                        T.C. Memo. 2006-267



                      UNITED STATES TAX COURT



         NATHANIEL H. AND CAROL A. GARFIELD, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4017-05.                  Filed December 18, 2006.



     Ronald J. Cohen and David S. Schwan, for petitioners.

     Frank J. Jackson and Karen A. Rennie, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     FOLEY, Judge:   The issues for decision are whether income

received by petitioners should be treated as ordinary income or

long-term capital gain and whether petitioners are liable for the

section 66621 accuracy-related penalty.


     1
         Unless otherwise indicated, all section references are to
                                                    (continued...)
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                         FINDINGS OF FACT

     On June 1, 1969, Nathaniel Garfield and Thomas McSherry

formed McSherry Associates, LP (the partnership), a New York

limited partnership.   The purpose of the partnership was to

finance, research, and develop a variety of mechanical patents.

Mr. McSherry, the general partner, had a 51-percent equity

interest, and Mr. Garfield, after making an initial $25,000

contribution, was a limited partner with the remaining 49-percent

equity interest.   On July 10, 1969, Thomas McSherry filed an

application with the U.S. Patent Office for his invention, the

expansible fastener.   At the time of his application, Mr.

McSherry also recorded an assignment to the partnership of all

patent rights relating to the expansible fastener.

     On September 18, 1970, Mr. McSherry and Mr. Garfield

incorporated Mechanical Plastics Corp. (MPC).   Upon formation of

the corporation, the partnership owned 74 shares of MPC stock,

and J. Wolfe Golden, another investor, owned the remaining 26

shares.   On September 22, 1970, Mr. McSherry signed an employment

agreement with MPC providing him with an annual salary and

royalties relating to his inventions.   Also on that date, MPC’s

board of directors held a special meeting at which they executed



     1
      (...continued)
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
                               - 3 -

a shareholders’ agreement.   The shareholders’ agreement

delineated the shareholders’ rights and restricted the transfer

of company stock.

     On October 10, 1970, the partnership and MPC executed an

assignment agreement, which assigned the rights to the expansible

fastener (i.e., for which a patent application was pending) from

the partnership to MPC.   In consideration of the transfer of

patent rights, MPC was obligated to make payments to the

partnership of 4 percent of the gross proceeds from the sale of

expansible fasteners.

     On October 10, 1970, the partnership dissolved.   Thereafter,

Mr. McSherry owned 38 percent, and Mr. Garfield owned 36 percent

of MPC shares.   Pursuant to the dissolution agreement, all shares

of MPC owned by the partnership were distributed to Mr. McSherry

and Mr. Garfield.   The dissolution agreement further provided

that Mr. McSherry and Mr. Garfield would each receive 50 percent

of MPC’s payments due to the partnership.   In addition, the

assignment agreement provided that, upon dissolution of the

partnership, payments relating to the expansible fastener were to

be made directly to Mr. McSherry and Mr. Garfield.

     On March 28, 1972, the U.S. Patent Office granted the patent

for the expansible fastener, and, thereafter, Mr. McSherry and

Mr. Garfield began to collect royalty payments from the sales of

the device.   From 1978 through 1985, petitioner and Mr. McSherry
                               - 4 -

made joint assignments to MPC of the rights relating to various

inventions (i.e., for which patent applications were pending).

     Petitioners timely filed their joint Federal income tax

returns relating to 2000, 2001, and 2002.   On December 2, 2004,

respondent issued petitioners a notice of deficiency in which he

determined that income reported by petitioners as long-term

capital gain (i.e., in the amounts of $247,977, $224,962, and

$339,560 relating to 2000, 2001, and 2002, respectively) was

ordinary income.   Respondent further determined that petitioners

were liable for a section 6662 penalty relating to 2000, 2001,

and 2002.

     On March 1, 2005, petitioners, while residing in Purchase,

New York, filed their petition with the Court.

                              OPINION

     Petitioners contend that, pursuant to section 1235, income

reported by petitioners in the amounts of $247,977, $224,962,

and $339,560 relating to 2000, 2001, and 2002, respectively,

qualifies for long-term capital gain treatment.   Section 1235(a)

provides that a transfer of property consisting of all

substantial rights to a patent is considered a sale or exchange

of a capital asset held for more than 1 year (i.e., a long-term

capital asset), regardless of how long the transferor actually

held the rights to the patent.   Long-term capital gain

treatment, however, is not available pursuant to section 1235 if
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such a transfer is made to a related person as defined in

section 267(b).   See sec. 1235(d).   For purposes of section

1235, a corporation and an individual owning more than 25

percent of such corporation are related persons.    Sec.

267(b)(2).

     The patent rights to the expansible fastener were

transferred to the partnership by Mr. McSherry on July 10, 1969,

the same date that he filed an application with the U.S. Patent

Office.   On that date, Mr. Garfield was an equity partner in the

partnership but did not hold any patent rights associated with

the expansible fastener.   Mr. Garfield transferred all of his

patent rights to MPC after October 10, 1970.    On that date, and

thereafter, Mr. Garfield had a 36-percent interest in MPC.

Because Mr. Garfield owned more than 25 percent of the stock of

MPC, he and MPC were related persons.    Secs. 267(b)(2),

1235(d)(1).   Thus, pursuant to section 1235, royalty payments

from MPC to Mr. Garfield do not qualify for long-term capital

gain treatment.   Petitioners contend that Mr. Garfield and Mr.

McSherry signed a forbearance agreement in 1969 that transferred

to the partnership all substantial rights to any patents; that

this transfer qualifies for long-term capital gain treatment

pursuant to section 1235(a); and that upon formation of MPC in

1970, the terms of the purported forbearance agreement carried

over to the shareholders of MPC, thereby qualifying the reported
                                   - 6 -

income for capital gain treatment pursuant to section 1235.        We

reject petitioners’ contentions because there is insufficient

credible evidence to establish the existence of a forbearance

agreement.

      Petitioners further contend that if capital gain treatment

is not available pursuant to section 1235, then the payments are

entitled to such treatment pursuant to sections 1221 and 1222.

Section 1.1221-1(c)(1), Income Tax Regs., provides that a patent

may qualify as a capital asset.        In order to qualify for long-

term capital gain treatment, however, a taxpayer must hold his

capital asset for the requisite period prior to a sale or

exchange.      Sec. 1222(3).    At no time during the existence of the

partnership did Mr. Garfield hold a capital asset.        Mr. Garfield

and Mr. McSherry did make joint transfers of patent rights to

MPC between 1978 and 1985, but Mr. Garfield did not hold the

patent rights for the requisite period to qualify for long-term

capital gain treatment.        Accordingly, we sustain respondent’s

determination.2

         Section 6662(a) imposes a penalty equal to 20 percent of

the amount of any underpayment attributable to a substantial


     2
        Pursuant to sec. 7491(a), petitioners have the burden of
proof unless they introduce credible evidence relating to the
issue that would shift the burden to respondent. Rule 142(a).
Our conclusions, however, are based on a preponderance of the
evidence, and thus the allocation of the burden of proof is
immaterial. See Martin Ice Cream Co. v. Commissioner, 110 T.C.
189, 210 n.16 (1998).
                                - 7 -

understatement of income tax.    Sec. 6662(b)(2).    An

understatement is the amount by which the correct tax exceeds

the tax reported on the return.    Sec. 6662(d).    The

understatement is substantial if it exceeds the greater of

$5,000 or 10 percent of the tax required to be shown on the

return.   Sec. 6662(d)(1)(A)(i) and (ii).   Petitioners

erroneously reported income resulting in understatements of tax

of $48,603, $40,497, and $37,442 for 2000, 2001, and 2002,

respectively.

     An understatement is reduced by the portion of the

understatement that is attributable to the tax treatment of an

item for which there is substantial authority or with respect to

which there is adequate disclosure and a reasonable basis.    See

sec. 6662(d)(2)(B); sec. 1.6662-4(a), Income Tax Regs.

Petitioners did not have substantial authority for their

position, nor did they adequately disclose their position.    No

reduction, therefore, is appropriate.

     Section 6664(c)(1) provides that no penalty shall be

imposed if a taxpayer demonstrates that there was reasonable

cause for the underpayment and the taxpayer acted in good faith.

The determination of whether a taxpayer acted with reasonable

cause and in good faith depends upon the facts and

circumstances.   See sec. 1.6664-4(b)(1), Income Tax Regs.

Petitioners do not contend that they followed, or even sought,
                             - 8 -

the advice of a tax professional.    We conclude that petitioners

did not act with reasonable cause when they characterized the

royalty payments as long-term capital gains.   As a result,

petitioners are liable for the section 6662(a) accuracy-related

penalty.

     Contentions we have not addressed are irrelevant, moot, or

meritless.

     To reflect the foregoing,


                                          Decision will be entered

                                     for respondent.
