## Facts

- Herbert S. Lehman, an IBM chemist, agreed as a condition of employment to assign to IBM all rights in future inventions.
- In 1965, Lehman assigned to IBM his entire right, title, and interest in an invention and the related patent application; a patent later issued.
- In 1981, IBM paid Lehman a $30,000 award under an internal incentive plan described as recognizing employee contributions of significant value.
- IBM reported the $30,000 payment as wages on Lehman’s 1981 Form W-2.
- The Lehmans filed a joint 1981 return and treated the $30,000 as long-term capital gain under I.R.C. § 1235 as an amount received for transfer of all substantial patent rights.
- The Commissioner issued a notice of deficiency, treating the payment as ordinary income under I.R.C. § 61; the Tax Court sustained the deficiency, and the Lehmans appealed.

## Issues

1. Whether IBM’s 1981 $30,000 incentive award was an amount received “in exchange for the transfer of all substantial rights to a patent” under I.R.C. § 1235, or ordinary income under I.R.C. § 61.

## Decision

- The Second Circuit affirmed the Tax Court.
- The court held the $30,000 payment was ordinary income under I.R.C. § 61.
- The court concluded I.R.C. § 1235 did not apply because the award was not consideration for the 1965 transfer of patent rights.
- The court sustained the Tax Court’s deficiency determination.

## Legal Principles

- I.R.C. § 1235 applies only to amounts that are, in substance, consideration for the transfer of all substantial rights in a patent by a qualifying holder.
- A payment made long after an employee’s assignment of patent rights, under a discretionary employee incentive program and without contractual linkage to the earlier transfer, is treated as compensation for services and taxed as ordinary income under I.R.C. § 61.
- The characterization of a payment turns on its source and function (purchase price for rights vs. employment-based compensation), not merely on the fact that it is measured by or associated with a patent.

## Conclusion

The court treated IBM’s patent-related award as employee compensation rather than transfer proceeds because Lehman had already assigned all patent rights years earlier under his employment agreement and IBM was not contractually obligated to pay the award as part of the transfer price, making the payment taxable as ordinary income rather than capital gain under § 1235.


Lehman v. Comm’r of Internal Revenue, 835 F.2d 431 (2d Cir. 1987)