Tax patents considered: a practice by the U.S. Patent and Trademark Office of granting patents on tax strategies has raised red flags with many observers. Members of an AICPA volunteer task force tell why.

EXECUTIVE SUMMARY

* The U.S. Patent and Trademark Office since 1998 has granted patents to business methods. In recent years, these patents have come to include strategies to minimize tax, a development many observers find troubling. Tax strategy patents complicate tax advising, return preparation and compliance, since practitioners and taxpayers must worry about inadvertently infringing upon an existing patent.

* Because patent applicants must fully disclose their invention in the application, patents are generally considered to encourage more research and investment in new methods and processes aimed at further developing the invention after its patent period expires. But tax strategies don't appear to need any economic benefit beyond reducing tax liability.

* Other problems include the risk that taxpayers may assume a patented tax strategy carries a "seal of approval" by the government, even though the USPTO doesn't normally include legality in its criteria for granting patents.

* The AICPA is among several professional organizations that have formed committees or otherwise taken notice of the issue. The AICPA Tax Strategy Patent Task Force has urged Congress to curtail the use of tax strategy patents.

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Patents are now being issued for tax strategies. This development 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 (see accompanying abstract). 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 (see sidebar "How Tax Strategies Became Patented" for a complete description of the requirements for issuing a patent). 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 re-create 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 (see sidebar, "Making the Case").

A well-publicized infringement action concerned patent no. 6,567,790, commonly referred to as the "SOGRAT patent" (see accompanying 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.

AICPA RESOURCES

Web site

AICPA Tax Section links and documents, http://tax.aicpa.org/Resources/ Tax+Patents/.

OTHER RESOURCES

Web sites

* Transcript of hearing, Subcommittee on Select Revenue Measures of the House Ways and Means Committee, July 13, 2006, http://waysandmeans.house.gov/ hearings.asp?formmode=detail& hearing--492.

* American Bar Association materials, www.abanet.org/tax/patents/ material.html.

Article

"Whose Tax Law Is It?" Legal Times, Oct. 16, 2006, www.law.com/jsp/dc/ index.jsp.

How Tax Strategies Became Patented

Each application for a patent is evaluated by the U.S. Patent and Trademark Office (USPTO) to determine if the invention is for patentable subject matter, has utility and is novel and non-obvious.

Patentable Subject Matter. A patent may be obtained for "any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof' (35 USC [section] 101). The Supreme Court has excluded laws of nature, natural phenomena and abstract ideas from being patentable [Diamond v. Chakrabarty, 447 U.S. 303 (1980)].

Utility. The standard for utility is very broad. The U.S. Court of Appeals for the Federal Circuit, which has .jurisdiction over patent-related appellate cases, has stated, "The threshold of utility is not high: An invention is 'useful' ... if it is capable of providing some identifiable benefit" [Juicy Whip Inc. v. Orange Bang Inc., 185 F3d 1364, 1366 (Fed. Cir., 1999)].

Novelty. An invention is deemed not to be novel if it has been previously patented or if it involves "prior art," meaning it was known or used by others when the application was filed. In the patent application, the inventor should disclose known relevant prior art. In the review of a patent application, the examiner will search for additional evidence of prior art.

Obviousness. The invention should not be obvious to someone skilled in the subject matter of the patent, based on the extant prior art. Both the novelty and non-obviousness requirements are critical for tax strategy patents.

Patents on Business Methods

The Court of Appeals for the Federal Circuit in 1998 issued a landmark opinion involving a data system for investment fund partnerships patented by Signature Financial Group, a financial services company. State Street Bank and Trust Co. of Boston had sought to license the system and, when negotiations broke down, filed a lawsuit attacking the patent's validity. In upholding Signature's patent, the Federal Circuit rejected a longstanding precept that business methods were not suitable subject matter for patents [State Street Bank & Trust Company v Signature Financial Group, Inc., 149 F3d 1368 (Fed. Cir., 1998)]. Since State Street, the number of business-method patent applications has exploded to between 7,000 and 9,000 each year.

Business-method patents opened the door for the patenting of tax strategies. More than 50 tax strategy patents have been issued, with more than 80 applications in process. The USPTO uses a special classification (705/36T) for them, although due to inconsistencies in the classification of patent applications, tax strategy patents are not all found in this category. Issued patents cover subjects such as converting from a traditional IRA to a Roth IRA (see accompanying abstract) and developing a system for decomposing property into separately valued components (no. 7,107,239). Generally, the patents issued to date cover tax strategies related to wealth transfer and financial products including insurance, as well as employee benefits and real property exchanges. Tax-strategy patents and published applications classified in the 705/36T category can be viewed on the USPTO'S Web site at www.uspto.gov/patft/class705_ sub36t.html.

Making the Case

Proposed legislation sought by the MCPA on tax patents was introduced in May in the House of Representatives. HR 2365 was introduced by Rep. Rick Boucher, D-Va., with cosponsors Bob Goodlatte, R-Va., and Steve Chabot, R-Ohio, all members of the House Judiciary Committee. The bill would limit damages and other legal remedies in infringement actions against taxpayers, practitioners and firms involving patented tax planning methods.

Earlier, in a letter and a white paper to the leadership of the tax-writing and judiciary committees, the MCPA urged Congress to restrict tax patents or provide immunity from patent infringement liability for taxpayers and practitioners. The letter, signed by Jeffrey R. Hoops, chair of the AICPA Tax Executive Committee, said that such patents may:

* Limit the availability to taxpayers of tax law interpretations intended by Congress.

* Cause some taxpayers to pay more tax than Congress intended or to pay more tax than others similarly situated.

* Complicate practitioners' ability to provide tax advice.

* Hinder taxpayers' compliance with the law.

* Mislead taxpayers into thinking a patent confers validity in tax law of a transaction or position.

* Preclude tax professionals from challenging their validity. Other groups also have expressed concerns.

Tax Patent Abstracts

All patent applications must contain an abstract that describes in a summary manner the nature of the invention being patented. The following example abstracts are from patents that have been issued for tax strategies:

Process for evaluating the financial consequences of converting a standard form IRA to the Roth form IRA

Patent no. 6,058,376

Disclosed is a computer-implemented process for evaluating the financial consequences of converting a standard format IRA to a new Roth form IRA. The process includes computing and disclosing the substantial federal income tax consequences involved in converting the standard form IRA to the Roth form. It further includes multiple options that how [sic] a given IRA holder can cope with the substantial tax consequences, including without limitation how he or she will fare if he or she obtains term insurance on the federal tax liability of early withdrawal by reason of premature death, or if he or she deducts the federal taxes and insurance premium from the rollover amount, or in the alternative how he or she will fare by financing the federal tax consequences and insurance premium in order to preserve intact the entire IRA amount for rollover. Additionally, the disclosed process allows IRA holders to enter into the calculations estimated increases in federal tax rates which would be in effect in their retirement years. Whereas it is not known how the federal tax rates will change (if at all) in the ensuing years, the disclosed process will allow entry of educated guesses so that a given IRA holder can work through various chosen scenarios to see how he or she will fare under the chosen scenarios.

Establishing and managing grantor retained annuity trusts funded by nonqualifled stock options

Patent no. 6,567,790

An estate planning method for minimizing transfer tax liability with respect to the transfer of the value of stock options from a holder of stock options to a family member of the holder. The method comprises establishing a Grantor Retained Annuity Trust (GRAT) funded with nonqualifled stock options. The method maximizes the transfer of wealth from the grantor of the GRAT to a family member by minimizing the amount of estate and gift taxes paid. By placing the options outside the grantor's estate, the method takes advantage of the appreciation of the options in said GRAT. In one embodiment the method also maximizes the amount transferred to the family member by keeping as many of the options as possible in the GRAT until immediately prior to the termination of the GRAT, when the grantor substitutes an equivalent value of assets into the GRAT for the remaining options, and then exercises the options. The method is used for evaluation purposes in establishing the GRAT, and responds to a variety of grantor-selected options. An Irrevocable Life Insurance Trust (ILIT) may also be established to provide life insurance should the grantor die before the termination of the GRAT. If the GRAT continues until its natural termination date the ILIT will receive the assets of said GRAT and may purchase further life insurance on the grantor.

Method for Financing Future Needs

Patent no. 7,149,712

A method for financing future intentions of a first party pursuant to a first contract with a second party for a specified monetary sum. A contract involving a variable annuity is obtained from a third party. A guaranteed benefit equal to at least the specified monetary sum is paid to the second party by the third party to pay for the fulfillment of the future intentions of the first party. The variable annuity has a guaranteed annual increase.

Jack Cathey, CPA, Ph.D., and Howard Godfrey, CPA, Ph.D., are accounting professors at the University of North Carolina, Charlotte. Their e-mail addresses, respectively, are [e-mail] and [e-mail]. Justin Ransome, CPA, J.D., MBA, 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.