The Taxman, Technology Litigation And Cavalier Settlement Structures

• Published date: 28 February 2024
• Subject Matter: Intellectual Property, Tax, Patent, Income Tax
• Law Firm: Gray Reed & McGraw LLP
• Author: Mr Brian A. Clark, CPA and Joshua D. Smeltzer

Intellectual property ("IP") is hugely important to businesses. Given that importance, IP owners must occasionally litigate against the unauthorized use of their technology. The costs of such litigation and appurtenant settlements implicate a host of federal income tax issues. Some IP litigants do not consider those tax issues at all, while others aggressively overplay their hand. This post provides insights regarding federal income tax issues related to IP (mainly patent¹) litigation and settlements so that companies can know when they might have a tax issue and seek appropriate advice.

Tax Principles Regarding Patent Litigation Expenses

One of the difficulties with IP litigation is that no particular provision of the Internal Revenue Code (the "Code")² controls. As such, taxpayers might consider the general business deduction statute (' 162), production of income deduction (' 212) and general capitalization rule (' 263). The use of a particular Code Section is functionally determined by the "origin-of-the-claim" test set forth in United States v. Gilmore.³ The origin-of-the-claim test is unfortunately not objective and the filer's intent for filing the suit is not dispositive as to federal income tax consequences. In a patent case, litigants must distinguish between issues relating to ownership or title of the patent versus costs related to infringement of the patent. Ownership costs are typically capitalized which is a result facially confirmed by regulation:

Defense Or Perfection Of Title To Intangible Property'

In General. '

A taxpayer must capitalize amounts paid to another party to defend or perfect title to intangible property if that other party challenges the taxpayers title to the intangible property.⁴

Patent infringement claims for patents held in a trade or business are typically presently deductible.⁵ The value of such deductions following high-dollar patent litigation may be in the millions which provides businesses some comfort following a costly court battle (vis-à-vis capitalizing large costs that may not be recoverable for years). Well advised taxpayers should analyze their cases prior to filing or responding to know the likely tax treatment of litigation costs to avoid surprises and maximize deduction value.

Federal Income Tax Basics of Patent Settlements

The settlement of patent litigation provides more opportunities for income tax considerations (and for some taxpayers, tax chicanery). Damage awards in patent cases are essentially...