April 8, 2024 Court found stock transferred to a taxpayer was not qualified small-business stock, but left open the possibility of other shares remaining eligible
In Tongzhong Ju and Yanxia Li v. United States, the United States Court of Federal Claims granted in part and denied in part a doctor's summary judgment motion and the government's cross-motion for summary judgment with respect to payments the doctor received from two patents. Specifically, the court granted the government summary judgment on the treatment of the proceeds from a stock sale, finding a large portion of the stock was not eligible for qualified small-business stock treatment because the shares were not acquired at original issue and the doctor sold the stock within five years of its transfer to him. The court, however, denied summary judgment to both parties on the smaller portion of shares he first received from Selexys, finding those shares might qualify as qualified small-business stock depending on whether certain evidence could demonstrate that the requirements of IRC Section 1202 were satisfied. The court also denied summary judgment on other matters unrelated to the qualified small-business stock determination. Facts Dr. Ju was a former University of Oklahoma employee and inventor on two patents. Under the university's policy, the university owns any patents on inventions developed by university employees, and employees must assign their rights to any patents on inventions to the university. In November 2003, Dr. Ju assigned his rights to the patents to the university, which then licensed the patents to Selexys Pharmaceuticals Corporation in return for cash and shares of Selexys stock. The university's licensing policy requires the university to pay an inventor 35% of the gross revenues (including equity) from the patent license, with the employee receiving cash revenue and the stock being held by the Controller's Office until the employee leaves the university. Dr. Ju disagreed with the revenue he received from his patents in 2015 and entered into a settlement agreement with the university. The agreement stated that Selexys previously issued 583,921 shares of common stock to the university, and 18,017 shares to Dr. Ju. The agreement further required Selexys to reissue 53,441 shares in the name of Dr. Ju, instead of the university. It also included stock from Tetherex, as well as an additional payment of $33,500 from the university to Dr. Ju. He reported the payment as royalty income on his 2015 tax return and sold his Selexys stock the following year. He reported the income from that sale as long-term capital gain. Dr. Ju filed amended tax returns for 2015 and 2016 in 2019. On the amended 2015 tax return, he sought to change the treatment of the cash income he received from the university from royalties to long-term capital gain. On the amended 2016 return, he sought to treat the proceeds from the sale of the Selexys stock as qualified small-business stock, instead of long-term capital gains. He also claimed additional itemized deductions. The IRS disallowed the amended returns. Dr. Ju filed a complaint and an amended complaint, requesting a partial refund of his 2015 and 2016 taxes. Holding Dr. Ju did not acquire certain stock when it was originally issued or own it for at least five years before selling it IRC Section 1202 allows taxpayers to exclude half the gain from the sale or exchange of qualified small-business stock if (1) the taxpayer acquired the stock when it was originally issued and held it for more than five years, and (2) the small business satisfies the "qualified small business" definition in IRC Section 1202(d)(1). The court observed that Dr. Ju would have had to acquire the stock when it was originally issued in 2003 to qualify for the tax exclusion on the sale of his Selexys stock. The court also found that he would have had to hold the stock for at least five years from the original issue date to the date of sale. Both parties agreed that Dr. Ju did not receive the majority of his shares (53,441) until 2015, but he received 18,017 shares when they were originally issued in 2003. The court found that Dr. Ju did not obtain the 53,441 shares when they were originally issued — rather, the shares were first issued to the university, which then transferred the shares to Dr. Ju in 2015. It also noted that the settlement agreement with the university did not change the timing of when Dr. Ju received the 53,441 shares of stock. Additionally, the court rejected Dr. Ju's argument that he held the shares as a matter of law since 2003 because he was entitled to 35% of the licensing revenue from his patents under the university's policy. He relied on Merrill v. Commissioner, 40 T.C. 66, aff'd per curiam, 336 F.2d 771 (9th Cir. 1964), to support his argument. The court, however, observed that in Merrill "the Ninth Circuit held that determining who 'holds' real property requires looking at 'the intent of the parties as to when the benefits and burdens of ownership of the property are to be transferred' rather than 'passage of bare legal title.'" Specifically, the Ninth Circuit considered certain factors, such as "the use of the property and payments for repairs, taxes, and insurance premiums to determine who had taken on the benefits and burdens of ownership." Because Dr. Ju did not assert that there were any repairs or insurance premiums for the shares between 2003 and 2015, the court found that the factors in Merrill did not apply. The court determined that neither Dr. Ju nor the university acted as if Dr. Ju owned the shares from 2003 to 2015. The court further found (1) the settlement agreement and stock certificate indicate the 53,441 shares were transferred in 2015, and (2) Dr. Ju indicated he was responsible for any negative tax implications resulting from the transfer. Accordingly, the court held he was not eligible for qualified small-business stock treatment for the 53,441 shares. The court also ruled that there is a genuine dispute as to whether Dr. Ju held the 18,017 shares since original issuance because Dr. Ju did not provide a stock certificate from 2003. Genuine dispute as to whether Selexys was a qualified small business before 2009 Dr. Ju had to prove that Selexys had less than $50 million in gross assets before and immediately after November 2003 for the shares to qualify as qualified small-business stock. The court found Dr. Ju failed to prove Selexys was a qualified small business because he only provided financial records from 2009 to 2011 (i.e., many years after the 2003 issuance of Selexys shares). Because Dr. Ju did not provide earlier records, the court held he was not entitled to summary judgment that Selexys was a qualified small business. The court also held that the government is not entitled to summary judgment simply because Dr. Ju failed to provide "sufficient evidence right now." Therefore, the court held both Dr. Ju and the government were not entitled to summary judgment because a genuine dispute existed over when Dr. Ju received the 18,017 shares and whether Selexys "was a qualified small business before and immediately after 2003." Implications Dr. Ju received many of the Selexys shares in 2015 as a result of a settlement agreement between him and a university of which he was a former employee. Thus, according to the court, these shares were not acquired in 2015 by him at original issuance.1 Taxpayers need to be mindful of satisfying the original issuance requirement in all cases to benefit from the qualified small-business stock exclusion. If an acquisition, however, results from a legal settlement under which shares are re-issued fromone person to another, it appears this requirement cannot be satisfied.2 As to the remaining Selexys shares, the court was reluctant to grant the taxpayer summary judgement when the only evidence that the company was a qualified small business (within the meaning of IRC Section 1202(d)) was based on financial records relating to the gross asset value of the business six years after the relevant issuance. Therefore, taxpayers who sell stock and wish to receive favorable qualified small-business stock treatment should maintain clear and contemporaneous evidence of the value of a company's gross assets before and after that issuance.
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