Watson v. Commissioner

Orla Watson (plaintiff) designed a grocery cart that telescoped horizontally, one into another. Watson filed a patent application, which was later issued. While the application was pending, Watson entered an agreement with George Oliver O’Donnell, trustee for Telescope Carts, Inc. The agreement granted Telescope Carts the exclusive right to manufacture, distribute, sell, develop, and use the telescoping carts throughout the United States during the patent application’s pendency, the patent’s term, and any extensions. The contract, titled “License Agreement,” referred to Watson as “licensor” and Telescope Carts as “licensee.” Several provisions addressed the scope and effect of the grant. A termination provision allowed Watson to license others if Telescope Carts failed to make and sell 2,500 carts in any six-month period after the first year. An assignment restriction barred Telescope Carts from assigning its rights without Watson’s written consent. A royalty-payment provision granted Watson royalties as consideration. One provision relating to patent-infringement suits suspended royalties if the invention was alleged to infringe another patent, with payments resuming or ceasing depending on the outcome. Another provision obligated the parties to act jointly in defending the patent and specified how damages would be divided. In 1950, Watson reported the royalties he received under the agreement as ordinary income. Watson later filed a claim for refund, asserting that the payments were proceeds from the sale of a capital asset taxable as long-term capital gain. After the Internal Revenue Service took no action, Watson sued the commissioner (defendant) for a refund. The district court held that the agreement constituted a license, not an assignment, and taxed the payments as ordinary income. Watson appealed.