## Facts

- Thomas McClain was employed by Lockheed Aircraft Corp. as an engineer.
- As a condition of employment, McClain agreed to assign to Lockheed all inventions relating to Lockheed’s business that he made during employment.
- In 1940, McClain conceived a new aircraft windshield design embodying two patentable inventions within Lockheed’s business.
- McClain executed assignments of the inventions to Lockheed in 1941 and 1942; patents later issued in Lockheed’s name.
- Lockheed adopted employee patent-incentive plans allowing employees whose inventions were exploited to receive payments calculated by reference to royalties Lockheed received.
- Under the plans, Lockheed retained ownership of the patents; employees received only a contractual right to payments under the plan’s formula.
- In 1957 and 1958, McClain received patent-plan payments (in addition to salary) tied to royalties from Lockheed’s licensing of the windshield patents.
- McClain reported the patent-plan payments as long-term capital gain; the Commissioner determined deficiencies, treating the amounts as ordinary income.

## Issues

1. Whether payments to an employee under an employer’s patent-incentive plan, computed by reference to employer royalties, qualify as long-term capital gain from a sale or exchange (or qualifying transfer) of patent rights, or are ordinary income as compensation for services.

## Decision

- The Tax Court sustained the Commissioner’s deficiency determinations for 1957 and 1958.
- The court held the patent-plan payments were ordinary income in the nature of additional compensation for services.
- The court rejected capital-gain treatment because McClain did not transfer patent rights during the tax years at issue and retained no ownership interest in the patents.

## Legal Principles

- Capital-gain treatment for patent-related receipts generally requires a qualifying transfer of a property interest (e.g., a sale or exchange or transfer of all substantial rights) during the relevant taxable period.
- When an employee is contractually obligated to assign inventions to an employer as part of employment, and the employer acquires and retains full title to resulting patents, later incentive payments tied to employer royalties are compensation rather than proceeds from a property transfer.
- Payments characterized as bonuses or rewards for inventive effort, where the employee’s right is merely contractual and measured by employer receipts, are taxable as ordinary income under the general gross-income rule.

## Conclusion

The Tax Court held that royalty-based payments made to an employee under an employer’s patent-incentive program were ordinary income because the employee had already assigned all patent rights to the employer under an employment agreement and did not make a contemporaneous qualifying transfer of patent rights in the years the payments were received.


McClain v. Comm’r, 40 T.C. 841 (1963)