New Trend Sees Patent Damages Treated as Capital Gains for Income Tax Reporting

Since the previous year, there has been a new trend in the intersection of intellectual property law and tax law.  More specifically, there has been a rise in claimants and plaintiffs that have treated the awards they win, from patent litigation, as capital gains when it comes to filing taxes.  This is in stark contrast to the more normal routine of treating monetary settlements as an extension of royalties, which is then only taxable as ordinary income.  

Why Treat Patent Damages Awards as Capital Gains?

To understand how one may treat damages as capital gains, one needs to know the basics of tax law.  Generally, capital gains are considered highly desirable because of the tax advantages that come along with them.  The best benefit of a long-term capital gain itself, as it is always seen as a positive, is when one is able to generate profit off of such an investment.  Capital gains usually arise when there is a sale.

As such, it then follows that inventors or patent owners may be able to treat judgments, settlements, or similar proceeds from litigation as capital gains because the tax definition of “capital asset” has traditionally excluded most forms of intellectual property with a notable exception for patents.  And while the 2018 Tax Cuts and Jobs Act made it so that a patent or invention could not qualify as capital assets, it again did not exclude patents from being treated as capital gains.  

How Settlements of Patent Damages Can Be Treated as Capital Gains

Lastly, as a final caveat, one must understand that the IRS generally views awards, settlements, or recoveries from infringement as something akin to royalties.  If the IRS deems it to be royalties, then it will treat it as ordinary income.  In that case, the client or counsel should know that under section 1235 of the tax code, it allows for these aforementioned recoveries and damages to be treated as capital gains, as long as the money award is tied to the transfer of all substantial rights to the patent.                                                                                                                                         

Key Takeaways for Treating Patent Damages as Capital Gains

Tax experts have seen a new trend where patent damages are being treated as capital gains.  This can happen because:

  • section 1235 allows qualification for capital gains when the money award is tied to a transfer of all rights to the patent (sale); and

  • the law has historically made exceptions for patents.

For more information on patent litigation, see our IP Litigation and Industry Focused Legal Solutions pages.

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