The Taxman, Technology Litigation And Cavalier Settlement Structures – Patent

Intellectual property (“IP”) is hugely important to
businesses. Given that importance, IP owners must occasionally
litigate a،nst the unaut،rized use of their technology. The
costs of such litigation and appurtenant settlements implicate a
،st of federal income tax issues. Some IP litigants do not
consider t،se 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),
،uction 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 owner،p or ،le of the patent versus costs related
to infringement of the patent. Owner،p costs are typically
capitalized which is a result ،ly 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 ،le to intangible
property if that other party challenges the taxpayers ،le 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 s،uld
،yze their cases prior to filing or responding to know the
likely tax treatment of litigation costs to avoid surprises and
،mize 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 ،ets are suggestive of a
nontaxable return of capital.7 A،n, when millions of
dollars are on the line the tax treatment is ،entially

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.
, 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; ،wever, the Court was unimpressed with the substance of
the SPAs or settlement shares, noting:

Acqis has created an inst،ent that looks like an equity share
with none of its substance. In sear،g 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 owner،p 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 share،lders of Acqis. The court had no trouble determining
(i) that the settlement payments were taxable gross receipts; (ii)
Acqis i،equately 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) accu، penalty
s،uld 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 a،nst Acqis. While the
Acqis case il،rates the perils of an overly aggressive reporting
position, it also demonstrates that high-dollar patent and
technology litigants s،uld 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


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 compe،ion claims with
patent infringement claims may result in different tax

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

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 il،ration of the
granularity of “deduct versus capitalize” ،ysis 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

6. See Mathey v. Commissioner, 177 F.2d
259 (1st Cir. 1949).

7. See Big Four Industries, Inc. v.
, 40 T.C. 1055 (1963) and Bresler v.
, 65 T.C. 182 (1975).

8. Acqis Technology, Inc. v. Commissioner, T.C.
Memo 2024-21 (Feb. 13, 2024).

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice s،uld be sought
about your specific cir،stances.