Are Payments Made To Settle a Patent Violation Deductible?

March 20, 2015 | Roger A. McEowen

There have been numerous cases in recent years involving farmers who have been found to have violated a patent on seeds and had to pay a tidy sum as a result.  One question came into us recently about whether a payment a farmer had to make to settle a claim concerning patented seeds that he illegally saved, replanted and also resold could be deducted. 

The tax code says that a taxpayer can deduct ordinary and necessary expenses that are paid or incurred in the tax year to conduct the taxpayer’s business.  But, a taxpayer can’t deduct illegal payments such as bribes and kickbacks. 

So how do you tell the difference?  The U.S. Supreme Court says that you look to the “origin of the claim.”  Under that test, if the action against the taxpayer relates to the taxpayer’s business, then the expense (payment) is a deductible business expense. 

When a farmer buys patent-protected seed, a fee has to be paid to use the seed.  Call it a “tech fee” or a “license fee,” but it’s a cost of doing business and is deductible as a cost of doing business.  If that fee isn’t paid, and the farmer ends up settling with the seed company for violation of the company’s patent rights, that settlement payment relates to the farmer’s business activity and would be deductible.  Even if the farmer isn’t sued, but settles the matter to avoid litigation the settlement payment can be deductible.  There’s no requirement that a lawsuit be field or a judgment be entered against a farmer for the payment to be deductible.  In a non-ag situation, the IRS has allowed a deduction for payments made to a state governmental entity.  If those payments are deductible, the payments to settle a civil dispute related to the taxpayer’s business should certainly be deductible. 

Back to the question that we got, the payment by the farmer is not really a “fine.” It’s intended to compensate the seed company. 

Was it business activity that gave rise to the claim?  If so, you’ve got a good argument for deductibility.