deductibility of legal fees incurred for defense of a patent

(law school paper)

To:     Mr. Abbott Controller, Signature Financial Group, Inc.
From: Travis A. Wise
Re:     Treatment of patent defense costs

The issue address by this memorandum is what the best treatment would be for the legal costs incurred in defending patent '056, "Data Processing System for Hub and Spoke Financial Services Configuration," held by Signature Financial Group, Inc. (Signature).
Signature filed and defended the '056 patent to protect a data processing system developed by Signature by which mutual funds pool their assets into an investment portfolio organized as a partnership. The legal costs were incurred in successfully defending the patent from a competitor, State Street, who alleged that the patent was invalid for failure to claim the patent under one of the statutory subject matters under which a patent may be issued. Undoubtedly State Street wished to nullify the patent so that they could implement the Hub-and-Spoke business model. The Federal appeals court determined that Signature's patent was valid, despite being a mathematical algorithm, because it produced a useful, concrete and tangible result which was a practical application, and thus able to be patented. (State Street v. Signature Financial Group, Inc., 149 F.3d 1368, 1998).
    Applicable Statutes and Precedent
The ideal treatment of these costs would be a deduction in the current taxable year in order to reduce the present tax burden faced by Signature. Deductions are the exceptions to the norm of capitalization, and are permitted only if clearly provided for in the code (Indopco v. Commissioner, 503 U.S. 79, 1992). The following summarizes the tax provisions most likely to afford a deduction to Signature:
IRC �162 allows for the deduction of ordinary and necessary business expenses incurred in the carrying on of a business. This generous statute has been limited by case law: "Ordinary and necessary" expenses do not include expenses incurred for the benefit of future operations (General Bancshares Corp. v. Commissioner, 326 F.2d 712, 1964). If the expenses resulted in creation or enhancement of an asset with a useful life of greater than one year, the expense must be capitalized under IRC �263 and amortized over the useful life of the asset (Commissioner v. Lincoln Savings, 403 U.S. 345, 1971). In making this determination, the taxpayer must analyze the expense to determine if the taxpayer will realize benefits from the expense beyond the present year, and if so, the expense must be capitalized (U.S. v. Mississippi Chemical Corp., 405 U.S. 298, 1972).
In Indopco, the Supreme Court held that expenses incurred for the acquisition of another business had to be capitalized because those expenses resulted in the acquisition of an asset with greater than one year life. The expenses in question included banking and legal fees, which the court held accrued long-term benefits to the taxpayer and therefore required capitalization under �263. Under IRC �263, no deduction is permitted for any expenditures resulting in improvements made to increase the value of capital assets. Rather, the expenses are capitalized and amortized over the useful life of the asset.
In Safety Tube Corp. v. Commissioner (168 F.2d 787, 1948), the court held that legal fees incurred for defending a patent were capital expenditures and not deductible as ordinary and necessary business expenses. Legal fees for trademark protection, arguably comparable to a patent, have similarly been held to be a capital expenditure (Rust-Oleum Corp. v. U. S., 280 F.Supp. 796, 1967).
As an alternative means of deduction, IRC �174(a) allows for deduction of research and experimental expenses if those expenses are qualified under �174. Attorneys' fees expended in making and perfecting a patent are included as qualified expenses (26 C.F.R. 1.174-2(a)). However, the research and development must be conducted in the experimental or laboratory sense to eliminate taxpayer's uncertainty as to taxpayer's development or improvement of a product (Id.).
IRC �197 allows for a 15-year amortized deduction of goodwill and other intangibles acquired in connection with a trade or business. "Intangibles" includes patents under �197(d)(1)(C)(iii), but �197(C)(2) excludes self-created intangibles except those expressly listed, of which patents and legal fees are not included.
    Application To '056 Patent
In order for Signature to be able to deduct the legal costs of defending the '056 patent, a statutory allowance will need to be identified that permits the deduction. The �162 "ordinary and necessary" business expense deduction would seem to be the most likely source of a deduction allowance. However, the General Bancshares and Lincoln Savings cases cited above preclude that treatment. Signature's legal costs were incurred for the benefit of future operations in that the patent will be used for the indefinite future in Signature's investment methods, and the patent right resulting from the costs incurred will last for more than one year. Additionally, Signature intends to realize benefits from the patent beyond the present year, and thus under Mississippi Chemical the expense must be capitalized.
Signatures expenses can be likened to the Indopco expenses, which were held to require capitalization. The Indopco expenses included professional service fees, including legal fees, incurred in the acquisition of a capital asset. The court held the expenses must be capitalized under �263, which requires capitalization of expenses resulting in improvements made to increase the value of capital assets. Given that Signature's patent is a capital asset, and the legal costs were incurred to increase the value of that asset in that the patent would have been of significantly less value but for the defense litigation, the Indopco holding and �263 require capitalization. This conclusion is further supported by the Safety Tube holding which, similar to this issue, required capitalization of legal fees incurred in defending a patent.
As an alternative to deduction under �162, �174(a) permits deduction for qualifying research and experimental costs. In order to qualify for this treatment, Signature would argue that the development of the mathematical equation contained in the '056 patent was qualified research and experimental costs, which qualify for deduction. This argument is not likely to be successful. To qualify for the deduction, the research and development must be conducted in the "experimental or laboratory sense" to eliminate uncertainty as to the development or improvement of the product. The facts do not indicate that the development of the formula or business method was at any time experimental, or that they were incurred to eliminate uncertainty as to the development of the product. Therefore, a �174 deduction seems unlikely.
Similarly, the expense is likely to not be deductible under �197, which provides that costs incurred in acquiring goodwill and intangibles acquired in connection with a trade or business can be deduction over a 15 year period of. Developing a patent to engage in a new type of business is an acquisition of a new trade or business, but because the '056 patent was developed by the Signature, and not purchased, it is a self-created intangible and therefore excluded by �197(C)(2). Therefore, the �197 deduction would not apply.
The legal fees incurred by Signature in defending the '057 patent should be capitalized over the 20 year life of the asset. If Signature wishes to be aggressive about deducting the expense, the most favorable source of the deduction would be �174(a), but Signature would need to support the deduction with evidence that the patent was the result of research and development in the "experimental or laboratory sense."

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