William Bailey v. Commissioner of Internal Revenue

Since 1921, William Bailey (plaintiff) had been president and majority stockholder of William M. Bailey Company (the company). The company was in the business of selling the products of other companies, such as chimney and goggle valves for blast furnaces. If the company’s employees designed and patented saleable products, the company had a longstanding practice of paying royalties to the employee-inventor for use and sales of the invention. For example, the company paid chief engineer Andrew Boland royalties of 3 or 5 percent on steel products or mechanical valves designed by Boland, under unwritten and written agreements. In 1934, Bailey obtained a patent on a valve equipped with a steel plate. Under an oral agreement, the company began to make 5 percent royalty payments to Bailey. On May 1, 1936, and April 8, 1943, the company executed written agreements with Bailey to pay a 3 and 5 percent royalty, respectively, on his invention. On November 8, 1945, the company and Bailey entered another agreement that granted the company, as “licensee,” the exclusive right to “make, use, and sell” Bailey’s patented inventions. The agreement provided that the purpose of the agreement was to “confirm and ratify [the parties’] past oral or informal agreements, to the same effect.” The company was required to obtain Bailey’s permission if it wished to assign its license, and both the company and Bailey could prosecute patent-infringement suits. Thereafter, Bailey reported the receipt of royalties from the company as long-term capital gains. The Internal Revenue Service (IRS) (defendant) issued a notice of deficiency based on finding that the amounts were ordinary income. Bailey filed suit to challenge the IRS’s finding.