possible that the addendum was signed in contemplation of some sort of transfer. In any event, in the context of the other evidence, in particular the credible testimony of key participants in the transaction, the Court stated that it could not decide that the date on the addendum foreclosed a conclusion that PC agreed to pay the additional amounts under the addendum in exchange for the IP.
The IRS also argued that the addendum was some kind of “makeshift noncompete agreement,” rather than consideration for the rights to the IP, and that PC compensated Taxpayer for those rights in some other way.
However, Taxpayer had no involvement with the Accounts after securing them for Employer, and the Court found no evidence that Taxpayer had the desire or the capacity to manage the Accounts himself. Furthermore, the record showed that PC assigned some value to the IP – it sought to acquire the IP from Taxpayer, not a noncompete agreement. For this reason, the Court also rejected the IRS’s theory that the IP had only nominal value to PC. The Court was also convinced that PC wanted something in return for the additional payments under the modified addendum, and the only valuable consideration remaining was the IP.
Therefore, the Court found that the addendum provided for additional payments in exchange for Taxpayer’s transfer of all his rights in the IP to PC (notwithstanding that the amount of such payments was determined by reference to a formula that had been used to calculate the Taxpayer’s commission for services rendered).
The Court also found that Taxpayer’s failure to retain a security interest was a reflection of the parties’ circumstances as they were discussing the transfer rather than evidence that the addendum constituted an ordinary commission or noncompete agreement. Both Taxpayer and PC were focused on transferring the IP as soon as possible – Taxpayer wanted cash to invest in a new venture, and PC wanted to obtain the rights before PC was sold.[ix]
Thus, the Court concluded that Taxpayer’s transfer of the IP to PC met the requirements for long-term capital gain treatment under Section 1235 of the Code. Because the payments on the Accounts attributable to the addendum were consideration for the rights to the IP, those payments were properly classified as long-term capital gains.
“That’s Not What You Said”
Taxpayer had a close call. The addendum did not refer to the transfer of the IP. It did refer to the commission payments on the Accounts, which had previously been treated as ordinary income to Taxpayer. Employer issued a 1099-MISC to Corp, reporting non-employee compensation, and Taxpayer and Corp initially filed their respective income tax returns consistently therewith. Neither party to the addendum sought an appraisal of the IP. Finally, it should be noted that, by the time of the Tax Court proceeding, the patent application had been abandoned, presumably by PC, which may have been an indication of its value.
It appears that Taxpayer’s success in the face of the foregoing rested, in large part, upon the “credible testimony” of Taxpayer and of the PC representative who negotiated the terms of the addendum. Not the ideal game plan, especially where the taxpayer bears the burden of proof; after all, memories become stale, people disappear, and relationships deteriorate.
Taxpayer would have been better served if he and PC had retained counsel to ensure that the addendum – within its four corners – accurately reflected their understanding regarding the transfer of the IP and the payments made in exchange therefor.[x]
Of course, there are situations in which the parties to an agreement “genuinely” disagree on the tax treatment of a specific payment made pursuant to its terms, usually as a result of someone’s not having focused on it. For example, the payment made by a partnership to a departing partner in liquidation of their interest where the agreement fails to properly characterize the payment for tax purposes. The partnership may seek to treat such a payment as a guaranteed payment (deductible by the partnership, and includible as ordinary income by the former partner, for tax purposes), whereas the former partner will treat it as a payment made in exchange for their interest in the partnership’s assets, including goodwill (treated as a return of capital, and then as capital gain, except to the extent of any “hot assets”).[xi]
Then there are those situations where a “not-so-good” actor will do as they please insofar as reporting the tax consequences of a transaction is concerned.[xii]
In most cases, it will behoove the conscientious taxpayer and their advisors to ensure, as best they can, that the four-corners of the agreement either express the tax treatment intended by the parties, or include such terms that inexorably manifest such intent. If a taxpayer is unable to secure the foregoing, then they should be on alert as to the intentions of the other party, and act accordingly.
[i] Too many times have I heard a fellow adviser say that some ambiguity on a key term of a transaction document or settlement agreement may be a good thing; yeah, if you enjoy litigation and the associated costs and anxiety.
One of my high school physics teachers had a sign above his blackboard that read, “Eschew Obfuscation.” Thank you, Mr. Gordon.
[ii] Normally treated as ordinary income by Taxpayer, and deductible by Employer under Sec. 162 as an ordinary and necessary business expense.
[iii] Seemingly unrelated to the IP.
[iv] Based on the 1099-MISC.
[v] The “holder,” for purposes of Section 1235, includes “any individual whose efforts created such property.”
[vi] And taxed as long-term capital gain.
[viii] The “Danielson rule.” In brief: although a taxpayer is free to organize their affairs as they choose, once having done so, they must accept the tax consequences of such choice, whether contemplated or not, and may not enjoy the benefit of some other route they might have chosen to follow but did not. A taxpayer who falls within the scope of this rule is generally stuck with the form of their business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.
[ix] Finally, the Court was not convinced that PC’s reporting of the payments indicated that the addendum did not relate to the IP. Because those payments mirrored Taxpayer’s commissions, it was reasonable for both PC and Taxpayer to continue reporting commission payments as they always had in the absence of any tax or legal advice. The Court would not bind Taxpayer to the reporting by PC in the face of other contrary evidence.
[x] Query, however, whether an appraisal of the IP would have defeated capital gain treatment for the transfer of the IP. What if its fair market value was insignificant?
What if PC or Employer had deducted the payments on their tax return(s)?
[xi] IRC Sec. 736.