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 patent[1]) 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 either taxable income or a nontaxable return of capital. The origin and character of the underlying suit usually control. For instance, recovery from a suit to recover lost profits for patent infringement usually results in gross income.[6] As a general principle of tax law, not necessarily unique to patents or IP, recovery for damages to capital assets are suggestive of a nontaxable return of capital.[7] Again, when millions of dollars are on the line the tax treatment is potentially significant.
Cavalier Patent Settlement Structuring
A very recent decision provides an example of a taxpayer that attempted to squeeze a plain damage settlement into the capital contribution bucket. In Acqis Technology, Inc. v. Commissioner, T.C. Memo 2024-21 (Feb. 13, 2024), a computer hardware development and licensing business (“Acqis”) entered into settlements with four defendants following patent infringement litigation. The settlements required the defendants to enter share purchase agreements (“SPA”) and patent license agreements whereby the parties to the suit would dismiss all pending litigation, and each defendant would purchase “settlement shares” and a license to use Acqis’s patents. Acqis offered a reduced settlement for using the SPA structure. The “settlement shares” purported to be equity in Acqis; however, the Court was unimpressed with the substance of the SPAs or settlement shares, noting:
Acqis has created an instrument that looks like an equity share with none of its substance. In searching for words to describe Acqis’s creation, we find ourselves comparing it to a ceremonial “Key to the City”: It bears the appearance of an item we know well, but opens no doors, bestows no ownership or function, and is instead merely representational.[8]
Quite contrary to Acqis’ reporting position, each of the defendants testified they would have paid the settlement irrespective of the SPAs. Two of the defendants donated the settlement shares to charities and reported the settlement payments as licensing fees while claiming business deductions. Three of the defendants even provided statements that they never intended to become shareholders of Acqis. The court had no trouble determining (i) that the settlement payments were taxable gross receipts; (ii) Acqis inadequately disclosed the settlement payments in its tax returns, resulting in the application of the 25% of gross-income omitted rule of § 6501(e) and a six year statute of limitations period; and (iii) the § 6662(a) accuracy penalty should be sustained because Acqis could not prove reasonable cause for the position taken on their return. The court ultimately upheld $15.57 million of taxes and penalties against Acqis. While the Acqis case illustrates the perils of an overly aggressive reporting position, it also demonstrates that high-dollar patent and technology litigants should take steps to plan for tax consequences from inception of the case. Note too that there are tax structuring strategies that can provide tax efficiencies while still staying within the confines of extant tax laws. As Benjamin Franklin famously said, “by failing to prepare, you are preparing to fail.”
[1] While general tax principles are applicable to all IP species, there are many nuances applicable to the different forms of IP. As non-exclusive examples, trademark cases vary from copyright cases and the inclusion of unfair competition claims with patent infringement claims may result in different tax treatment.
[2] All “§” references are to specific sections of the Code unless otherwise noted.
[3] United States v. Gilmore, 372 U.S. 39 (1963); see also Hort v. Commissioner, 313 U.S. 28 (1941).
[4] Treas. Reg. § 1.263(a)-4(d)(9). See also Treas. Reg. § 1.263(a)-4(e)(5).
[5] See Urquhart v. Commissioner, 215 F.2d 17 (3d Cir. 1954). For an interesting illustration of the granularity of “deduct versus capitalize” analysis in the pharmaceutical industry, see IRS AM 2014-006. See also IRS FSA 199925012 (A “tacit acceptance of Urquhart lends support to the notion that patent litigation expenses are presumed deductible as an initial premise.”)
[6] See Mathey v. Commissioner, 177 F.2d 259 (1st Cir. 1949).
[7] See Big Four Industries, Inc. v. Commissioner, 40 T.C. 1055 (1963) and Bresler v. Commissioner, 65 T.C. 182 (1975).
[8] Acqis Technology, Inc. v. Commissioner, T.C. Memo 2024-21 (Feb. 13, 2024).
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