On January 13, 2021, the Tax Court issued a Memorandum Opinion in the case of Filler v. Commissioner (T.C. Memo. 2021-6). The issues presented in Filler v. Commissioner were whether the petitioner (1) properly reported $100,000 in income received as capital gain rather than ordinary income; (2) is liable for self-employment tax; (3) is entitled to deduct a net operating loss carryover originating in tax year 2012; and (4) is liable for penalty under IRC § 6662(a).
Background to Filler v. Commissioner
The petitioner is no idiot. He is, quite literally, a brain surgeon – a board-certified one at that.
Nevertheless, he represented himself pro se, and so he might as well be a brain plumber in my estimation…not that there is anything wrong with plumbers, just the pro-se-dingbat-cheapskate-brain-plumber in question.
It should come as no surprise the good doctor organized, owned, and/or provided services to at least five corporations and several sole proprietorships—one for which he performed services as a corporate promoter. Specifically, he promoted the formation of a new California corporation. The petitioner also owned rights to a patented technology used in MRIs. In 1997, the petitioner executed a pre-incorporation agreement with respect to a new corporation NeuroGrafix, Inc. (“NGI”).
NGI was expected the issue 100,000 shares, of which the petitioner would receive 75,000 shares in exchange for his preformation activities, which were conducted through one of his sole proprietorships. The preformation activities included amounts expended for legal, consulting, travel, and business development, as well as future expenses related to legal arrangements associated with the incorporation of NGI. The petitioner was also to negotiate personal licenses to the patent, which he would then transfer to NGI.
NGI was incorporated in California on December 16, 1998. After incorporation, the petitioner, through his sole proprietorship, entered into a licensing agreement with NGI for the transfer of the patent to NGI. In return the petitioner received 75,000 shares of NGI and “royalties” of 20% of NGI’s gross income (up to $100,000). He was also to receive compensation of $100,000 per year. NGI initiated a number of lawsuits from 2008 to 2012 (some of which, the Tax Court acknowledges, are still pending) with respect to infringement of the patent. NGI was successful—to the tune of $10.3 million in settlements.
The Returns
For 2010 through 2012, the petitioner and his wife timely filed joint Federal income tax returns using a CPA firm to prepare and file them. In 2013 the return, though timely, was self-prepared. Further, each of the three original returns were subsequently amended twice—with no tax professional being consulted on any such amendment.
The first amended return was for tax year 2011 and reported that the major changes were due to capital gains treatment of purchase payments for a patent under IRC § 1231 according to a 1998 agreement. The same explanation was provided on the 1040X for tax years 2010 and 2012 (which, I might add, were unsigned and undated). The second major amended return, this time for 2012, reported a $5.25 million loss from theft or involuntary conversion of property used in a trade or business; however, this return was not processed by the IRS…however, it did generate (in the good doctor’s mind) a fairly sizeable net operating loss (NOL) that he carried back ($4.1m) to 2010 and 2011 and forward to 2013, all of which years he submitted a second amended return.
Perhaps coming to his senses, the petitioner once again hired the CPA firm to prepare his 2014 return, which reported $100,000 the petitioner received from NGI as capital gain from an installment sale as well as a $1.95 million NOL carryover. Ironically, it was the 2014 return that the IRS selected for examination.
The Notice of Deficiency
The IRS disallowed the entirety of the NOL and had the gall to observe that the petitioner had “no reasonable basis for claiming the disallowed NOL.” The IRS likewise challenged the $100,000 reported as capital gain from installment sale proceeds, which it recharacterized as royalty income reportable on Schedule E (subject to self-employment tax). For good measure, the IRS slapped on a substantial understatement or negligence penalty under IRC § 6662(a), (b)(1), and (b)(2).
Long-Term Capital Gain or Ordinary Income
The Tax Court first tackles whether the $100,000 the petitioner received from NGI is taxable as ordinary income or as long-term capital gain subject to tax at the preferential rates set forth in IRC § 1(h). IRC § 1235(a) provides that a transfer (other than by gift, inheritance, or devise) of all substantial rights to a patent by any holder shall be treated as the sale or exchange of a capital asset held for more than 1 year (i.e., long-term capital gain) regardless of the period the asset is held or whether the payments in consideration of the transfer are contingent upon the productivity, use, or disposition of the property transferred. Thus, for the transfer of a patent to qualify as a sale or exchange of a long-term capital asset under IRC § 1235, the holder does not have to hold the asset for more than one year. See IRC § 1235(a). Critically, however, IRC § 1235(a) does not apply if the transferee is a related person. See IRC § 1235(d).
An individual shareholder and corporation are considered related persons if the individual owns 25% or more of the stock of the corporation directly or indirectly. IRC § 267(b)(2); IRC § 267(c), IRC § 1235(d). A transfer by a person other than a holder or a transfer by a holder to a related person is not governed by IRC § 1235. Treas. Reg. § 1.1235-1(b). Instead, the tax consequences of such transactions are determined under other provisions of the Code. NGI was a related person at the time of the transfer of the patent because the petitioner owned 75% of the corporation.
When IRC § 1235 does not apply to the transfer of rights in a patent, the character of the gain is determined under other provisions of the Code. Treas. Reg. § 1.1235-(b); Rev. Rul. 69-482, 1969-2 C.B. 164; see also Cascade Designs, Inc. v. Commissioner, T.C. Memo. 2000-58. Among these other provisions are IRC § 1222 (definition of long-term gain) and IRC § 1231 (allowance of long-term capital gain treatment).
IRC § 1222(3) generally provides that gain from the sale or exchange of capital assets held for more than one year will result in long-term capital gain. First and foremost, to satisfy this provision the transferor must hold the asset for one year or more. IRC § 1222(3). The petitioner never actually “held” the patent. He had transferred the rights of the patent while it was still pending in 1993, and did not fully hold it in 1998 when its license was transferred to NGI. Furthermore, simply serving as a “middleman” does not satisfy the “sale or exchange” requirement of IRC § 1222(3). See Juda v. Commissioner, 90 T.C. 1263, 1281-1282 (1988), aff’d, 877 F.2d 1075 (1st Cir. 1989); see also Cooper v. Commissioner, 143 T.C. 194, 207 (2014), aff’d, 877 F.3d 1086 (9th Cir. 2017); Kaczmarek v. Commissioner, T.C. Memo. 1982-66.
IRC § 1231, too, may afford long-term capital gain treatment for transfers of certain property if net gain exceeds net losses. IRC § 1231(a)(1) and (2). Generally, IRC § 1231 applies to the sale or exchange of property held for more than one year that is used in a trade or business subject to the allowance of depreciation under IRC § 167. IRC § 1231(a)(3); IRC § 1231(b)(1). As previously discussed, the petitioner did not receive the $100,000 of remuneration in connection with a sale or exchange of property held for more than one year. He therefore also fails to achieve capital gain treatment under IRC § 1231.
Liability for Self-Employment Tax
In addition to other taxes, IRC § 1401 imposes self-employment tax on the amount of self-employment income for each taxable year. The term “self-employment income” is defined as the net earnings from self-employment derived by an individual during any taxable year. IRC § 1402(b). The term “net earnings from self-employment” is defined as the gross income derived from any trade or business carried on by the individual, less deductions. IRC § 1402(a).
The term “trade or business” has the same meaning under IRC § 1402(a), defining “net earnings from self-employment,” as under IRC § 162. IRC § 1402(c); Bot v. Commissioner, 118 T.C. 138, 146 (2002), aff’d, 353 F.3d 595 (8th Cir. 2003). “Trade or business” under IRC § 162 has been interpreted to mean an activity conducted “with continuity and regularity” and with the primary purpose of making income or a profit. See Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); Bot, 118 T.C. at 146. The carrying on of a trade or business for purposes of self-employment tax generally does not include the performance of services as an employee. IRC § 1402(c)(2); Robinson v. Commissioner, 117 T.C. 308, 320 (2001).
The petitioner bears the burden of proof with respect to the self-employment tax issue. See Rule 142(a); Welch v. Helvering, 290 U.S. at 115. He did not pursue an argument on brief with respect to this issue, and therefore the Tax Court deemed the issue conceded. See Mendes v. Commissioner, 121 T.C. 308, 312-313 (2003) (holding that arguments not addressed in posttrial brief may be considered abandoned); Leahy v. Commissioner, 87 T.C. 56, 73-74 (1986) (same).
Net Operating Loss (with a Frolic and Detour into Theft Losses)
IRC § 172 allows a taxpayer to deduct an NOL for a taxable year. A taxpayer may generally deduct as an NOL for a taxable year an amount equal to the sum of the NOL carryovers and carrybacks to that year. IRC § 172(a). An NOL is defined as the excess of deductions over gross income for a particular taxable year, with certain modifications. See IRC § 172(c) and (d). The petitioner, as the claimant of an NOL deduction, must prove his right thereto. See Rule 142(a); United States v. Olympic Radio & Television, Inc., 349 U.S. 232, 235 (1955). As a part of his burden, the petitioner must prove that he is entitled to deduct his reported loss under the Code. See New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); see also INDOPCO, Inc. v. Commissioner, 503 U.S. at 84 (generally, deductions are a matter of legislative grace and not a matter of right); Jones v. Commissioner, 24 T.C. 525, 527 (1955); Allen v. Commissioner, 16 T.C. 163, 166 (1951).
IRC § 165(a) permits a deduction for any loss sustained during the taxable year and not compensated by insurance or otherwise. Realization is required before a loss may be recognized for tax purposes. IRC § 165(a); United States v. S.S. White Dental Mfg. Co., 274 U.S. 398, 401 (1927); Treas. Reg. § 1.165-1(d)(1). Taxpayers are eligible to claim a loss deduction if the following three requirements are met: (1) there is a closed and completed transaction, (2) fixed by identifiable events, and (3) the loss is actually sustained. Treas. Reg. § 1.165-1(b), (d).
There is no “closed and complete transaction, fixed by identifiable events” for a mere fluctuation in the value of property owned by the taxpayer. Sunset Fuel Co. v. United States, 519 F.2d 781, 783 (9th Cir. 1975) (quoting Treas. Reg. § 1.165-1(b)); see also S.S. White Dental Mfg. Co., 274 U.S. at 401-402; Eisner v. Macomber, 252 U.S. 189 (1920) (mere appreciation in value is not a taxable gain). Rather, an affirmative step, such as abandonment or a sale or exchange, combined with a diminution in value fixes the amount of the loss. Lakewood Assocs. v. Commissioner, 109 T.C. 450, 459 (1997), aff’d without published opinion, 173 F.3d 850 (4th Cir. 1998).
The petitioner argued that the settlement agreement he entered into was an inverse condemnation of his stock in NGI, which made his stock “unsalable” at that point—meaning that there was no reasonable prospect of recovery, and the transaction was closed and completed. The Tax Court, ever so politely, tells the good doctor to shove it. Even if the Tax Court was the right forum to decide his cockamamie questions of law, the petitioner has “claimed nothing but a mere diminution in value in his stock,” which is not a realization event that supports a loss deduction. See Sunset Fuel Co., 519 F.2d at 783; Treas. Reg. § 1.165-1(b), (d); Treas. Reg. § 1.165-4(a) (observing that “[a] mere shrinkage in the value of stock owned by the taxpayer, even though extensive, does not give rise to a deduction under section 165(a) if the stock has any recognizable value on the date claimed as the date of loss”).
(T.C. Memo. 2021-6) Filler v. Commissioner
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