## Facts

- Since 1921, William Bailey was president and majority stockholder of William M. Bailey Company, a business that sold industrial products made by others, including valves used with blast furnaces.
- The company had a long practice of paying royalties to employee-inventors when it used and sold patented inventions developed by those employees.
- The company previously paid its chief engineer, Andrew Boland, royalties (e.g., 3% or 5%) on patented products Boland designed, under both informal arrangements and later written agreements.
- In 1934, Bailey obtained a patent on a valve improvement (a valve equipped with a steel plate).
- After Bailey obtained the patent, the company began making payments to Bailey under an oral agreement, generally computed as a percentage royalty tied to sales.
- On May 1, 1936, the company executed a written agreement providing for royalty payments to Bailey (described in the record as a percentage royalty on the patented product).
- On April 8, 1943, the company executed another written agreement with Bailey adjusting the royalty arrangement (again using a percentage-of-sales approach).
- On November 8, 1945, Bailey and the company entered into another agreement stating that its purpose was to “confirm and ratify” their prior oral or informal arrangements regarding the patented invention.
- The 1945 agreement characterized the company as a “licensee” and granted the company the exclusive right to “make, use, and sell” the patented invention.
- The 1945 agreement required the company to obtain Bailey’s permission before assigning its rights, and it allowed both Bailey and the company to prosecute patent-infringement suits.
- After the 1945 agreement, Bailey reported amounts received from the company as long-term capital gain.
- The IRS issued a notice of deficiency on the ground that the amounts Bailey received were ordinary income, and Bailey petitioned the Tax Court.

## Issues

1. Whether amounts Bailey received from his controlled corporation for use of his patented valve were taxable as long-term capital gain as proceeds from a sale or exchange of the patent, or as ordinary income from royalties.
2. Whether Bailey’s arrangement with the company transferred “all substantial rights” in the patent to the company, or instead left Bailey with significant rights consistent with a license.

## Decision

- The Tax Court sustained the IRS determination that Bailey’s patent-related receipts were ordinary income.
- The court treated the payments as royalty income from a licensing relationship rather than capital-gain proceeds from a sale or exchange transferring all substantial rights.

## Legal Principles

- Capital-gain treatment for patent receipts generally requires a transaction that, in substance, is a sale or exchange of the patent or a transfer of all substantial rights in the patent.
- Courts look to the actual rights transferred and retained—not just the label used in the contract (e.g., “license” or “exclusive license”)—to determine tax character.
- Retained controls and continuing participation rights (such as restrictions on assignment without the inventor’s consent and shared authority to pursue infringement litigation) are indicators that the inventor has not transferred all substantial rights.
- Payments calculated as a continuing percentage of sales commonly resemble royalties for use of property and are generally taxed as ordinary income absent a qualifying sale.

## Conclusion

William Bailey’s corporation paid him percentage-based amounts for use and sale of his patented valve under agreements culminating in a 1945 “exclusive” license that confirmed prior royalty arrangements and reserved meaningful rights to Bailey, including control over assignment and participation in enforcement. Because the arrangement did not transfer all substantial rights in the patent and instead operated as a continuing license for royalties, the Tax Court agreed with the IRS that the payments were ordinary income rather than long-term capital gain.


William Bailey v. Commissioner of Internal Revenue, 1950 U.S. Tax Ct. LEXIS 69 (1950)