The movie opens with Tony (Robert Downey Jr.) narrating a story about how we create our own demons.
In a flashback to New Year's Eve 1999, Tony, meets a botanical scientist named Maya Hansen (Rebecca Hall) in Bern, Switzerland, and arrogantly avoids crippled scientist Aldrich Killian (Guy Pearce).
Aldrich wants Tony's backing in his endeavor, Advanced Idea Mechanics (AIM). Maya has an experimental plant.
Maya has been working on experimental (and in some cases unethical) biological research in plants that causes their DNA to change drastically and has the power to cure incurable diseases and paralysis.
Cut back to present day America at Tony Stark's beach side Malibu mansion where it's Christmas time.
It's been quite some time after the events of New York City and the Avengers Initiative, a haunted Tony Stark has obsessively built several Iron Man suits in his mansion.
Tony works on a new model, the Mark 42, which is modular; all the suit pieces fly to him and recombine. The first attempt at making the MK42 work is met with a funk version of "Here Comes Santa Claus" with Tony dancing while the pieces are coming at him.
As per the course, Tony of course completely ignores any safety measures that JARVIS takes. It ends rather poorly when Tony is thrown across the room attempting flight with the MK42 and it shatters into pieces. JARVIS of course gloats with an "I told you so" moment.
Back at Stark Industries, Pepper (Gwyneth Paltrow) goes to meet her 4:00 appointment, who is Aldrich Killian, and he looks much different than he did in 1999.
Aldrich wants Stark Industries' backing in his think tank called "Advanced Idea Mechanics". AIM's goal is a biological experiment called "Extremis" which harnesses' the brain's power to alter human DNA.
He shows Pepper a massive hologram reconstructing of his brain and how Extremis can utilize parts of the brain that would otherwise go unused. Pepper tells Aldrich that Stark Industries isn't interested in funding AIM because the ideas could be translate into human weapons.
Happy Hogan (Jon Favreau) has found a new career as the head of security at Stark Industries although he's annoying nearly 99% of the company's personnel and visitors with his penchant for requiring everybody to wear badges, and Pepper explains that complaints against him have risen nearly 200% since he started working there.
Tony then continues his story about creating demons. He then talks about how he turned on the TV to find a new terrorist at work called "The Mandarin". The Mandarin has hijacked American airwaves and makes his American debut by explaining about an attack that he carried out on a US military station in Afghanistan and has killed a lot of people in the process and takes credit for the attack.
The president's initial response to the Mandarin however makes him the butt of the jokes of late night talk show hosts. It seems the only thing that he's able to come up with is to take MK8, with James Rhodes, the one formerly known as "War Machine" which is then repainted, rebranded, and reintroduced as "The Iron Patriot".