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Red Flags on Tax Patents

An AICPA volunteer task force reveals why a U.S. Patent and Trademark Office practice of granting patents on tax strategies has raised concerns.

July 2007
from Journal of Accountancy

Patents are now being issued for tax strategies, which creates an additional level of complexity for tax advisers, tax return preparers and even taxpayers. Before an adviser suggests a strategy, a preparer completes a return or a taxpayer files a return, they now must determine whether any strategy they have proposed or implemented has been patented, and if so, whether a royalty should be paid to the patent holder. This article explores the consequences of this development for tax practitioners, taxpayers and tax authorities.

Recently, a number of financial advisers and professionals who work with nonprofit organizations have received a letter from the owner of patent no. 7,149,712, which covers a strategy of purchasing an annuity contract to fund a charitable remainder trust. While the letter does not specifically threaten an infringement action, it does invite the recipient to meet to discuss “benefits of this new idea.” The most shocking aspect of this patent is that the method appears to be widely used and, in the opinion of many tax professionals, is missing two of the elements necessary for patentability, non-obviousness and novelty. This strategy of funding a charitable remainder trust by purchasing an annuity contract was approved by the IRS in 1989 in Letter Ruling 9009047 and addressed favorably by the IRS in 1997 in Technical Advice Memorandum 9825001. These IRS pronouncements were published by major tax publishers, and tax professionals have known about them and used the strategy widely in recent years.

Responding to such concerns, the AICPA in May 2006 convened a Tax Patent Task Force. AICPA members and staff spoke with congressional staff before a 2006 hearing of the Subcommittee on Select Revenue Measures of the House Ways and Means Committee and have sent legislative recommendations to Congress. In addition, the AICPA is a member of the Joint Intellectual Property/Estate Planning Task Force, along with the American Bar Association sections of taxation and real property, probate and trust law. Also participating are the American College of Trust and Estate Counsel and the American Bankers Association.

Issues Created by Tax Strategy Patents

Is patenting tax strategies desirable as public policy? The public policy argument for patents generally is that an equitable result occurs when a limited-life monopoly right, which is intended to encourage investment in new methods and processes, is granted to a patent holder in exchange for the complete disclosure of an invention, which others may use after the right expires to recreate and potentially extend the invention.

Problems arise when this argument is applied to tax strategies. First, given the significant number of tax strategies that have been created without patent protection, there appears to be more than adequate economic incentive to promote their development. Second, as a matter of policy, the federal government would have no clear reason to create additional incentives to reduce federal tax revenues.

When a business is granted patent protection on a product it has designed and developed, other businesses and individuals usually have a choice. They can in some cases purchase a license from the patent holder. If a license is unavailable at a viable price, they can pursue other activities, products or markets. But that choice, others argue, is lacking in patents for tax strategies, because taxpayers do not have a choice regarding whether to comply with the tax law.

A fundamental tax concept holds that two similarly situated taxpayers should pay the same amount of tax. However, a tax strategy patent holder may elect to license a strategy to one taxpayer and not to another. The taxpayer who is unable to negotiate a license will potentially pay more tax, even though the basic facts and circumstances are the same as those for the taxpayer who obtained a license.

Control of tax policy may shift from Congress to a shared position with patent holders. What if Congress created an incentive for a large class of taxpayers for certain types of real estate investments? If an entrepreneur anticipated Congress’ action and patented a highly tax-efficient manner to harness the incentive, the entrepreneur could license the strategy to a smaller class of taxpayers than Congress had intended, and congressional intent would be thwarted.

Tax strategy patents also may confuse taxpayers about tax law. When the USPTO reviews a patent application, it considers only whether the application fully complies with the requirements of patentability. It does not consider the merits or legality of the process or method. As a result, an ineffective or illegal tax strategy may be patented. In testimony in July 2006 before the House Ways and Means Committee’s Subcommittee on Select Revenue Measures regarding the patenting of tax strategies, James Toupin, general counsel to the USPTO, said patents have been issued for “inventions that may arguably be illegal at least in certain jurisdictions, and may be considered to be immoral or offensive by some.” Nonetheless, some may view a patent as the government’s seal of approval on the tax strategy. In congressional testimony in 2006, then-IRS Commissioner Mark Everson said the IRS would not become directly involved in patent reviews.

Patenting tax strategies increases the compliance burden for tax advisers and taxpayers. Tax practitioners need to continually review newly issued tax strategy patents to make sure their own advice or routine use of certain tax-planning techniques doesn’t infringe on a patent. Failure to license a patented tax strategy can give rise to a patent infringement lawsuit, with the burden of proof on the defendant. Meeting the burden is difficult and costly. Both taxpayers and their advisers might be considered infringers. The taxpayer may be liable because the return infringed upon the patented strategy. The tax adviser may be liable for aiding and abetting in the infringement. Damages for infringement would, at a minimum, require payment of a reasonable royalty and may be increased to three times the normal rate for willful infringement. Lack of awareness of a patent is not an adequate defense in an infringement claim, because patents are publicly disclosed when they are issued. Proposed legislation would limit damages in such cases.

A well-publicized infringement action concerned patent no. 6,567,790, commonly referred to as the “SOGRAT patent” (see abstract). Owned by the Wealth Transfer Group LLC of Altamonte Springs, Fla., it covers establishing a grantor retained annuity trust (SOGRAT) funded with nonqualified stock options to maximize wealth transfer while minimizing estate and gift taxes. The patent holder filed an infringement suit early in 2006 against John Rowe, who at that time was the CEO of Aetna. Wealth Transfer Group became aware of the use of the SOGRAT after Rowe reported a transfer of options under the SEC’s insider-reporting requirements. In March 2007, a private settlement was reached between the two parties.

Patenting tax strategies may have a chilling effect on public discussion among tax practitioners. Tax professionals may choose not to discuss in a public forum a tax strategy they have suggested or are contemplating suggesting for fear of alerting a patent holder and becoming the target of an infringement action.

Both Treasury and Congress have begun to consider how to address this development. Treasury is considering whether tax strategies covered by patents should be added to the reportable transactions list. Besides a bill that would limit infringement damages, legislation has been introduced in the House of Representatives and Senate that could eliminate the ability to patent tax strategies. While such an approach might be preferred by many in the tax community, Congress has in the past been reluctant to make this kind of sweeping change.

Until Congress addresses the issues created by patenting tax strategies, tax practitioners should review tax patents as they are issued and consult lawyers specializing in intellectual property rights when there is a potential for infringement. Before using a patented strategy, they should contact the patent holder and attempt to negotiate a license or consider abandoning the strategy.

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Jack Cathey, CPA, Ph.D., Howard Godfrey, CPA, Ph.D. and Justin Ransome, CPA, J.D., MBA are contributing writers for the Journal of Accountancy. Both Cathey and Godfrey are accounting professors at the University of North Carolina, Charlotte. Ransome is a partner in the National Tax Office of Grant Thornton LLP, Washington, D.C., and chairs the AICPA Tax Strategy Patent Task Force, of which Cathey and Godfrey are also members.