A recent private letter ruling provides helpful guidance to taxpayers who incur legal fees pursuing patent infringement litigation. Unlike most situations involving patent infringement litigation, the taxpayer incurring the expenses in the case covered by the ruling was not the owner of the patent. Instead, an affiliate of the taxpayer was the owner of the patent, and the taxpayer entered into a license agreement with its affiliate to use the patent. Under the agreement, the affiliate retained sole control of the defense of the patent and any related settlement negotiations with a third party that infringed on the patent. The license agreement also provided that expenses incurred in defending the intellectual property were to be shared by the taxpayer and its affiliate based on the proportion of the economic benefit derived from sales of products covered by the intellectual property.
The federal tax treatment of costs incurred in a patent lawsuit depends on the nature of the claim. Patent lawsuit costs generally are required to be capitalized by IRS regulations if they are incurred for the defense or perfection of title to the patent. However, case law has established that these costs normally are deductible if they are incurred to protect against infringement of the patent. If the costs are incurred for both purposes, then a direct tracing, if possible, or a reasonable allocation of costs if a direct tracing is not possible, is necessary to determine the proper treatment of the patent infringement costs for federal tax purposes.
In its recent ruling, the IRS concluded the amounts were deductible because the legal fees were not related to the defense or perfection of title of the patent. The fact that the taxpayer was a licensee of the patent and not the owner of the patent was not a factor in the ruling. However, the IRS did note that if the lawsuit addressed both patent infringement and legal title questions, it would be necessary to allocate the expenses between capitalizable and deductible amounts.
A private letter ruling is nonbinding advice provided relevant to a specific taxpayer’s situation and may be relied upon only by the taxpayer for which it is requested. However, a private letter ruling is useful in determining the position of the IRS and may be helpful if pursuing penalty relief. Any taxpayer following the guidance in this private letter ruling should review carefully its fact pattern in light of the IRS ruling. Taxpayers also should consider that although only patent costs are addressed in the private letter ruling, it may be possible to extend these principles to other intangibles including copyrights and trademarks.