## Facts

- Orla E. Watson invented and patented a horizontally telescoping grocery cart; Edith Watson joined him on a joint federal return and in the refund suit.
- Watson and Fred E. Taylor entered an arrangement under which Taylor financed development and was to receive half of profits, but the parties intended Taylor to have no ownership interest in the patent rights.
- While the patent application was pending, Watson executed a written “License Agreement” granting a corporation the exclusive right to manufacture, use, and sell the carts during the application period, the patent term, and any extensions.
- The agreement contained (i) a sales-quota/termination mechanism allowing Watson to license others if minimum production and sales were not met, (ii) a restriction on the corporation’s ability to assign its rights without Watson’s written consent, (iii) periodic royalty-type payments to Watson, and (iv) provisions for shared participation in infringement litigation and related payment suspensions.
- In 1950, Watson received $78,442.75 under the agreement and paid Taylor approximately half; the Watsons reported their share as ordinary income, then sought a refund claiming the receipts were long-term capital gain as proceeds from a sale of patent rights.
- The district court ruled the agreement was a license and that the payments were ordinary income; the taxpayers appealed.

## Issues

1. Whether the agreement constituted an assignment (sale) of the patent rights or only a license for federal income tax purposes.
2. Whether the payments received under the agreement were taxable as long-term capital gain or as ordinary income (royalties).

## Decision

- The Tenth Circuit affirmed judgment for the United States.
- The court held the agreement was a license, not an assignment of the patent.
- Because Watson did not transfer all substantial rights in the patent, the payments were ordinary income rather than capital-gain proceeds from a sale.

## Legal Principles

- Tax characterization of payments under a patent-related contract turns on whether the patentee transferred “all substantial rights” in the patent; an assignment may support capital-gain treatment, while a license yields ordinary income.
- Contract labels are not controlling; courts look to the legal effect of the rights transferred and the rights retained.
- Retained controls and interests—such as defeasible exclusivity (termination/quota provisions), restrictions on the transferee’s ability to assign, royalty-based contingent consideration, and continued shared enforcement interests—indicate a license rather than a sale.

## Conclusion

The court treated the arrangement as a licensing transaction because the patentee retained significant rights and controls, so the 1950 payments were taxable as ordinary income and the taxpayers were not entitled to a refund.


Watson v. United States, 222 F.2d 689 (10th Cir. 1955)