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Many taxpayers and their intellectual property attorneys fail to consider the tax treatment of proceeds from litigation involving intellectual property. As a result, they may treat proceeds from litigation involving intellectual property as ordinary income rather than capital income. Of course, for individuals and passthrough entities, the characterization of litigation proceeds as capital gains is preferable. To illustrate, consider the following hypothetical: A taxpayer settles a patent infringement case for $5 million. If the taxpayer is a passthrough entity (e.g. an S-corporation or partnership) the difference in the tax cost between treating the litigation proceeds as ordinary income versus capital gain is roughly $1 million. That is, if the taxpayer is unable to characterize the litigation proceeds as capital income, the taxpayer will be subject to an additional $1 million tax liability. There is authority for treating proceeds from the settlement or resolution of litigation involving capital assets, such as goodwill, patents and trademarks, as capital income rather than ordinary income. For example, in the case of Big Four Industries v. Commissioner, 40 T.C. 1055 (1963), the taxpayer corporation received a settlement in a patent infringement action. The taxpayer treated a portion of the settlement amount as a non-taxable return of capital. The taxpayer argued that a portion of the award represented damage to its corporate capital structure and goodwill. The court noted that to the extent the award was intended to include the cost of litigation, the amount of such costs constituted the receipt of ordinary income. Thus, the court subtracted the taxpayer’s costs from the amount of the settlement treated as capital gain. The court held the remaining amount to be taxable as capital gain. Similarly, in the case of State Fish Corp. v. Commissioner, 48 T.C. 465 (1967), modified by 49 T.C. 13 (1967), the court concluded that a recovery received by a taxpayer constituted compensation for diminution in the goodwill of the business and, therefore, was taxable as capital gain. In that case, the taxpayer had bought an established and ongoing business, with the seller agreeing not to open a similar business and compete with the taxpayer for a period of five years. The seller, however, breached the covenant not to compete, and the taxpayer brought suit alleging damage to the goodwill of the business. After the taxpayer was awarded a judgment, the seller paid a lesser sum in settlement of the judgment. In holding that the recovery (net of costs) was for damages to goodwill rather than lost profits, as contended by the IRS, the court relied heavily on the allegations set forth in the complaint, a majority of which concerned goodwill. Also, in the case of Inco Electroenergy Corporation v. Commissioner, T.C. Memo 1987-437 (1987), the court found that the underlying dispute giving rise to the litigation proceeds was in the nature of a claim for damages to a trademark and the goodwill associated therewith. The court noted that the plaintiff in the litigation never alleged that it was entitled to, or attempted to obtain, lost profits. The court also noted that the issue of lost sales arose only in the plaintiff’s attempt to place a value on the damage to the trademark and goodwill. The court concluded that the use of lost profits as an evidentiary factor in determining damage to goodwill did not alter the true basis of the recovery. Thus, the court held that the actual basis of the recovery of the settlement proceeds by the plaintiff was for damages to its trademark and the associated goodwill. The court concluded that since these items are capital assets, the proceeds were taxable as capital gains. Finally, the IRS has acknowledged that an amount realized in settlement of a legal action can, for Federal income tax purposes, be treated as return of capital. For example, in private ruling 8104066 the IRS concedes that it is well established that a recovery represents a return of capital if received as the replacement of destroyed or injured capital rather than for lost profits. Thus, legal authority exists for characterizing litigation proceeds from the resolution of litigation involving intellectual property as capital income rather than ordinary income. This characterization clearly benefits S-corporations and partnership taxpayers. However, the characterization of litigation proceeds as capital income rather than ordinary income may also benefit C-corporations with capital loss carryovers or that otherwise could utilize capital income. Although legal authority may exist for characterizing litigation proceeds from patent or trademark litigation, or even litigation involving covenants not to compete or goodwill, as return of capital (which would be tax-free to the extent the taxpayer had basis in such assets and taxed as capital gains to the extent such capital income exceeded basis), the determination of whether such litigation proceeds can be characterized as capital income appears to be extremely dependent on the facts and circumstances of the litigation. Pleadings and settlement documents may be a significant factor in determining the appropriate tax treatment of litigation proceeds. Therefore, taxpayers and their legal professionals involved in litigation relating to patents, trademarks, goodwill, covenants not to complete or other intellectual property should consider the tax treatment of any future recovery as early in the litigation process as possible. Consideration must also be given to the appropriate tax treatment of litigation costs associated with patent, trademark, goodwill, and other intellectual property litigation, because costs incurred to protect or establish capital assets must generally be capitalized and, thus, would not be currently deductible.

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