Cooper v. Commissioner ( 2017 )


Menu:
  •                  FOR PUBLICATION
    UNITED STATES COURT OF APPEALS
    FOR THE NINTH CIRCUIT
    JAMES C. COOPER; LORELEI M.               No. 15-70863
    COOPER,
    Petitioners-Appellants,        Tax Ct. No.
    17284-12
    v.
    COMMISSIONER OF INTERNAL                      OPINION
    REVENUE,
    Respondent-Appellee.
    Appeal from a Decision of the
    United States Tax Court
    Argued and Submitted October 4, 2017
    Pasadena, California
    Filed December 15, 2017
    Before: Andrew J. Kleinfeld, Susan P. Graber,
    and Morgan Christen, Circuit Judges.
    Opinion by Judge Graber;
    Partial Concurrence and Partial Dissent by Judge Kleinfeld
    2                          COOPER V. CIR
    SUMMARY*
    Tax
    The panel affirmed the Tax Court’s decision, after a
    bench trial, on a petition for redetermination of federal
    income tax deficiencies in which taxpayers sought capital
    gains treatment of patent-generated royalties pursuant to
    26 U.S.C. § 1235(a).
    Taxpayer James Cooper is an engineer and inventor
    whose patents generated significant royalties. He and his
    wife incorporated and transferred their rights to the patents to
    Technology Licensing Corporation (TLC), which was formed
    by taxpayers and two other individuals, Walters and Coulter.
    If a patent holder, through effective control of the
    corporation, retains the right to retrieve ownership of the
    patent at will, then there has not been a transfer of all
    substantial rights to the patent so as to warrant capital gains
    treatment of the royalties under § 1235(a). The panel held that
    the Tax Court permissibly concluded that Mr. Cooper did not
    transfer “all substantial rights” to the patents to TLC because
    Walters and Coulter acted at Mr. Cooper’s direction, did not
    exercise independent judgment, and returned patents to Mr.
    Cooper when requested for no consideration.
    Taxpayers claimed a deduction for a nonbusiness “bad
    debt” pursuant to 26 U.S.C. § 166(d)(1)(B), which allows
    short-term capital-loss treatment of a loss “where any
    nonbusiness debt becomes worthless within the taxable year.”
    *
    This summary constitutes no part of the opinion of the court. It has
    been prepared by court staff for the convenience of the reader.
    COOPER V. CIR                         3
    The panel held that the Tax Court permissibly concluded that
    the debt had not become “totally worthless.”
    Finally, the panel upheld the Tax Court’s determination
    that taxpayers failed to meet their burden of showing that they
    actually relied in good faith on their advisers’ judgment so as
    to avoid accuracy-related penalties under 26 U.S.C. §§ 6662
    and 6664.
    Judge Kleinfeld dissented as to Section A of the majority
    opinion regarding the royalty payments as capital gains,
    joined in Section B as to the bad debt deduction, and
    observed that the accuracy penalties discussed under Section
    C would need to be revisited if his view on the royalties were
    to be accepted. Judge Kleinfeld opined that the better
    approach to distinguishing “control” from “mere influence”
    over a corporation is the approach set forth in Charlson v.
    United States, 
    525 F.2d 1046
    (Ct. Cl. 1975) (per curiam), and
    Lee v. United States, 
    302 F. Supp. 945
    (E.D. Wis. 1969): that
    “control” means the ability to compel what the transferee
    corporation does.
    COUNSEL
    Richard G. Stack (argued) and Dennis N. Brager, Brager Tax
    Law Group P.C., Los Angeles, California, for Petitioners-
    Appellants.
    Clint A. Carpenter (argued) and Richard Farber, Attorneys,
    Tax Division; Caroline D. Ciraolo, Principal Deputy
    Assistant Attorney General; United States Department of
    Justice, Washington, D.C.; for Respondent-Appellee.
    4                       COOPER V. CIR
    OPINION
    GRABER, Circuit Judge:
    Petitioners James and Lorelei Cooper are married
    taxpayers who challenge the Commissioner of Internal
    Revenue’s notice of deficiency for tax years 2006, 2007, and
    2008. Mr. Cooper’s patents generated significant royalties
    during those years. Petitioners sought capital gains treatment
    of those royalties pursuant to 26 U.S.C. § 1235(a) on the
    theory that Mr. Cooper had transferred to a corporation “all
    substantial rights” to the patents. After a bench trial, the Tax
    Court disagreed, finding that Mr. Cooper effectively
    controlled the recipient corporation such that he had not
    transferred all substantial rights to the patents. The Tax Court
    also found that Petitioners could not take a bad debt tax
    deduction in 2008 because the debt at issue had not become
    worthless during that year, and that Petitioners had not
    established reasonable cause to avoid accuracy penalties
    arising from their underpayment. Because the Tax Court
    accurately applied the law and did not clearly err in its factual
    findings, we affirm.
    FACTUAL AND PROCEDURAL HISTORY
    Mr. Cooper is an engineer and inventor. He is the named
    inventor on more than 75 patents in the United States. His
    patents are primarily for products and components used in the
    transmission of audio and video signals. Petitioners are co-
    trustees of a family trust, referred to as the “Cooper Trust.”
    In 1983, Petitioners incorporated Pixel Instruments
    Corporation (“Pixel”). Mr. Cooper was president, and Ms.
    Cooper held various positions, including vice president.
    Petitioners wholly owned Pixel until 2006.
    COOPER V. CIR                          5
    In 1988, Mr. Cooper and Pixel entered into a
    commercialization agreement with Daniel Leckrone. Mr.
    Cooper and Pixel assigned their patents to a licensing
    company formed by Leckrone, in exchange for royalty
    payments arising from the commercialization of the patents.
    The arrangement brought significant tax benefits to
    Petitioners.     Because Petitioners had transferred “all
    substantial rights” to the patents to the licensing company,
    26 U.S.C. § 1235(a) permitted Petitioners to treat the
    payments from the licensing company as capital gains. But
    in 1997, after disputes with Leckrone, Mr. Cooper terminated
    the commercialization agreement. All of Mr. Cooper’s patent
    rights reverted to his assignee pursuant to a settlement and
    arbitration.
    Understandably, Petitioners sought to retain the tax
    benefits afforded by § 1235 and, to that end, they sought legal
    advice from Gordon Baker. Baker advised them that they
    could set up a licensing company to which to transfer the
    patents, so long as they complied with two requirements that
    are relevant here. First, he advised them that, pursuant to
    § 1235(c),1 they could not own 25 percent or more of the
    company. Second, he advised them that, regardless of formal
    ownership, they could not effectively control the new
    company. The prohibition on effective control had been
    discussed at length in Charlson v. United States, 
    525 F.2d 1046
    , 1053 (Ct. Cl. 1975) (per curiam).
    1
    Section 1235(c) formerly was labeled § 1235(d). We use the
    present-day citation.
    6                          COOPER V. CIR
    Petitioners, joined by Lois Walters and Janet Coulter,
    incorporated Technology Licensing Corporation (“TLC”).2
    Walters is Ms. Cooper’s sister, and Coulter is a long-time
    friend of Ms. Cooper and Walters. During all relevant times,
    Coulter and Walters lived in Ohio, and both held full-time
    jobs unrelated to TLC. Neither Coulter nor Walters had any
    experience in patent licensing or patent commercialization
    before their involvement with TLC.
    Consistent with Baker’s advice, Petitioners, as co-trustees
    of the Cooper Trust, owned only 24% of the TLC stock;
    Walters owned 38%; and Coulter owned 38%. Walters was
    president and chief financial officer, Ms. Cooper was vice
    president, and Coulter was secretary.
    In 1997, Mr. Cooper and Pixel entered into agreements
    with TLC. Under the TLC agreements, Mr. Cooper and Pixel
    transferred to TLC all rights to certain patents, and TLC
    agreed to pay Mr. Cooper and Pixel royalty payments using
    a formula that relied on percentages of gross and net proceeds
    received from licensing the patents. During 2006, 2007, and
    2008—the years at issue here—Mr. Cooper received royalty
    payments pursuant to the TLC agreements, and Petitioners
    treated those payments as capital gains.
    During 2008, Petitioners also claimed a deduction on their
    2008 tax return for a nonbusiness “bad debt” pursuant to
    2
    In 2003, Petitioners moved from California to Nevada. They then
    incorporated a second Technology Licensing Corporation in that state,
    with the same board membership and the same stock ownership. The two
    corporations merged in 2004, with the Nevada corporation emerging as
    the surviving corporation. We follow the Tax Court’s convention of
    referring to both the original corporation and the surviving corporation as
    “TLC.”
    COOPER V. CIR                               7
    26 U.S.C. § 166(d)(1)(B), which allows short-term capital-
    loss treatment of a loss “where any nonbusiness debt becomes
    worthless within the taxable year.” The debt arose from a
    working capital promissory note from the Cooper Trust to
    Pixel. At the end of 2008, the outstanding balance on the
    promissory note was a little more than $2 million, and Mr.
    Cooper concluded that Pixel could not pay the outstanding
    balance.
    The Commissioner issued a notice of deficiency to
    Petitioners. Relevant here, the Commissioner disagreed that
    the royalty payments from TLC qualified as capital gains; he
    disagreed that the Pixel promissory note debt qualified as a
    bad debt deduction; and he assessed penalties for those errors.
    Petitioners sought review by the Tax Court. After a trial, the
    Tax Court agreed with the Commissioner on all three points,
    and the court ordered Petitioners to pay deficiencies and
    penalties totaling approximately $1.5 million. Petitioners
    timely appeal.3 See 26 U.S.C. § 7482(a)(1) (permitting
    appeals from the Tax Court to the applicable circuit court).
    STANDARDS OF REVIEW
    “We review decisions 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 questions of
    fact are reviewed for clear error.” Johanson v. Comm’r,
    
    541 F.3d 973
    , 976 (9th Cir. 2008) (internal quotation marks
    omitted).
    3
    The Tax Court ruled in favor of Petitioners on a separate issue; the
    Commissioner did not cross-appeal. That ruling therefore is final.
    8                      COOPER V. CIR
    DISCUSSION
    “Determinations made by the Commissioner in a notice
    of deficiency normally are presumed to be correct, and the
    taxpayer bears the burden of proving that those
    determinations are erroneous.” Merkel v. Comm’r, 
    192 F.3d 844
    , 852 (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 challenge the Tax Court’s conclusion that
    they bear the burden of proof.
    Petitioners challenge the Tax Court’s rulings on (A) the
    treatment of royalty payments as capital gains; (B) the
    treatment of the Pixel loan as a bad debt; and (C) the
    imposition of penalties.
    A. Royalty Payments as Capital Gains
    The Tax Code generally treats income derived from a
    capital asset as ordinary income. By contrast, the Tax Code
    generally treats the proceeds from the sale of a capital asset
    more favorably, as capital gains. Real property provides a
    good example: If a homeowner rents a house, the rents are
    ordinary income; but if the homeowner sells the house, the
    proceeds from the sale are capital gains. Patents do not fit
    neatly within that dichotomy, because patent holders often
    sell all substantial rights to a patent in exchange for periodic
    payments contingent on the patent’s productivity. But
    because that payment arrangement appears so similar to rent,
    the Commissioner originally treated the proceeds from such
    exchanges as ordinary income—even though the patent
    holder had divested all meaningful property rights in the
    COOPER V. CIR                            9
    patent. See Fawick v. Comm’r, 
    436 F.2d 655
    , 659–61 (6th
    Cir. 1971) (describing this history).
    In 1954, Congress responded by enacting 26 U.S.C.
    § 1235. Subsection 1235(a) provides:
    A transfer (other than by gift, inheritance,
    or devise) of property consisting of all
    substantial rights to a patent . . . by any holder
    shall be considered the sale or exchange of a
    capital asset held for more than 1 year,
    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.
    Accordingly, if a patent holder transfers “all substantial rights
    to a patent,” then the resulting royalty payments are treated as
    capital gains, because the patent has been “sold.” By
    contrast, if a patent holder retains substantial rights to a patent
    and merely licenses the patent, then the resulting payments
    are not treated as capital gains, because the patent has not
    been “sold.” The key consideration is whether the patent
    holder “transfer[red] . . . all substantial rights” to the patent.
    
    Id. Petitioners urge
    us, for the first time on appeal, to
    determine whether there has been a transfer of all substantial
    rights by looking solely to the formal documents, without
    10                          COOPER V. CIR
    regard to the practical realities of the transaction.4 We
    decline the invitation. A bedrock principle of tax law—now
    and in 1954—is that substance controls over form. See, e.g.,
    United States v. Eurodif S.A., 
    555 U.S. 305
    , 317–18 (2009)
    (“[I]t is well settled that in reading regulatory and taxation
    statutes, form should be disregarded for substance and the
    emphasis should be on economic reality.” (internal quotation
    marks omitted)); Helvering v. F. & R. Lazarus & Co.,
    
    308 U.S. 252
    , 255 (1939) (“In the field of taxation,
    administrators of the laws and the courts are concerned with
    substance and realities, and formal written documents are not
    rigidly binding.”). Nothing in § 1235 suggests that Congress
    intended a different rule to apply here. To the contrary,
    considerable legal authority supports our conclusion that,
    when determining whether there has been a transfer of all
    substantial rights, we must look beyond the bare form of the
    transaction.
    Acting pursuant to an express statutory delegation,
    26 U.S.C. § 7805(a), the Secretary of the Treasury
    (“Secretary”) has promulgated regulations concerning the
    statutory phrase “all substantial rights to a patent.” 26 C.F.R.
    § 1.1235-2(b). We defer to the Secretary’s regulations. See
    Kueneman v. Comm’r, 
    628 F.2d 1196
    , 1201 (9th Cir. 1980)
    (“The Secretary has broad authority to promulgate reasonable
    regulations to implement the revenue laws . . . .”); Comm’r v.
    Portland Cement Co. of Utah, 
    450 U.S. 156
    , 169 (1981)
    (“Treasury Regulations ‘must be sustained unless
    unreasonable and plainly inconsistent with the revenue
    4
    The issue is purely one of law, and the parties have briefed it to us.
    We exercise our discretion to reach the issue, despite Petitioners’ failure
    to raise it before the Tax Court. Bolker v. Comm’r, 
    760 F.2d 1039
    , 1042
    (9th Cir. 1985).
    COOPER V. CIR                         11
    statutes.’” (quoting Comm’r v. S. Tex. Lumber Co., 
    333 U.S. 496
    , 501 (1948))). The pertinent Treasury Regulation states:
    “The circumstances of the whole transaction, rather than the
    particular terminology used in the instrument of transfer, shall
    be considered in determining whether or not all substantial
    rights to a patent are transferred in a transaction.” 26 C.F.R.
    § 1.1235-2(b)(1). That interpretation finds support in the
    legislative history, specifically a Senate Finance Committee
    report that stated:
    It is the intention of your committee to
    continue this realistic test, [developed under
    prior case law,] whereby the entire
    transaction, regardless of formalities, should
    be examined in its factual context to
    determine whether or not substantially all
    rights of the owner in the patent property have
    been released to the transferee . . . .
    S. Rep. No. 83-1622, at 440 (1954), as reprinted in 1954
    U.S.C.C.A.N. 4621, 5083. Not surprisingly, then, we
    previously have described the inquiry in practical terms:
    “What did the taxpayer actually give up by the transfer; that
    is, was there an actual transfer of the monopoly rights in a
    patent . . . .” 
    Kueneman, 628 F.2d at 1199
    (emphases added
    and original emphasis omitted) (quoting Mros v. Comm’r,
    
    493 F.2d 813
    , 816 (9th Cir. 1974) (per curiam)).
    In Charlson, 
    525 F.2d 1046
    , the United States Court of
    Claims described how the principle applies in a case
    involving a transfer of patent rights to a corporation. In that
    case, the inventor formally transferred all substantial rights to
    certain patents to a corporation that was owned by the
    inventor’s close friends and associates. 
    Id. at 1048–49.
    12                      COOPER V. CIR
    Section 1235(c) provides that royalties from a patent transfer
    are not taxable as capital gains if the recipient is a “related”
    person or entity.         The 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
    exclusive or exhaustive statement of the impact of control
    over a § 1235(a) transaction.” 
    Id. at 1053.
    It is “clear,” the
    court held, “that retention of control by a holder over an
    unrelated corporation can defeat capital gains treatment, if the
    retention prevents the transfer of ‘all substantial rights.’” 
    Id. “This is
    because the holder’s control over the unrelated
    transferee . . . places him in essentially the same position as
    if all substantial rights had not been transferred.” Id.; see also
    
    id. (describing Congress’
    “obvious intent of having a
    transferor’s acts speak louder than his words in establishing
    whether a sale of a patent has occurred”).
    We agree: If a patent holder exercises control over the
    recipient corporation such that, in effect, there has not been
    a transfer of all substantial rights in the subject patent(s), then
    the requirements of § 1235(a) are not met, even if the
    documents describing the transfer formally assign all
    substantial rights. The key inquiry remains whether, as a
    practical matter, the transferor shifted all substantial rights to
    the recipient. Mere influence by the patent holder is
    insufficient to defeat § 1235(a) treatment, as is control by the
    patent holder of aspects of the corporation apart from the
    patent rights. A patent holder who formally transfers all
    substantial patent rights to a qualifying corporation is entitled
    to the benefits of § 1235(a) unless, through effective control
    of the corporation, he or she did not effectively transfer all
    substantial rights to the patent(s).
    COOPER V. CIR                         13
    Importantly, “[t]he retention of a right to terminate the
    transfer at will is the retention of a substantial right for the
    purposes of section 1235.” 26 C.F.R. § 1.1235-2(b)(4).
    Accordingly, if a patent holder, through effective control of
    the corporation, retains the right to retrieve ownership of the
    patent at will, then there has not been a transfer of all
    substantial rights. Stated differently, if the recipient
    corporation stands ready, as a practical matter, to return
    ownership of the patent to the patent holder at the holder’s
    direction, then there has not been a transfer of all substantial
    rights.
    Here, the Tax Court found, and we agree, that Petitioners
    complied with the formal requirements of § 1235. Mr.
    Cooper formally transferred all substantial rights to the
    patents to TLC, and Petitioners owned less than 25 percent of
    TLC. The Tax Court further found, however, that Mr.
    Cooper effectively controlled TLC within the meaning of
    Charlson such that, in effect, there had not been a transfer of
    all substantial rights to the patents. For the reasons that
    follow, we hold that the Tax Court did not clearly err.
    The Tax Court found that Walters and Coulter—the two
    shareholders other than the Cooper Trust—exercised no
    independent judgment and acted at Mr. Cooper’s direction.
    “During the years at issue, [Walters’ and Coulter’s] duties as
    directors and officers consisted largely of signing checks and
    transferring funds as directed by TLC’s accountants and
    signing agreements as directed by TLC’s attorneys.”
    “[S]ubstantially all of TLC’s decisions regarding licensing,
    patent infringement, and patent transfers were made either by
    Mr. Cooper or at his direction.” Walters and Coulter “acted
    in their capacities as directors and officers of TLC at the
    direction of Mr. Cooper. They did not make independent
    14                      COOPER V. CIR
    decisions in accordance with their fiduciary duties to TLC or
    act in their best interests as shareholders.”
    Those findings strongly suggest that TLC would take
    practically any action requested by Mr. Cooper—including
    the return of patent rights—without regard to the interests of
    TLC’s shareholders and without regard to the personal
    interests of Walters and Coulter. But the Tax Court was not
    required to speculate as to whether, upon Mr. Cooper’s
    request, TLC would return valuable patent rights to Mr.
    Cooper; that event in fact occurred. In 2006, upon request,
    TLC returned valuable patent rights to Mr. Cooper for no
    consideration. Mr. Cooper quickly commercialized the
    patents through a separate entity, which received $120,000 in
    revenue.
    In sum, the Tax Court permissibly concluded that Walters
    and Coulter acted at Mr. Cooper’s direction; did not exercise
    independent judgment; and, when requested, returned patents
    to Mr. Cooper for no consideration. Given that Walters and
    Coulter acquiesced, without question or explanation, in the
    rescission of the transfer of certain patents, there is no reason
    to think that they would have objected to the rescission of any
    other transfer of patents. Because the right to retrieve
    ownership of the patent is a substantial right, the Tax Court
    did not clearly err in ruling that Mr. Cooper did not transfer
    “all substantial rights” to the patents.
    We respectfully part ways from the dissent’s thoughtful
    analysis of this issue and offer the following observations in
    response.
    For all the reasons described above, the inquiry into
    whether there was a transfer of all substantial rights is a
    COOPER V. CIR                        15
    practical one, not merely a formalistic or legalistic one. We
    therefore reject the dissent’s suggestion that we must ask
    whether, in theory, TLC could have declined to transfer the
    patents back to Mr. Cooper; instead, we must ask whether, as
    a practical matter, Mr. Cooper retained the ability to retrieve
    the patents at will. Similarly, whether Mr. Cooper
    hypothetically could have forced TLC to comply with his
    wishes on other matters is beside the point.
    We recognize that there is a difference between mere
    influence to control sufficient to defeat § 1235(a) tax
    treatment. Reasonable minds may differ on where a
    particular situation lies. Having examined the record
    developed at trial in this case, and reviewing for clear error,
    we hold only that the Tax Court’s conclusion was a
    permissible one. Relatedly, we disagree with the dissent that
    the facts of Charlson require a different result here. The
    officers of the corporation in Charlson exercised independent
    judgment, and the corporation never returned patents to the
    inventor without consideration.
    Finally, we emphasize that our analysis is limited solely
    to the tax consequences of Petitioners’ business
    arrangements. Allowing an inventor to have effective control
    of the recipient corporation very well may be a smart business
    practice in some circumstances. We hold only that, if the
    patent holder effectively controls the corporation such that he
    or she did not transfer all substantial rights to the patents,
    then the tax treatment allowed by § 1235 does not apply.
    B. Bad Debt Deduction
    We review for clear error the Tax Court’s finding of the
    worthlessness of a debt. L.A. Shipbuilding & Drydock Corp.
    16                     COOPER V. CIR
    v. United States, 
    289 F.2d 222
    , 228–29 (9th Cir. 1961);
    accord Cox v. Comm’r, 
    68 F.3d 128
    , 131 (5th Cir. 1995).
    The taxpayer bears the burden of proving “that the debt
    became worthless within the tax year.” Andrew v. Comm’r,
    
    54 T.C. 239
    , 244–45 (1970). “The year a debt becomes
    worthless is fixed by identifiable events that form the basis of
    reasonable grounds for abandoning any hope of recovery.
    Petitioner must establish sufficient objective facts from which
    worthlessness could be concluded; mere belief of
    worthlessness is insufficient.” Aston v. Comm’r, 
    109 T.C. 400
    , 415 (1997) (citation omitted). The debt must “become
    totally worthless, and no deduction shall be allowed for a
    nonbusiness debt which is recoverable in part during the
    taxable year.” 26 C.F.R. § 1.166-5(a)(2). A taxpayer need
    not have initiated legal action against the debtor, but “he does
    have the burden of establishing that such an action, when
    considered in the light of objective standards, would in all
    probability have been entirely unsuccessful.” Dustin v.
    Comm’r, 
    467 F.2d 47
    , 48 (9th Cir. 1972) (footnotes omitted).
    The Tax Court found that, contrary to Petitioner’s
    assertion, the debt on Pixel’s promissory note did not become
    “worthless” in July 2008. 26 U.S.C. § 166(d)(1)(B). The
    court reasoned:
    Pixel had total yearend assets each year
    from 2008 through 2012 in excess of
    $172,000, including more than $319,000 in
    assets in 2011 and 2012. It appears to us that
    Pixel remained a going concern well past
    2008. . . . Pixel experienced a decline in its
    business in 2008, but its gross receipts
    increased in 2009. Petitioners as cotrustees of
    the Cooper Trust continued to advance funds
    COOPER V. CIR                       17
    to Pixel under the terms of the promissory
    note throughout 2008. Indeed, petitioners
    advanced $148,255 to Pixel under the terms of
    the promissory note between July and
    December 2008. We do not find it credible
    that petitioners would have advanced nearly
    $150,000 to Pixel after July 2008 if they
    believed the promissory note had been
    rendered worthless in July 2008 . . . . The
    evidence shows that Pixel had substantial
    assets at the end of the 2008 tax year and that
    its gross receipts increased in 2009.
    Moreover, at the very least, Pixel was entitled
    to an indefinitely continuing annual royalty of
    $22,500 and owned rights in several other
    patents. . . . Pixel’s liabilities to petitioners
    under the terms of the promissory note
    comprised substantially all of Pixel’s
    liabilities in 2008.
    (Formatting omitted.)      Those findings are not clearly
    erroneous.
    In short, Pixel had a steady, if small, income stream, and
    it had hundreds of thousands of dollars worth of assets.
    Petitioners almost certainly could not have recovered the full
    $2 million and change but, considering that they were
    essentially the only creditors, they likely could have made a
    partial recovery. The Tax Court permissibly concluded that
    the debt had not become “totally worthless.” 26 C.F.R.
    § 1.166-5(a)(2).
    18                     COOPER V. CIR
    C. Accuracy Penalties
    Title 26 U.S.C. § 6662(a) imposes a 20 percent penalty to
    underpayments of tax if any of the conditions in § 6662(b) is
    met. Here, the Tax Court found that two conditions were
    met: “Negligence or disregard of rules or regulations,” 
    id. § 6662(b)(1),
    and “[a]ny substantial understatement of
    income tax,” 
    id. § 6662(b)(2).
    On appeal, Petitioners do not
    challenge those findings.
    Section 6664(c) provides a “[r]easonable cause exception
    for underpayments”: “No penalty shall be imposed under
    section 6662 or 6663 with respect to any portion of an
    underpayment if it is shown that there was a reasonable cause
    for such portion and that the taxpayer acted in good faith with
    respect to such portion.” 26 U.S.C. § 6664(c)(1). Petitioners
    assert that they relied in good faith on professional advice.
    Reliance on professional advice may
    establish reasonable cause and good faith.
    Treas. Reg. § 1.6664-4(b)(1). The Tax Court
    requires a taxpayer to prove three elements in
    order to show that reliance on advice was
    reasonable: “(1) The adviser was a competent
    professional who had sufficient expertise to
    justify reliance, (2) the taxpayer provided
    necessary and accurate information to the
    adviser, and (3) the taxpayer actually relied in
    good faith on the adviser’s judgment.”
    Neonatology Assocs., P.A. v. Comm’r,
    
    115 T.C. 43
    , 99 (2000).             Once the
    Commissioner produces evidence showing
    that an accuracy-related penalty applies, the
    COOPER V. CIR                        19
    burden of proving the existence of reasonable
    cause and good faith falls on the taxpayer.
    DJB Holding Corp. v. Comm’r, 
    803 F.3d 1014
    , 1029–30 (9th
    Cir. 2015). Here, the Tax Court held that Petitioners failed to
    meet their burden of showing that they actually relied in good
    faith on an adviser’s judgment. “Whether the taxpayer acted
    with reasonable cause and in good faith is a finding of fact
    reviewed for clear error.” 
    Id. at 1022.
    1. Royalty Penalty
    With respect to the royalty penalty, Petitioners contended
    that they relied on the advice of Baker. The Tax Court found:
    Mr. Baker testified with respect to the
    royalty payments and petitioners’ compliance
    with section 1235 that he advised petitioners
    that Mr. Cooper could not indirectly control
    TLC. Moreover, Mr. Baker did not provide
    advice to petitioners before they filed their
    Forms 1040 for the years at issue, nor did he
    provide advice to petitioners regarding
    whether Mr. Cooper controlled TLC
    following TLC’s incorporation. Petitioners
    did not follow Mr. Baker’s advice to ensure
    that Mr. Cooper did not indirectly control
    TLC. Consequently, petitioners cannot claim
    reliance on the professional advice of Mr.
    Baker to negate the section 6662(a) penalty
    with respect to their erroneous capital gain
    treatment of the royalty payments Mr. Cooper
    received during the years at issue.
    20                     COOPER V. CIR
    Those findings are not clearly erroneous, and the Tax
    Court’s reasoning is sound. Baker advised Petitioners at the
    time they formed TLC that, in order to receive capital gains
    treatment, Mr. Cooper could not control TLC indirectly.
    Baker also testified specifically that he had no recollection
    that he ever advised Petitioners that the way in which they
    were operating TLC actually conformed to his advice.
    Indeed, there is no evidence that Petitioners ever sought post-
    formation advice from anyone about whether their conduct
    actually complied with Baker’s advice.
    Nor was the penalty inappropriate because of the
    allegedly uncertain state of the law.          “[A]n honest
    misunderstanding of fact or law that is reasonable in light of
    all of the facts and circumstances” can excuse an
    understatement of tax. 26 C.F.R. § 1.6664-4(b)(1). But there
    is patently no honest misunderstanding here: Petitioners’
    theory at trial was that Baker advised them to conform with
    Charlson such that they did not informally control TLC.
    Indeed, they conceded before the Tax Court that Charlson
    provided the binding legal rule: Capital gains treatment is
    unavailable if the taxpayer informally controls the
    corporation. It is only on appeal that they have challenged
    the legal standard. Accordingly, whatever merit Petitioners’
    argument might have had if they truly had been uncertain
    about the validity of Charlson (despite the fact that no court
    has questioned its validity), Petitioners cannot benefit from
    that purported uncertainty because it was not until this appeal
    that they alleged any uncertainty.
    COOPER V. CIR                        21
    2. Bad Debt Penalty
    With respect to the bad debt penalty, Petitioners
    contended that they relied on the advice of Mitch Mitchell
    and Baker. The Tax Court found:
    With regard to the bad debt deduction,
    petitioners have failed to introduce evidence
    regarding what information they provided to
    Mr. Baker and Mr. Mitchell to enable them to
    determine 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 any evidence
    regarding Mr. Mitchell’s advice. Similarly,
    Mr. Baker did not testify regarding any advice
    he may have given to petitioners that would
    indicate that it was his opinion that the
    promissory note became worthless in 2008.
    In short, petitioners have failed to prove that
    they received or relied on the professional
    advice of Mr. Baker and Mr. Mitchell with
    respect to their erroneous section 166 bad debt
    deduction in 2008.
    Again, there is no clear error. Petitioners have not
    rebutted the Tax Court’s finding that Petitioners failed to
    prove that “the taxpayer provided necessary and accurate
    information to the adviser.” DJB Holding 
    Corp., 803 F.3d at 1030
    . Mitchell did not testify, and neither Petitioners nor the
    Commissioner asked Baker any questions about the bad debt
    22                         COOPER V. CIR
    or about any advice he may have given Petitioners on that
    topic.
    AFFIRMED.
    KLEINFELD, Senior Circuit Judge, concurring in part and
    dissenting in part:
    I respectfully dissent. My dissent is directed only to
    Section A, “Royalty Payments as Capital Gains.” I join in
    Section B, “Bad Debt Deduction.” As for Section C,
    “Accuracy Penalties,” whether and how the penalties would
    apply would need to be revisited if my view on royalties were
    to be accepted.
    The majority errs because it dilutes the meaning of
    “control” from the ability to compel a result to something less
    and indeterminate. This puts us at odds with our only sister
    circuit to rule on the matter, the Court of Claims in Charlson
    v. United States.1 Both Charlson and the Commissioner’s
    own regulations show the error of the majority’s approach.
    The majority opinion accurately notes that in Charlson,
    the corporation to which inventor Lynn Charlson transferred
    his patent was owned by his “close friends and associates.”
    Actually, they were more than close friends and associates:
    three of the shareholders and directors were his employees,
    1
    
    525 F.2d 1046
    (Ct. Cl. 1975) (per curiam); cf. S. Corp. v. United
    States, 
    690 F.2d 1368
    , 1370–71 (Fed. Cir. 1982) (en banc) (adopting Court
    of Claims opinions as binding precedent).
    COOPER V. CIR                   23
    and the fourth was his personal attorney.2 As such, Charlson
    could fire each of them if he disliked how they voted. The
    corporation also “frequently sought, received, and followed
    the recommendations of Charlson,”3 and Charlson and the
    directors were “solicitous of each other’s individual interests
    as well as their mutual interests.”4 The Commissioner argued
    that the corporation, the directors of which had their
    livelihoods subject to Charlson’s preferences, followed his
    recommendations, and were solicitous of his personal
    interests, was “controlled” by Charlson.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 his case. The Commissioner lost.6
    Despite the evidence that the corporation did what Charlson
    wanted, the Court of Claims concluded that he did not
    “control” the corporation such that the transfer of patent
    rights was not genuine. Today’s majority opinion quotes
    Charlson’s statement that the “retention of control by a
    holder of an unrelated corporation can defeat capital gains
    treatment, if the retention prevents the transfer of all
    substantial rights.”7 That language marks the boundary of
    2
    
    Charlson, 525 F.2d at 1048
    –49.
    3
    
    Id. at 1056.
       4
    
    Id. at 1055.
       5
    
    Id. at 1052.
       6
    
    Id. at 1057.
       7
    
    Id. at 1053
    (internal quotation marks omitted).
    24                           COOPER V. CIR
    capital gains treatment, but Charlson held that the boundary
    was not crossed. Charlson had power over the corporate
    directors—far more power than Cooper had over TLC’s
    directors—but Charlson did not “control” the directors for the
    purposes of § 1235.
    The regulations make it clear that even though the
    directors in this case are Cooper’s friends and relatives, that
    does not amount to control or make TLC a “related” entity.
    The regulations are at pains to say that even transferring
    patent rights to a corporation controlled by one’s own brother
    “is not considered as transferring such rights to a related
    person.”8 Since a brother is not a “related 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 by
    the patent holder is insufficient to defeat § 1235(a)
    treatment.” But influence is all Cooper had. His authority
    over Walters (his sister-in-law) and Coulter (a friend of
    Walters and of Cooper’s wife) was considerably less than
    Charlson’s authority over his employees. Cooper’s situation
    is more like the one in Lee v. United States, where the transfer
    put the taxpayer’s own longtime personal friend in charge.9
    Yet in Lee, as in Charlson, the Commissioner lost. Lee held
    that the issue of control is whether the taxpayer can “force”
    the transferee to do his bidding.10 There is no evidence
    whatsoever that Cooper had that power.
    8
    26 C.F.R. § 1.1235-2(f)(3); see 26 U.S.C. § 1235(c)(2).
    9
    
    302 F. Supp. 945
    , 948 (E.D. Wis. 1969).
    10
    
    Id. at 950.
                           COOPER V. CIR                       25
    Walters and Coulter, like the directors in Charlson, were
    solicitous of Cooper’s and each other’s personal interests.
    They did transfer a few patents to Cooper for no
    consideration so that he could in turn transfer them to a
    corporation in which his children had an interest. But
    Walters and Coulter still owned 76% of the new corporation.
    (Instead of Cooper and his wife owning 24%, Cooper and his
    wife owned 1% and their children owned 23%.) And Cooper
    was not the only one who benefitted from TLC. Walters and
    Coulter each received $40,000 in director’s fees, and TLC
    bought them long-term insurance policies worth $115,406
    and $63,089, respectively. Cooper did not receive an
    insurance policy.
    Although the Commissioner argues that the patent
    transfer benefitting Cooper’s children somehow breached a
    fiduciary duty to TLC’s shareholders, that argument would
    apply equally to the payments made to Walters and Coulter.
    And it would be equally irrelevant. All that a breach of
    fiduciary duty means is that Walters and Coulter, acting in
    their capacity as shareholders, could theoretically sue
    themselves in their capacity as directors. That unlikely
    possibility does not show control. The core of the
    Commissioner’s argument—that the directors knew nothing
    about Cooper’s sophisticated inventions and simply followed
    his instructions—does not show control. If anything, it shows
    that there was no good reason for them to reject Cooper’s
    recommendations, because it was his knowledge and skill that
    generated millions in revenue, so he did not need control.
    In distinguishing control from influence, our focus should
    not be merely on whether TLC’s directors did what Cooper
    wanted. There was no reason for them to do anything else.
    Instead we must ask whether, as a practical matter, they could
    26                            COOPER V. CIR
    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 own
    a majority of its stock. For example, owning 100% of the
    stock defeated the tax benefits in the classic sham case
    Gregory v. Helvering.11 However, Congress provided that a
    patent holder cannot receive capital gains treatment if he
    owns 25% or more of the corporation to which he transferred
    his patents.12 That is why Cooper and his wife owned only
    24% of TLC’s stock.
    Minority shareholders may still control a corporation by
    controlling its directors’ votes, and there are well-established
    means by which Cooper might have done so. Those means
    are often used in close corporations to protect minority
    shareholders from oppression. One way to retain control is
    to write the articles of incorporation to require a super-
    majority so that no decision can be made without the minority
    shareholders’ consent.13 Another is to establish a voting trust
    so that the majority must vote their shares in line with the
    minority’s preferences.14 A third means is to use classified
    shares with the minority shares controlling the class that
    chooses the directors.15 And a fourth is to contractually
    obligate the directors to vote consistently with the minority
    11
    
    293 U.S. 465
    , 467–69 (1935).
    12
    26 U.S.C. § 1235(c)(1); see 
    id. § 267(b)(2).
         13
    ROBERT C. CLARK, CORPORATE LAW 775 (1986).
    14
    
    Id. at 777.
         15
    
    Id. at 780.
                             COOPER V. CIR                      27
    shareholders’ preferences.16 This list is not exhaustive, of
    course. But Cooper did not do any of these things. If he had,
    then he would have genuinely controlled TLC, not just
    influenced it.
    Because Cooper’s inventions generated TLC’s revenue,
    Walters and Coulter no doubt thought it was in TLC’s best
    interest to accommodate Cooper and keep him productive.
    But Cooper could not always count on Walters and Coulter to
    do things his way. At some point, he would age out of his
    peak productivity, meaning there would be less reason to
    listen to him. Moreover, a change in circumstances could
    always occur. As Professor Clark wrote in his treatise:
    As time passes, the personal relationships
    among the major participants in a close
    corporation always change in important ways.
    One of several participants will retire or die,
    leaving a gap in a shareholding or managerial
    role that might or might not be filled.
    Participants who were once friendly to each
    other will accumulate grudges.           Some
    participants will want to go on to other
    ventures. Others will want to bring in new
    associates, who may or may not be acceptable
    to the others.17
    If, for example, a buyout offer could enrich Walters and
    Coulter but would end Cooper’s influence over TLC, that
    might create conflict between the shareholders. Yet Cooper
    16
    
    Id. at 781–83.
       17
    
    Id. at 763.
    28                           COOPER V. CIR
    would lack any power to make Walters and Coulter reject the
    buyout. They would be multimillionaires and he would lose
    his connection to his own inventions.
    Because the majority opinion makes “control” a vague
    and ambiguous term, it risks eviscerating § 1235 capital gains
    treatment when transfers are made to close corporations.
    Congress thought it was a good idea to give patent holders a
    tax benefit, but the majority’s decision creates so much risk
    of litigation that it may be a bad idea to claim the benefit. A
    transfer to a corporation directed by the inventor’s employees
    and attorney was good enough in Charlson.18 A transfer to a
    corporation directed by one’s longtime friend was good
    enough in Lee.19 And a transfer to a corporation controlled by
    one’s own brother is good enough under the regulations.20
    Yet now a transfer to a corporation controlled by one’s sister-
    in-law and her friend is not good enough, even if the taxpayer
    lacks any means to compel those directors to do his will.
    Accordingly, it is not possible to say with confidence what
    close corporation arrangement will qualify for capital gains
    treatment.
    In short, the majority opinion does not say how “control”
    is distinct from “mere influence,” so mere influence of some
    vague and indeterminate kind prevents capital gains
    treatment. “Control” means the taxpayer can make the
    transferee corporation do what he wants, while “influence”
    means that although the corporation may defer to his
    
    18 525 F.2d at 1048
    –49, 1057.
    
    19 302 F. Supp. at 948
    , 950.
    20
    26 C.F.R. § 1.1235-2(f)(3).
    COOPER V. CIR                       29
    judgment or be persuaded by his view, he cannot make the
    corporation do what he wants. The better approach is the one
    seen in Charlson and Lee: that “control” means the ability to
    compel what the transferee corporation does.