F OR P UBLICATION



### UNIT E D ST AT E S CO URT O F APPE AL S FO R T H E NINT H CIRCUIT

J A M E S C. C O O P E R ; L O R E L E I M. C O O P E R , Petitioners-Appellants
,

v

.

C O M M I S S I O N E R O F I

N T E R N A L R E V E N U E , Respondent-Appellee. N o. 15-70863

Tax Ct. No. 17284-12

OPI NI ON

Appeal from a Decision of the U nited States Tax Court

A rg ued and Submitted October 4, 2017 Pasadena, California

F iled December 15, 2017

B efore: Andrew J . Kleinfeld, Susan P. Graber, and Morg an Christen, Circuit J udg es.
Opinion by

J udg e Graber; Partial Concurrence and Partial Dissent by J udg e KleinfeldC O O P E R V

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2

SUMMARY *

Tax

The panel affirmed the Tax Cour t ’ s d ecision, after a bench trial, on a petition for re d e termination o f federal income tax d e ficiencies in which tax pay ers soug h t capital
g ains treatment of patent-g enerated r o y alties pursuant to 26 U.S.C. § 1235(a).

Tax pay e r J ames Cooper is a n eng ineer and inventor whose patents g enerated sig nificant roy a l t ies. He and his wife incorporated and transferred their rig hts to the patents to Technolog y L icensing Corporation ( T L C), which was formed by tax pay ers and two other individuals, Walters and Coulter. I f a p atent holder, throug h effective c ontrol of t h e corporation, retains the rig h t to retrieve ownership o f the patent at will, then there has not been a tra n sfer o f all substan tial rig hts to the p atent so a s to warrant capital g ains
treatment of the roy a lties under § 1235(a). The panel held that the T ax Court permissibly concluded that Mr. Cooper did not transfer “all substantial rig hts” to the patents to TL C because W a lters and Coulter acted at Mr. Cooper’s d irection, did not

ex e r cise independent judg ment, and retur n e d patents to Mr. Cooper when requested for no consideration.

Tax pay e rs cla imed a deduction for a nonbusiness “bad debt” pursuant to 26 U.S.C. § 166(d)(1)(B ), which a llows short-term capital-loss treatment of a loss “where any nonbusiness debt becomes worthless within the tax able y e ar.”

* T h is su m m ary co n stitu

tes n o p art o f th e o pin io n o f th e co u rt. It h as b een p rep ared b y

co u rt staf

f f o r th e co n v en i en ce o f

th e read er.C O O P E R V

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The panel held that the Tax Court permissibly concluded that the debt had not become “totally worthless.”

F inally
, the panel u

ph e l d t he Tax Court’s determination that tax pay ers f

ailed to meet their b u rden of showing that they actually relied in g o od faith on their a dvisers’ judg ment so a s to avoid accuracy

-related penalties u nder 26 U.S.C. §§ 6662 and 6664.

J udg e Kleinfeld dissented a s to Section A of the majority opinion reg a

rdi ng the r oy alty pay

ments as capital g a ins, joined in Section B as to the bad debt deduc t i o n, a nd observed that the accuracy penalties discussed under Section C would need to be revisited if his view on the roy alties were to be accepted. J ud ge Kleinfeld opined that the better approach to disting uishing “control” from “mere influence”

over a corporation is the approach set forth in Charlson v

. United S tates , 525 F .2d 1046 (Ct. Cl. 1975) (per curiam), a nd Lee v. United States
, 302 F

. Supp. 945 (E.D. W is. 1969): that “control” means the a

bility to compel w h a t t h e transferee corporation does.

COUNSEL

Richard G. Stack (arg

ued) and Dennis N. B rag e r, B rag er Tax L aw Group P.C., L os Ang eles, California, for PetitionersAppellants.

Clint A. Carpenter (arg

u e d ) and Ric h a r d F arber, Attorney s, Tax Division; Caroline D. Ciraolo
, Principal Deputy Assi s t ant Attorney General; United States Department o f J ustice, W ashing ton, D.C.; for Respondent-Appellee.C O O P E R V

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OP INION

GRAB ER, Circuit J udg e:

Petitioners J ames and L orelei Cooper are marr i ed
tax pay e rs w ho challeng e t h e Commissioner of I nternal Revenue’s notice o f d eficiency for tax y ears 2006, 2007, a nd 2008. Mr. Cooper’s patents g enerated sig nificant roy alties during those y ears. Petitioners soug ht capital g a ins treatment of those r oy alties pursuant t o 26 U.S.C. § 1235(a) o n the theory that Mr. Cooper had t r a nsferred to a c orporation “ all substantial rig hts” to the patents. A fter a bench trial, the Tax Court disag reed, finding that Mr. Cooper effectiv ely controlled the recipient corporat i o n such that he had not transferred a ll substantial rig hts to the patents. The Tax Court also found that Petitioners c o uld n o t t a k e a bad debt tax deduction in 2008 because the debt at iss u e h ad not become worthless during that y ear, a nd that P e titioners had not established reasonable cause to avoid a c c u racy penalties arising from their underpay ment. B ecause the T a x Court accurately applied the law and did not clearly err in its f actual finding s, we affirm.

F ACTUAL

AND PROCEDURAL

HI STORY

Mr. Cooper is a

n eng ineer and inventor. He is the named inventor on more t h an 75 patents in the United States. His patents are primarily for products and components used in the transmission of audio and video sig n als. Pet i tioners are cotrustees of a family trust , referred to as the “Cooper Trust.” I n 1983, Petitioners incorporated Pix el I nstruments C orporation (“Pix el”). Mr. Cooper was president, a n d M s

. Cooper held various posit ions, including vice president. Petitioners wholly o wned Pix el until 2006.C O O P E R V

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I n 1988, Mr. Cooper and Pix el entered into a commercializ ation ag reement with Daniel L e ckrone. Mr. Cooper and Pix el a ssig ned their patents to a licensing
company formed by L eckrone, in e x chang e for roy alty
pay ments arising from the commercializ ation of the patents. The arr a ng ement broug ht sig nificant tax benefits to Petitioners. B ec ause Petitioners had transferred “ all substantial rig hts” to the patents to the l i c e n sing company , 26 U.S.C. § 1235(a) permitted P e titioners to treat the
pay ments from the licensing company a s capital gains. B ut in 1997, a fter disputes with L e c krone, Mr. Cooper terminated the commercializ ation ag r eement. All of Mr. Cooper’s patent rig hts reverted t o h i s a ssig nee pursuant to a settlement a nd arbitration.

Understandably
, Petitioners so u g h t to retain the tax benefits afforded by § 1235 and, to that end, they soug ht leg al advice from Gordon B aker. B aker advi s e d them that they could set u

p a licensing company to wh i c h to transfer the patents, so long a s they complied with two requirements that

are relevant here. F irst, he advised t h e m t hat, p u rsuant to § 1235(c), 1 they could not o wn 25 percent or more of the
company

. Second, he advised them that, reg ardless of formal ownership, they could not effectively control t h e new company

. The pro h i b i tion o n effective control had been discussed at leng th in Charlson v

. United States
, 525 F .2d 1046, 1053 (Ct. Cl. 1975) (per curiam).

1 Sectio n 1 2 3 5 (c) f

o rm erly w as lab eled § 1 2 3 5 ( d )

. W e u se th e p resen t

- d ay

citatio n

.C O O P E R V

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Petitioners, joined by L ois W alters and J a net Coulter, incorporated Technolo g y L icensing Corporation (“TL C”). 2 W a lters is Ms. Cooper’s sister, and Coulter is a long -time friend of Ms. Cooper and W a lters. During all relevant times, Coulter and W alters lived in Ohio, and both held full -time jobs unrelated to TL C. Neither Coulter nor W alters had any

ex p erience in patent licensing or patent commercial i z a t ion before their involvement with TL C.

Consistent w i th B aker’s a dvice, Petitioners, as co-trustees of the Cooper Trust, owned only 24% of the TL C stock; W a lters owned 38%; and Cou lter owned 38%. W a lters was president a

nd chief f

inancial officer, Ms. Co o p e r was vice president, and Coulter was secretary

.

I n 1997, Mr. Cooper and Pix el entered into ag reements with TL C. Under the TL C a g reements, Mr. Cooper a nd Pix el transferred to TL C all rig hts to cert a in patents, and TL C
ag reed to pay Mr. Cooper and Pix el roy alty pay ments using

a formula that relied on percentag es of g ross and n e t proceeds received from licensing the patents. During 2006, 2007, a nd 2008—the y ears at issue here—Mr. Cooper received roy alty
pay ments p ursuant to the TL C ag reements, a nd Petiti oners treated those pay

ments as capital g ains.

During 2 008, Petitioners also cl a i med a d eduction o n their 2008 ta x r eturn for a nonbusiness “bad debt” pursuant to

2 In 2 0 03
, P etitio n ers m ov ed f ro m Calif o rn ia to Nev ad a. T h ey th en in co rp o rated a seco n d T ech n o lo g y L icen sin g Co rp orat io n in th at state,

w ith th e sam e b o ard m em b ersh ip an d th e sam e s to ck o w n ersh ip

. T h e tw o

co rp o ratio n s m erg ed in 2 0 0 4
, w ith th e Nev ad a co rp o ratio n em erg in g as t h e s u rv iv i n g co rp o ratio n

. W e f o llo w th e T ax Co u rt’ s co n v en tio n of ref errin g to b o th th e o rig in al co rp o ratio n an d th e su rv iv in g co rp oratio n as

“ T L C.”C O O P E R V

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2 6 U.S.C. § 1 66(d)(1)(B ), which allows short-term capital

loss treatment of a loss “ w here any nonbusiness debt becomes

w o r t h less within the tax able y ear.” The debt arose fro m a working c apital promissory note from the Cooper Tr u s t to P ix el. At the end of 2008, the outstanding balance o n t h e promissory note was a little more than $2 million, a n d M r. Cooper c oncluded that Pix e l c ould not pay the outstanding balance.

The Commissioner issued a notice of deficiency to Petitioners. Relevant here, the Commissioner disag reed that the roy alty pay

ments from T L C qualified as capital g ains; he disag reed that th e P i x el promissory note debt qualified as a bad debt deduction; and he a ssessed penalties for those e rrors. Petitioners soug ht review by the Tax Court. After a trial, the Tax Court ag reed with the Commissioner on all three p o ints, and the court ordered Petitioners to p a y deficiencies a nd penalties totaling approx imately $ 1.5 million

. Petitioners timely appeal. 3 S

e e 26 U .S.C. § 748 2 ( a ) ( 1 ) (permitting appeals from the Tax Court to the applicable circuit court).

STANDARDS OF REVI EW

“W e review dec i sions of the Tax Court under the same standards as civil bench trials in the district court. Therefore, conclusions of law are reviewed de novo, and q u estions o f fact ar e r e v iewed for clear error.” Johanson v. Comm’r
, 541 F .3d 973, 9 7 6 (9th Cir. 2008) (internal quotation marks omitted).

3 T h e T ax C o u rt ru led in f av o r o f P etitio n ers o n a sep arate issu e; th e Co m m i ssio n er d id n o t cro ss- ap peal. T h at ru lin g th eref o re is f in al.C O O P E R V

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D I SCUSSI ON

“Determinations made by the Commissioner in a notice of deficiency normally a

re presumed to be correct, and the
tax pay e r bears the burden o f pro v i n g that those determinations are erroneous.” M erkel v. Comm’r
, 192 F .3d 844
, 8 52 ( 9th Cir. 1999). The burden shifts back to the Commissioner in certain circumstances, 26 U.S.C. § 7491(a), but the Tax Court held that Petitioners have neither asserted

nor proved that they have met those requirements. On appeal, Petitioners do not challeng e the Tax Court’s conclusion that they bear the burden of proof.

Petitioners challeng e th e Tax Court’s ruling s on (A) the
treatment of r oy alty p a y ments a s c apital g ains; (B ) the
treatment of the Pix el loa n a s a bad debt; and (C) the imposition of penalties.

A. Royalty Payments as Capital Gains

The Tax Code g enerally treats income derived from a capital a sset as ordinary income. B y contrast, the Tax Code
g enerally treats the procee d s from the sale of a capital asset

more favorably
, as capital ga i n s. Real property p rovides a g ood ex ample: I f a h omeowner ren t s a house, the rents a re ordinary income; but if the home o wner sells the h ouse, the
p r o c eeds from the sale are capital g ains. Patents do not f i t neatly within that dichotomy
, because patent holders often sell all substantial rig hts to a patent in ex chang e for periodic
pay ments conting ent on the patent’s productivity

. B ut because that pay

ment arrang ement appears so similar to rent, the Commissioner o rig inall y treated the proceeds from such

ex c h a ng e s as ordinary income—even thoug h the patent holder had divested all meaning f ul property rig hts in theC O O P E R V

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patent. See Fawick v

. Comm’r
, 436 F .2d 6 5 5
, 6 59–61 (6th Cir. 1971) (describing this history ).

I n 1954, Cong ress responded by enacting 26 U.S.C. § 1235. Subsection 1235(a) provides:

A transfer (other than by g ift, inheritance,

or d evise) o f property consisting of all substantial rig hts to a patent

. . . by any holder shall b e considered the sale or e x c h a ng e of a capital asset h eld for more t h a n 1 y ear, reg ardless of w hether o r not pay ments in consideration of such transfer are–

(1) pay able p er i o dically over a period
g enerally cotermi n o us with the transferee’s use of the patent, or

(2) conting ent on the productivity
, use, o r disposition of the property transferred.

According ly
, if a patent holder transfers “all substantial rig hts
to a patent,” then the resulting roy alty pay ments are treated a s capital g ains, because the patent has been “sold.” B y contrast, if a patent h older retains substantial rig hts to a patent and merely licenses t h e patent, then the resulting pay ments

are not t r eated as capital g ains, because the patent has not been “sold.” The key consideration is whether t he patent holder “transfer[ red]

. . . all substantial rig hts” to the patent. Id.

Petitioners u r ge us, for the first time o n appeal, to determine whether there has b een a transfer of all substantial rig hts by looking solely to the f ormal documents, wit h o u tC O O P E R V

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10

reg ard to the pra ctical realities of the transaction. 4 W e decline the invitation. A bedrock principle of tax law—now and in 1954—is that substance controls over form. See, e.g. , U n i ted States v

. Eurodif S.A.
, 5 55 U.S. 305, 317–18 ( 2 0 0 9 ) (“[ I ]t is well settled that in reading reg ulatory and tax ation statutes, form should be disreg arded for substance a n d t h e emphasis should be on e c onomic reality .” (internal quotation marks o mitted)); Helvering v. F. & R

. Lazarus & Co.
, 308 U

. S. 252, 255 ( 1939) (“I n the field o f tax ation, administrators of the laws and the courts are concerned with substance a

nd r ealities, and formal written documents are not rig idly binding .”). N othing in § 1235 sug g ests that Cong ress intended a different rule to apply here. To t h e contrary , considerable leg al authority supports our co nclusion that, when determining whether there has b e e n a transfer o f all substantial rig h ts, we must look bey o nd the bare form of the transaction.

Acting pursuant to an e x p r ess statutory deleg ation, 26 U .S.C. § 7805(a), the Secretary of the Treasury (“Secretary

”) has promulg ated reg ulations con c e r ning the statutory p hrase “ all substantial rig hts to a patent.” 26 C.F .R. § 1.1235-2(b). W e defer to the Secretary ’s r eg u lations. See Kueneman v

. Comm’r
, 628 F .2d 1196, 1201 (9th Cir. 1 980) (“The Secretary has broad authority to p romulg ate reasonable
reg ulations to implement the revenue laws

. . . .”); Comm’r v

. Portland Cement Co. o

f U t ah
, 450 U .S. 156, 1 6 9 (1981) ( “ T r e a s u r y R e gu l a t i o n s ‘ m u s t b e s u s t a i n e d u n l e s s

unreasona

b le and plainly inconsistent with the revenue

4 T h e i ssu e is p u rely o n e of l aw , an d th e p arties h av e b rief ed it to u s. W e ex ercise o u r d iscretio n t o reach th e issu e, d esp ite P etitio n ers’ f ailu re to raise it b ef

o re t h e T ax C o u rt. Bo lker v. Co m m’r
, 7 6 0 F.2 d 1 0 3 9
, 1 0 4 2 (9 th Cir. 1 98 5 ).C O O P E R V

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statutes.’” (quoting Comm’r v. S. Tex. Lumber Co.
, 333 U.S. 496, 501 ( 1948))). The pertinent Treasury Reg ulation states: “The circumstances of the whole transaction, rather than the particular terminolog y used in the instrument of transfer, shall be considered in determin i n g whether or not all substantial rig hts to a patent are transferred in a transaction.” 2 6 C.F .R. § 1.1235-2(b)(1). T hat interpretation f inds support in the leg islative history
, specifically a Senate F inance Committee report that stated:

I t is t h e i n tention of y our committee to continue this realistic test, [ developed under
p r i o r c as e l a w , ] w h e r e b y t h e e n t i r e transaction, reg ardles s of f ormalities, should be ex amined in its f actual contex t to determin e w hether or not substantially all rig hts of the owner in the patent property have been released to the transferee . . . .

S. Rep. No. 83-1622, at 440 (1954), as rep r i n t e d in 1954 U.S.C.C.A.N. 4621, 5 083. Not sur p r i s ing ly
, then, we previously have described the inquiry in p r a ctical terms: “W h a t did the tax p ay er a ctually g ive up by the transfer; that is, was there an actua l t r a n s fer of the monopoly r ig hts in a patent . . . .” Kueneman
, 628 F .2d at 1199 (emphases added and orig inal emphasis omitted) (quoting Mros v. Comm’r
, 493 F .2d 813, 816 (9th Cir. 1974) (per curiam)).

I n Charls o n , 525 F .2d 1046, the United States Court o f Claims described how the pri n c i p le applies in a case involving a transfer o f patent rig hts to a corporation. I n that
case, the inventor formally transferred all substantial rig hts to certain patents to a c orporation that w a s owned b y the i n ventor’s close friends and associates. Id. at 1048

– 4 9

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Section 1235(c) p rovides that roy alties from a patent transfer

are not tax able as capital g ains if the r ecipient is a “ related”
person or entity

. T h e court held that § 1235(c )’ s requirements concerning formal ownership had been met, but the court “stressed that § 1235[ (c)] was not intended to be an

ex c lusive o r ex haustive statement of the impact of c o n t r ol

over a § 1235(a) transaction.” Id. at 1 053. I t is “clear,” the
court held, “that retention of control by a holder o v e r an unrelated corporation can defeat capital g ains treatment, if the retention prevents the transfer o f ‘all substantial r ig hts.’” Id. “This is becaus e the holder’s control over the unrelated transferee

. . . places h im in e ssentially the same position a s if all substantial r ig hts h ad n ot been transferred.” Id. ; see also id. (desc ri b ing Cong ress’ “obvious intent of having a transferor’s acts speak louder than his words in establishing whether a sale of a patent has occurred”).

W e a g r ee: I f a patent holder ex erci s e s c ontrol over the

r e c i pient corporation such that, in effect, there has not been

a transfer of all substantial rig hts in the subject patent(s), then the req u i r e m e n t s of § 1235(a) are not met, even if the documents describing the tra n s f er formally a ssig n all substantial rig hts. The key inquir y r e m a ins whether, as a practical matter, the transferor shifted all substantial rig hts to the recipient. Mere influence by t h e p a t ent holder is insufficient to defeat § 1235(a) treatment, as is control by the patent holder of aspects of the c o r p o r a tion apart from the patent rig h ts. A patent holde r w h o f ormally transfers all substantial patent rig hts to a qualify ing corporation is entitled to the benefits of § 1235(a) unless, throug h effective control of the corporatio n , h e o r she did not effectively transfer all substantial rig h ts to the patent(s).C O O P E R V

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I mportantly
, “[ t] he r e t ention of a rig ht to terminate the transfer at will is the retention of a substantial r i g ht for the
purposes of secti o n 1 235.” 26 C.F .R. § 1.1235-2(b)(4). According ly
, if a p atent holder, thro u gh effective control o f the corporation, retains the rig ht to retrieve ownership of the patent at will, then ther e has not been a transfer o f all substantial rig hts. State d d i fferently
, if the recipient corporation stands ready
, as a p r actical matter, t o r e turn ownership o f the patent to the patent h o l der a t the holder’s direction, then there has not b een a transfer of all substantial rig hts.

Here, the Tax Court found, and we ag ree, that Petitioners complied w i t h the formal requirements of § 1235. Mr. Cooper formally transferred all su bstantial rig hts to the patents to TL C, and Petitioners owned less than 25 percent o f TL C. The T ax Court further found, howeve r , t hat Mr. Cooper effectively controlled TL C within the meaning o f Charlson such that, in e ffect, there had n ot been a transfer o f all substantial rig hts to the p a tents. F o r t h e r easons that follow, we hold that the Tax Court did not clearly err.

The Tax Court f

ound that W alters and Coulter—the two shareholders other than the Cooper T rust—ex erc i s ed no independent judg ment and acted a t Mr. Cooper ’ s d i rection. “During the y ears a t issue, [ W alters’ and Coulter’s] duties a s directors and officers consisted larg e ly of sig ning checks a nd transferring funds as directed b y TL C’s accountants a nd sig ning ag reements as directed by TL C’s attorney s.” “[ S] ubstantially all of T L C’s decisions reg arding li c e nsing
, patent infring ement, and patent transfers were made either b y Mr. Cooper or at his direction.” W alters and Coulter “acted i n their capacities as directors and officers of TL C at the directi on of Mr. Cooper. T hey did n ot make independentC O O P E R V

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decisions in accordance with their fiduciary duties to TL C o r act in their best interests as shareholders.”

Those finding s strong ly sug g est t h at TL C would take practically any action requested by Mr. Cooper—includ i ng the return of patent rig h ts—without reg ard to the interests o f T L C ’s shareholders and without r eg ard to the persona l interests of W alters and Coulter. B ut the Tax Court was not required to speculate as to whe t h e r , upon Mr. Cooper’s request, TL C would return valuable patent rig hts to M r. Cooper; that event in f

a c t o c curred. I n 2006, upon request, TL C returned valua b l e p atent r ig hts to Mr. Cooper for no

c o nsideration

. Mr. Cooper quickly commercializ e d the patents throug h a separate e ntity
, which r eceived $120,000 in

revenue.

I n sum, the Tax Court permissibly concluded that W alters and Coulter a cted at Mr. Cooper’s direction; did not ex ercise independent judg ment; and, when r equested, returned patents to Mr. Cooper for no consideration. Given that W alters and Coulter acquiesced, without question or ex planation, in the rescission of the transfer of c ertain patents, there is no reason to think that they would have objected to the rescission of any other transfer of p atents. B ecause the rig ht to retrieve ownership of t h e p atent is a substantial rig ht, the T ax Court d id not clearly err in ruling that Mr. Cooper did not transfer “all substantial rig hts” to the patents.

W e respectfully part way s from the di ssent’s thoug htful analy sis of this issue and offer the following observations in
response.

F or all the reasons d e s cr i bed above, the inquiry into

w h e t h er there was a transfer of all substantial rig hts i s aC O O P E R V

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practical one, n ot merely a formalistic or leg alistic one. W e therefore reject the dissent’s sug g estion that we must ask whether, in theory
, TL C could h a v e d e c lined to transfer the patents b ack to Mr. Cooper; instead, we must ask whether, a s

a practical matter, Mr. Cooper retained the ability to retrieve the p a t ents at will. Similarly
, whether Mr. Cooper hy pothetically could have forced TL C to c omply with his wishes on other matters is beside the point.

W e recog niz e tha t there is a difference between mere in f l u e n c e to control sufficient to d efeat § 1235(a) tax treatment. Reasonable minds may d i ffer on where a parti c u lar situation lies. Having ex amined the record dev e l o p e d a t trial in this case, and reviewing for clear error,

we hold o n ly that the Tax C o u r t’s conclusion was a permissible o ne. Relatedly
, w e disag ree with the dissent that the facts of Charlson require a different result here. The officers o f the c orporation in Charlson ex ercised independent judg ment, and the corporation never r eturn e d patents to the inventor without consideration.

F inally
, w e emphasiz e that our analy sis i s limited solely
t o t h e t a x c o n s e q u e n c e s o f P e t i t i o n e r s ’ b u s i n e s s arrang ements. Allowing an inventor to have effective control of the recipient corporation very well may be a smart business practice in some c ircumstances. W e h old only that, if the patent holder effectively c ontrols the corporation such that he

or she did not transfer all substantial rig h ts to the p atents, then the tax treatment allowed by § 1235 does not apply

.

B

. Bad Debt Deduction

W e review for clear error t h e Tax Court’s finding of the worthlessness of a debt. L.A. Shipbuilding & D rydock Corp.C O O P E R V

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16

v. Unit ed States
, 289 F .2d 222, 228–29 (9th Cir. 1 961); accord Cox v

. C o mm ’ r , 68 F

. 3d 128, 131 (5th Cir. 1995). The tax pay er bears the burden of proving “that the d ebt became worthless within t he tax y ear.” Andrew v. Comm’r
, 54 T .C. 239, 244–45 (1970). “The y e a r a debt becomes worthless is fix ed by identifiable events that form the basis o f reasonable g rounds for a b andoning any h o pe of r ecovery

. Petiti o n e r m

u s t establish sufficient objective facts from which worthlessness c ould b e concluded; mere b elief o f worthlessness is insufficient.” A ston v. Comm’r
, 1 0 9 T.C. 400, 415 (1997) (citation omitted). The debt m u st “become totally w orthless, and no deduction shall be allowed for a nonbusiness debt whic h i s recoverable in part during the
tax able y e ar.” 26 C.F .R. § 1.166-5(a)(2). A tax pay e r need
not have initiated leg al action ag a inst the debtor, but “he does have the burden of establishing tha t s u c h an action, when considered in the lig ht of objective standards, w ould in all probability h ave been e n tirely unsuccessful.” Dustin v

. Comm’r
, 467 F .2d 47, 4 8 (9th Cir. 1972) (footnotes omitted).

The T ax Court fou nd that, contrary to Petitioner’s assertion, the debt o n Pix el’s promissory note did not become “worthless” in J uly 2008. 2 6 U.S.C. § 166 ( d ) ( 1 ) (B ). The court reasoned:

Pix el had to t al y earend assets each y e ar from 2008 throug h 2012 in ex cess o f $172,000, including more than $ 3 19,000 in
assets in 2 0 11 and 2 012. I t a ppears to us that Pix el r emain e d a g oing concern well past 2008.

. . . Pix el ex perienced a d e c l ine in its bu siness in 2008, but its g ross receipts increased in 2009. Petitioners as cotrustees o f the Cooper Trust continued to advance fundsC O O P E R V

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to Pi x e l under the terms of the promissory
note throug hout 2008. I ndeed, petit i o n ers advanced $148,255 to Pix el under the terms o f the promissory note b etwee n J uly a nd Dec e m b e r 2008. W e do not find it credible that petitioners would have a d vanced nearly $150,000 to Pix e l after J uly 2008 i f t h ey believed the promissory note h a d been rendered worthles s in J uly 2008

. . . . The evidence s h ows that Pix el had substantial
assets a t the end of the 2008 tax y ear and that its g ro s s re ceipts increased in 2009. Moreover, at the very least, Pix el was entitled
to an indefinitely continuing annual roy alty o f $22,500 and o wned rig h ts in several other patents.

. . . Pix e l’s liabilities to pet itioners under the ter m s of the p romissory note comprised subs t a n t i a l l y a l l o f P ix e l’s liabilities in 2008.

(F ormatting omitted

. ) T hose finding s are not clearly

erroneous.

I n short, Pix el had a steady
, if small, income stream, a nd i t h a d h undreds of thousands of dollars worth o f assets. Petitioners almost certainly could not h ave recovered the full $2 million and change b u t , considering that they were essentially the only creditors, they likely could ha v e made a partial reco v e r y

. The Tax Court permissibly concluded that the debt had not become “totally worthless

. ” 2 6 C.F .R. § 1.166-5(a)(2).C O O P E R V

. CI R

18

C. Accuracy Penalties

Title 26 U.S.C. § 6662(a) imposes a 20 percent penalty to underpay ments of tax if any of the conditions in § 6662(b) is

m e t

. Here, the Tax Court f ound that two conditions we r e met: “Neg lig ence or d isreg ard of rules or reg ulatio n s,” id. § 6662(b)(1), and “ [a] ny substantial understatement o f income tax
, ” id. § 6662(b)(2). On appeal, Petitioners do not challeng e those finding s.

Section 6664(c) provides a “[ r] easonable cause ex c eption for und er pay ments”: “No penalty shall be imposed under secti o n 6 6 6 2 or 6663 with respect to any portion of an underpay ment if it is shown that there w as a reasonable cause for such portion and that the tax p a y er a cted in g ood faith with respect to such portion.” 26 U .S.C. § 6664(c)(1). Petitioners assert that they

relied in g ood faith on professional advice.

Reliance on professional advice may establ i sh reasonable cause and g ood f aith. Treas. Reg

. § 1.6664-4(b)(1). The Tax Court requires a tax p ay er to prove three elements in order to show that reliance o n a d v ice was reasonable: “(1) The adviser was a competent professional who h ad sufficient ex pertise to justif y reliance, (2) the tax pay er provided

n ecessary and accurate information to t h e adviser, a nd (3) the tax p ay er a c tually relied in
g ood faith on the adviser’s judg ment.” Neonatology A ssocs., P.A. v. Comm’r
, 115 T.C. 43, 99 ( 2000). Once the Commissioner produces eviden c e showing that an accuracy

-relat e d penalty applies, theC O O P E R V

. CI R 19

burden of proving the e x istence of reasonable cause and g ood faith falls on the tax pay e r.

DJB Holding Corp. v. Comm’r
, 803 F

. 3d 1014, 1029–30 (9th Cir. 2015). Here, the Tax Court h eld that Petitioners failed to meet their b urden of showing that they actually relied in g ood faith on an adviser’s judg ment. “W hether the tax pay er acted with reasonable cause a

n d in g ood f

aith is a f i n d i n g of fact reviewed for clear error.” Id. at 1022.

1. Royalty Penalty

W ith respect to the roy alty penalty
, Petitioners contended that they relied on the advice of B aker. The T ax Court f ound:

Mr. B aker testifi e d with respect to the
roy alty pay

ments and petitioners’ compliance with section 1235 that he advised petitioners that Mr. Cooper could n o t indirectly c ontrol TL C. Moreov er, Mr. B aker did not provide advice to petitioners before they fil e d t heir F orms 1040 f

or th e y e ars at issue, nor did he provide advice to petitioners re g arding

w h e t h e r M r

. C o o p e r c o n t ro l l e d T L C following T L C’s inco r

poration. Petitioners did no t f o llow Mr. B aker’s advice to ensure that Mr. Coop e r did not indirectly c ontrol TL C. Consequently
, petitioners cannot claim reliance on the p rofessional advi c e of Mr. B a ker to neg ate the section 6662(a) p e n alty with respect to their erroneous capital gain
treatment of the roy alty pay ments Mr. Cooper received during

the y ears at issue.C O O P E R V

. CI R

20

Those finding s are not clearly erroneous, and the Ta x Court’s reasoning is sound. B a ker advised Petitioners a t the time th e y f o rmed TLC that, in order to receive capital g ains treatment, Mr. Cooper c o uld not control TL C indirectly

. B aker a lso testified specifically that he had no recollection that h e ever advised P e t i t i oners that the way in w h ich they

were operating TL C actually conform e d t o his advice. I ndeed, there is no evidence that Petitioners ever soug ht postformation advice from any one about whether their conduct actually complied with B aker’s advice.

Nor w as the penalty inappropriate b e c a u se of the

a l l eg edly u ncertain state of the law. “[ A] n ho n e s t misunderstanding of fact o r law that is reasonable in lig h t of all of the facts and circumstances ” can ex cuse an understatement of tax

. 26 C.F .R. § 1.6664-4(b)(1). B ut there is patently no honest misunderstanding he r e : Petitioners’ theory at trial was that B aker a dvised them t o c onform with Charlson such that they d id not informally c ontrol TL C. I ndeed, they conceded before the Tax Court t h a t Charlson provided the binding leg al r u le: Cap i tal g ains treatment is unavailable if the tax pay e r informally controls the corporation. I t is only on a p p e al that they have challeng ed the leg al standard. According ly
, whatever merit Petitioners’

a r gu m e n t mig ht have h ad if they truly had been uncertain about the v alidity of Charlson (despite the fact that no court h as questioned its validity ), Petitioners cannot benefit f r o m that p urported uncertainty because it was not until this appeal that they alleg ed any

uncertainty

.C O O P E R V

. CI R 21

2. Bad Debt Penalty

W ith respect to the b ad de b t penalty
, Petitioners contended that they r elied on the advice of Mitch Mitc h e l l and B aker. The Tax Court found:

W ith re ga rd to the bad debt deduction, petitioners have failed to i n t roduce evidence
reg arding what information th ey provided to Mr. B aker and Mr. Mitchell to enable them to de t e r mine whether the promissory note was worthless within the meaning of section 166 in 2008. Petitioners did not call Mr. Mitchell
to testify or otherwise introduce a ny evidence
rega rding Mr. Mitchell’s advice. Similarly
, Mr. B aker d id not testify reg a rding any advice he m a y have g iven to petitioners that would indicate that it was his opi nion that the promissory note beca me worthless in 2008. I n short, petitioners have failed to p ro v e that they received o r relied on the pr o f e ssional

a d vice of Mr. B a ker a

nd Mr. Mitchell w i t h respect to their erroneous section 166 bad debt deduction in 2008.

Ag ain, ther e is no c lear error. Petitioners have not rebutted the T ax C o u r t’s finding that Petitioners f a iled to prove that “the tax pay er provided necessary and accurate information to the adviser.” DJB H olding Corp.
, 8 03 F .3d at 1030. Mitchell did not testify
, and neither Petitioners nor the Commissioner asked B aker any questions about the bad d ebtC O O P E R V

. CI R

22

or about a

ny advice h e may h ave g iven Petitioners o n that topic.

AF F IRMED.

KL E I N F EL D, Senior Circuit J udg e, c o n curring in part a nd dissenting in part:

I respectfully di s s en t

. My dissent is directed only to Sec t i on A, “Roy alty Pay

ments a s Capital Gains.” I join in Section B
, “ Bad Debt Deduction.” As for Section C, “Accuracy Penalties,” whether and h ow the penalt i e s would apply would need to b e revisited if my view on roy alties were to be accepted.

The majority errs because it d ilutes the meaning o f “control” from the ability to compel a result to something less

a n d indeterminate. This puts us at odds with o ur only sister circuit to rule on the matter, the Court of Claims in Charlson

v. United States

. 1 B oth Charlson and the Commiss i o n er’s
own regulations show the error of the majority ’s approach.

The majority opinion accurately notes that in Charlson
, the corporation to which inventor L y nn Charlson transferred his patent was owned by his “clos e f r iends and associates.” Actually
, they were more than c lose friends and associates: three o f the shareholders and directors were his employ ees,

1 5 2 5 F

. 2 d 1 0 4 6 (Ct. C l. 1 9 7 5) (p er cu riam ); cf. S

. Co rp

. v. Un ited S ta tes , 6 9 0 F.2 d 1 3 6 8, 1 3 7 0

– 7 1 ( Fed

. Cir. 1 9 8 2 ) (en b an c) (ad o p tin g Co u rt

o f Claim s o p in io n s as b in d i n g p reced en t).C O O P E R V

. CI R 23

and the fourth was h is personal attorney

. 2 As such, Charlson could fire e ach of them if he disliked how they voted. The corporation a lso “frequently so u g ht, received, and followed the recommendations of C harlson,” 3 and Charlson and the directors were “solicitous of each other’s individual interests

as well as their mutual interests.” 4 The Commissioner a rg u ed that the corporat i o n , the directors of which had their livelihoods subj e ct to Charlson’s preferences, followed his

recom m e n dations, and were solicitous of his personal interests, w as “controlled” b y C h a r lson. 5 And Charlson certainly had more ability to influence than Cooper does. Cooper cannot fire his sister-in-law and her friend from their jobs.

Yet Charlson won h is case. The Commissioner lost. 6 Despite the evidence that the corporation did what Charlson wanted, the Court of Claims conclude d that he did not “control” the corporation such that the transfer of patent rig hts was not g enuine. Today ’s majori t y o p inion q uotes Charlson ’ s statement that the “retention o f control by a holder of an unrelated corporation can defeat capital g ains treatment, if the retention p revents the transfe r o f all substantial rig hts.” 7 Th at lang uag e marks the boundary o f

2 Ch a rlso n , 5 2 5 F.2 d at 1 04 8

– 4 9

.

3 Id

. at 1 0 5 6

.

4 Id

. at 1 0 5 5

.

5 Id

. at 1 0 5 2

.

6 Id

. at 1 0 5 7

.

7 Id

. at 1 0 5 3 (in tern al q u o tatio n m ark s o m itted ).C O O P E R V

. CI R

24

capital g ains treatment, but Charlson held that the boundary

was n o t cros s ed

. Charlson had power over the corporate directors—far more p o w e r than Cooper had over TL C’s directors—but Charlson d id not “control” the directors for the purposes of § 1235.

The regu lations make it clear that even thoug h the direct o rs in this c ase are Cooper’s friends and relatives, that does not a mount to control or make TL C a “ related ” e n t i t y

. The reg ulations are at pains to say that even tr ansferring patent rig h ts to a corporation controlled b y one’s own brother “is n ot considered as transferring such rig hts to a r elated person.” 8 Since a brother is not a “relate d person” for § 1235(c) purposes, neither is a sister-in-law or a friend of a sister-in-law.

The majority correctly concedes that “[ m] ere influence b y the patent holder is insufficient to defeat § 1235(a) treatment.” B ut influence is all Cooper had. H is authority

over W a lters (his sister-in-law) and Co u l t er ( a f r iend o f W a lters and o f Cooper’s wife) was considerabl y l e s s than Charlson’s authority over h is employ ees. Cooper’s situation is more like the one in Lee v. United States
, where the transfer put the tax pay er’s o wn long time personal friend in charg e. 9 Yet in Lee
, as in Charlson
, the Commissioner lost. Lee h eld that the issue o f control is whether the tax pay er can “force” the transferee to d o h i s bidding

. 1 0 T h ere is no evidence whatsoever that Cooper had that power.

8 2 6 C.F.R. § 1 .1 23 5

- 2 (f

)(3 ); see 2 6 U.S.C. § 1 2 3 5 (c)(2 ).

9 3 0 2 F. Su

p p . 9 4 5, 9 4 8 (E.D. W i s. 1 9 69 ).

10 Id

. at 9 5 0

.C O O P E R V

. CI R 25

W a lters and Coulter, like the directors in Charlson
, were solicitous of Cooper’s and each ot h er’s personal interests. They did transfer a f ew patents to Cooper f o r no consideration so that h e could in turn transfer them to a corporation in which his c h i l d r en had an interest. B ut W a lters a nd Coulter still o wned 76% of the new corporation. (I nstead o f Cooper and his wife owning 24%, Cooper and his wife owned 1 % a

nd their children owned 23%.) And Cooper

was not the only one who benefitted from TL C. W alters a nd Coulter each received $40,000 in director’s fees, and TL C bo u g ht them long -term insurance policies w orth $115,406 and $63,089, respectively

. Cooper did n ot r e c ei v e an insurance policy

. Althoug h the Commissioner a rg ues that the p atent transfer benefitting Cooper’s child r e n somehow breached a fiduciary duty to TL C’s shareholders
, that a rg u ment would apply e qually to the p ay

ments made to W a l ters and Coulter. And it would be equally irrelevant. Al l t h a t a breach o f fiduciary duty means is that W a lters an d C o u l ter, acting in
t h eir capacity as shareholders, could theoretically s u e themselves in their capacity as directors

. That unlikely possibility does not sho w control. The core of the Commissioner’s arg u ment—that the directors knew nothing about Cooper’s sophisticated inventions and simply followed his instructions—does not show control. I f any thing
, it shows that there was no g ood r eason for them to reje c t C o oper’s

re c ommendations, because it was his knowledg e and skill that
g enerated millions in revenue, so he did not need control.

I n disting uishing control from influence, our focus should
not be merely on wheth e r T L C ’s d irectors did what Cooper wanted. There was no rea son for them to do any thing else. I nstead we must a sk whether, as a practical matter, they couldC O O P E R V

. CI R

26

have done otherwise. Cooper could have, but did not, set up the corporation to retain control.

The most obvious way to control a corporation is to o wn

a majority of its stock. For ex ample, o wning 100% of the

s tock defeated the tax b enefits in the classic sham c ase Gregory v. Helvering

. 1 1 However, Cong ress provided that a patent holder cannot receive capital g ains treatme n t if he

owns 25% or more of the corporation to which he transferred his patents. 1 2 That is why Co o p e r and h is wife owned only 24% of TL C’s stock.

Minority shareholders may still control a corporation b y controlling its directors’ votes, and there are well-established

means by which Coop e r mig ht have done so. Those means

are often used in close corpor a t i ons to p rotect minority shareholders from oppression. One way to retain c o n t r o l is
to write the articles of incorporation t o require a supermajority so that no decision can b e made without the minority shareholders’ consent. 1 3 Another is to establish a voting trust

so that the majority must vote their s hares in line with the minority ’s preferences. 1 4 A third mean s is to use classified shares with the minority shares con t r o lling the class that chooses the directors. 1 5 And a f ourth is to contractually oblig ate the directors to vote consistently with the minority

11 2 93 U.S. 4 6 5 , 4 6 7

– 6 9 (1 9 35 ).

12 2 6 U.S.C. § 1 2 3 5 (c)(1 ); see id

. § 2 6 7 (b )(2 ).

13 R OBE RT C. C L

A RK , C ORPORA T E L A W

7 7 5 (1 9 86 ).

14 Id

. at 7 7 7

.

15 Id

. at 7 8 0

.C O O P E R V

. CI R 27

shareholders’ preferences. 1 6 This list is not ex haustive, o f

course. B ut Cooper did n ot do any of these thing s. I f he had, then he would have g enuinely controlled TL C, not just influenced it.

B e cause Cooper’s inventi ons g enerated TL C’s revenue, W a lters and Coulter no dou b t thoug ht it was in TL C’s best interest to accommodate Cooper and keep h i m productive. B ut Cooper could not alway s count on W alters and Coulter to do thing s his w ay

. At some point, he would ag e o u t o f h i s peak productivi t y , m e a

n ing there would be less reason to listen to him. Moreover, a cha ng e in c ircumstances could alway s occur. As Professor Clark wrote in his treatise:

As time passes, the personal relationships
among t he major participants in a close corporation alway s chang e in important way s. One o f several participants will retire o r d ie, leaving a g ap in a shareholding o r manag erial

r o le that mig ht or mig ht n ot be fill ed

. Participants who were once friend l y to e ach other wi l l accumulate g rudg es. Some partici p a n ts will w ant to g o on to other
ventures. Others will want to bri ng in new associates, who may or may not be acceptable to the others. 1 7

I f, for e x a m p l e , a buy out o ffer could enrich W alters a nd Coulter but would end Cooper’s influe n c e o ver TL C, that mig ht create c onflict between the shareholders. Yet Cooper

16 Id

. at 7 8 1

– 8 3

.

17 Id

. at 7 6 3

.C O O P E R V

. CI R

28

would lack any power to make W alters and Coulter reject the buy out. They would be multimillionaires and he w ould lose his connection to his own inventions.

B e cause the m a

j o rity opinion makes “control” a v ag ue and ambig uous term, it risks e v iscerating § 1235 c apital g ains
tre a t m e n t when transfers are made to close corporations. Cong r ess thoug ht it was a g ood idea to g ive patent holders a
ta x b enefit, but the majority ’s decision creates so much risk of litig ation that it may be a bad idea to claim the benefit. A transfer to a corporation directed by the inventor’s employ ees and attorney was g ood enoug h in Charlson

. 1 8 A transfer to a corpo r ation directed by one’s long time friend was g ood
enoug h in Lee

. 1 9 And a transfer to a c orporation c ontrolled b y one’s own brother is g ood enoug h under the reg ulations. 2 0 Yet now a transfer to a c orporation controlled by one’s sisterin-law and her friend is not g ood enoug h, even if the tax pay er lacks any means to compel those direc tors to do his will. According ly
, it is not possible to say wit h c o nfidence what close corporation arrang e ment w ill qualify for capital g ains
treatment.

I n short, the majority opinion does not say how “control” is distinct from “mere influence,” so mere influence of some

v a gue and indeterminate kind prevents capital g a in s treatment. “Control” means the tax pay er can make the transferee corporation do what h e wants, while “influence”

means that a lthoug h the corporation may defer to his

18 5 25 F.2 d at 1 0 4 8

– 4 9 , 1 0 5 7

.

19 3 02 F. Su

p p . at 9 4 8 , 9 5 0

.

20 2 6 C.F.R. § 1 .1 23 5

- 2 (f )(3 ).C O O P E R V

. CI R 29

judg ment or b e persuaded by his v iew, he cannot make the corporation do what he wants. The better approach is the o ne

seen in Charlson and Lee : that “control” means the ability to compel what the transferee corporation does.