Court Opinion

ID: 9451171
Source: CourtListenerOpinion
Date Created: 2023-08-04 17:08:28.061581+00
Date Added: 2024-06-11T17:32:35.797699
License: Public Domain

*1003FRIENDLY, Circuit Judge
(concurring in the result):
Section 1235 of the Internal Revenue Code of 1954 confers extraordinary income tax advantages on holders of patents. It accords long-term capital gain treatment to the transfer of patent rights even though the particular patent is not a “capital asset” and has not been held for the six months ordinarily required, and although a usual form of the transfer, with payment contingent on production or sale and extending over a long period, is not what many people — importantly including the Commissioner of Internal Revenue, Mim. 6490, 1950-1 Cum. Bull., 9-10 — would regard as a “sale or exchange.” Naturally Congress did not want these unusual advantages to be available when the transferor retained a large measure of economic benefit through ownership in the transferee. Least of all could it have wanted a husband, by means of even the best faith transfer of a patent to his wife, to eat, drink and be merry, at long-term capital gains rates, on what would have been taxable as ordinary income to him if the transfer had not occurred. To that end it inserted § 1235(d), expressly denying the special tax treatment to transfers to related persons.
The problem here stems from the method adopted by the draftsmen of § 1235(d) to exclude such transactions — a cross-reference to § 267(b) of the Code, which disallows deductions for losses incurred in transactions between the taxpayers therein specified. The particular difficulty lies in the incomplete definition of “related taxpayer” in § 267; though speaking at some length about relationships between natural persons, between them and corporations, and between corporations, the section says nothing about relationships between natural persons and partnerships.
I heartily agree with my brothers in rejecting taxpayers’ primary position that because of this omission a transfer of a patent to a partnership is immune from the § 1235(d) disqualification of transactions with related persons —a position which would mean, for example, that a professional inventor could obtain long-term capital gain treatment by granting an exclusive license on his patent to a partnership in which he had a 75%, or even a 90%, interest.1 But I cannot agree with their rejection of the Commissioner’s primary position, namely, that when long-term capital gain treatment under § 1235 is sought for a transfer to a partnership, the transaction must be tested by applying the provisions of § 267(b), the section of the Code mentioned in § 1235(d), to the natural persons who form the partnership, and not by those of § 707, which § 1235(d) ignores.
The legislative history of § 1235 indicates the deep concern of Congress that the special treatment for transfers of patent rights there accorded should not be available for “possible non-arm’s-length transactions between related taxpayers.” 1954 U.S.Code Cong. & Ad.News, pp. 4422-23. The exclusion of transfers between related persons was expressly intended to “prevent possible abuses arising from the sale of patents within essentially the same economic group.” Ibid. To achieve this purpose, the related person limitation of § 1235(d) in the 1954 Code disqualified transfers to corporations when more than 50% of the stock was owned by the transferor; this was further tightened in 1958, to exelude transactions when the transferor held a 25% or greater interest in the corporation. 26 *1004U.S.C. § 1235(d), as amended, 72 Stat. 1644 (1958).2 3 Despite the absence of any similar mention of partnerships, mere statement creates serious question as to the good sense of a reading whereby a transfer to a partnership will qualify unless more than 80% is owned by the transferor, although retention of a 25% interest in a corporation would defeat the special § 1235 benefits. That no such anomaly was ever intended and that Congress, in omitting any reference to partnerships in § 1235, simply assumed that the partnership entity would be disregarded, becomes clear from the legislative history of § 707 and the rationale which was stated to underlie the liberal provisions of that section generally recognizing capital gains in transfers from individual partners to their own partnerships.
The House version of § 707, which contained the general rule that a partner who engages in a transaction with a partnership shall be treated as though he were an outsider, provided that no gain or loss should be recognized when the transferring partner had an interest of 50% or more in the capital or profits of the partnership — the same test employed in § 267(b) with respect to the allowance of losses in transfers to controlled corporations. 1954 U.S.Code Cong. & Ad. News pp. 4093-94, 4366-67. The Senate Finance Committee thought the proviso was “unduly harsh” because there was “little opportunity in this area to convert potential ordinary income into capital gains” and because much more lenient treatment was already available for similar transactions between stockholders and their corporations. It therefore substituted “the present provisions applicable in the case of ’corporations” — namely, that gains would be recognized save where the transferor owned in excess of 80% but losses would be recognized only if such interest did not exceed 50%. 1954 U. S. Code Cong. & Ad. News pp. 4726, 5028-29. The Senate provision was adopted by the Conference Committee, but the following express reservation was included in their report:
Both the House provision and the Senate amendment provide for the use of the “entity” approach in the treatment of the transactions between a partner and a partnership which are described above. No inference is intended, however, that a partnership is to be considered as a separate entity for the purpose of applying other provisions of the internal revenue laws if the concept of the partnership as a collection of individuals is more appropriate for such provisions. 1954 U.S.Code Cong. & Ad.News pp. 5319-20.
The legislative history not only does not disclose an intention that any transfer of a patent to a partnership meeting the tests of § 1235(a) and (b) should qualify for long-term capital gain treatment unless it falls within the exception of § 707(b) (2), but strongly indicates that reference to that subsection as the test for relationship is unwarranted. The opportunity to convert ordinary income into capital gain, the absence of which was the express reason for the Senate’s liberalizing the House version of § 707, is precisely what § 1235 creates; and treating the partnership as a collection of individuals is “appropriate” for fulfilling the purpose of § 1235(d) to prevent abuses from sales of patents within the same economic group. But there is much more than this. Since the stated philosophy of the broadened § 707 was that transfers to partnerships should receive the same treatment as transfers to corporations, it would be wholly inconsistent with the congressional purpose to utilize § 707 to give a transfer to a partnership a far more favorable posture under § 1235 than one to a corporation. The corporate analogue to § 707(b) (2) *1005is § 1239, which permits capital gains to be recognized unless the transferor owns more than 80%. Congress deliberately rejected that test in delimiting the transfers to a controlled corporation that would qualify for long-term capital gain treatment under § 1235; instead it imposed the more severe 50% test used in § 267 with respect to the allowance of losses, and subsequently it reduced the allowable percentage of control still further. It would be hard to find a more compelling basis for concluding that, in the application of § 1235, reliance on the entity concept of § 707 and use of § 707 (b) (2) as the standard for recognizing transfers to partnerships is not justified, and that disregard of the partnership entity would be “more appropriate,” in the language of the Conference Report, to avoid especially favorable treatment for patent transfers between related persons. Cf. Rossmoore v. C. I. R., 76 F.2d 520, 521 (2 Cir. 1935). The taxpayers here necessarily concede that if this is the proper approach, the transfer does not qualify under § 1235, see §§ 267(b) (1) and (c) (4).
It is true that ignoring the partnership entity will not provide equality as between partnerships and corporations for transfers that qualify for long-term capital gain treatment only because of § 1235. From the standpoint of equality alone, the ideal solution might be — or before the 1958 amendment of § 1235(d) might have been — to apply the 50% test used in § 707(b) (1) in regard to the allowance of losses. But to do that would be taking greater liberties with the text than a court may permissibly do. When the only available choice is between applying the liberal 80% test of § 707(b) (2), which Congress manifestly did not intend in this context, and disregarding the entity concept, which Congress directed the Commissioner and the courts to do when “more appropriate,” the answer can scarcely be in doubt. See United States v. American Trucking Ass’n, 310 U.S. 534, 543, 60 S.Ct. 1059, 84 L.Ed. 1345 (1940); J. C. Penney Co. v. C. I. R., 312 F.2d 65, 68-69, 72-78 (2 Cir. 1962).

. It might be argued that when the transferor’s interest approaches total ownership of the transferee partnership, there has been no transfer of “all substantial rights” in the patent, and § 1235 is hence inapplicable, even though the transfer was not a sham. See Soffron v. C. I. R., 35 T.C. 787 (1961). But the “substantial rights” provision seems rather to have been aimed against retention of legal rights in the patent transferred, see Treas.Reg. § 1.1235-2 (b); 3B Mertens, Federal Income Taxation § 22.135 at 610-11 (1958), whereas Congress relied on § 1235(d) to deal with a transferor’s economic interest in a transferee that had obtained substantially all such rights.

. Although the latter restriction is only applicable to transfers taking place after September 2, 1958, it indicates a strong legislative intention that the benefits of § 1235 be denied when the transferor holds a substantial interest in the transferee corporation.