Tax Strategy Patents: Truth and Consequences
Can Patents Encourage Invention Without Complicating Tax Preparation and Compliance?

By Evelyn McDowell

Background: What Are Tax Strategy Patents?

The Patent Act of 1952, the basis for the modern patent process, provides that any person who “invents or discovers any new and useful process, machine, manufacture or composition of matter, or any new and useful improvement thereof, may obtain a patent therefore, subject to the conditions and requirements of [Title 35].” The four core requirements for the issuance of a patent are as follows:

• the invention or discovery is of a proper subject matter;
• the invention or discovery is useful;
• the invention or discovery is novel; and
• the invention or discovery is non-obvious at the time it was made to a person of ordinary skill in the relevant art.

A patent gives the patentee a 20-year right over the invention or discovery, and violators can be assessed monetary damages. Patents cannot be obtained upon a mere idea or suggestion.

It was unclear whether business processes could be patented until the 1998 decision in State Street Bank & Trust Co. v. Signature Financial Group, Inc. [149 F. 3d 1368 (Fed Cir. 1988), cert. denied, 525 U.S. 1093 (1999)]. In that case, the judge ruled that mathematical algorithms used to calculate the share prices of mutual fund holdings in a way that satisfied tax regulations to be “a useful, concrete and tangible result” and, therefore, they could be patented. After this ruling, business method patents became one of the fastest-growing segments of patent applications, with 8,678 and 8,959 filed in 2005 and 2006, respectively.

According to the United States Patent and Trade Office (USPTO), 60 patents and 86 published applications in the special subcategory for tax strategies and data processing have been processed since June 2007 (www.uspto.gov). The special category, current U.S. classification 705/36T, includes patents for a wide variety of tax planning techniques. Some patents focus on the use of a computer as a crucial element of the business method. Others rely mainly on the tax structure itself.

Examples of patents granted and pending applications are included in Exhibit 1.

On March 9, 2007, an important lawsuit regarding tax strategy patents was settled. In the case, Wealth Transfer Group LLC v. John W. Rowe [Docket No. 3:06-cv-0024-AWT (D. Conn.)], Robert Slane, president of the Florida-based Wealth Transfer Group, alleged that John Rowe, former CEO of Aetna, Inc., used his patented tax strategy on his personal tax return. The patent, number 6,567,790, was designed to minimize estate and gift tax liability through the use of a grantor retained annuity trust (GRAT) funded with nonqualified stock options. Slane’s accusations were based on an Aetna SEC filing. The case, also known as the SOGRATS patent, was settled out of court with parties agreeing to a confidential patent licensing agreement. Court records stipulated that the patent was presumed to be valid.

According to testimony given by Dennis Belcher, an officer of the American College of Trust and Estate Counsel, to the subcommittee on Select Revenue Measures of the House Committee on Ways and Means on July 13, 2006, many estate-planning professionals were shocked to learn that the common gift tax strategy described in the SOGRATS patent, which had been authorized under the Treasury Regulations and approved by the IRS, was able to be patented.

The SOGRATS patent and the subsequent lawsuit highlighted the fears of many tax professionals. First, there is a possibility that a well-known tax strategy could be patented, albeit in error. Second, one person or corporation can restrict the use of a tax strategy and seek damages for infringement. Third, taxpayers can be sued while complying with tax law and relying on their advisor’s tax advice.

Background: Other Patent Concepts

The concept of “prior art” refers to the earlier existence of a claim made in the patent application. To determine whether a claim is novel, the patent examiner must search for the existence of prior art. If at any stage of the patenting process, including after the patent has been granted, prior art is found, the patent will be invalidated. Consequently, tax strategies documented in seminars, textbooks, and newsletters may be considered prior art and thus are important in the patenting process.

The public may be unable to provide evidence of prior art for some patents because some applications are never published. Patent applications are generally published within 18 months after the filing date; applicants not filing for protection outside of the United States can request that the application be unpublished until granted. According to Wynn Coggins, director of business methods technology center at the USTPO, only about 10% of business method applications are not published (see Dustin Stamper, “Tax Strategy Patents: A Problem Without Solutions,” Tax Notes, April 23, 2007). Exhibit 2 lists some resources to search for patents.

After a patent is granted, any unauthorized use of the method described constitutes an infringement. Under 35 USC section 271(a): “Whoever without authority makes, uses, offers to sell, or sells any patented invention, within the United States or imports into the United States any patented invention during the term of the patent therefor, infringes the patent.” In the case of a tax strategy patent, the infringers are likely to be the tax advisor and the taxpayer, with the taxpayer being the direct infringer. An infringer is liable for damages even if he was not aware of the patent. Trebled damage can be assessed if the infringer was aware of the patent. In addition to monetary damages, the law provides for injunctive relief. In other words, the patentee may have the right to stop the infringer from using the patented tax strategy.

The law provides a limited “prior user” defense from an infringement lawsuit. After State Street Bank was decided, there was concern that other persons using business methods that were previously thought not to be patentable could be sued by someone who held a patent. The American Inventor’s Protection Act of 1999 included the First Inventors Act, which provides an infringement defense to a defendant who can show she used the business method in the United States at least one year before the effective date of the patent and had commercially used it before the filing date.

The protection provided by patents depends on the ability of the patentees to enforce it. Filing lawsuits and retaining legal counsel can be expensive. An individual with means is better able to enjoy the benefits of a patent than others. In addition, a patentee must be able to detect infringement to achieve the advantages of a patent. In the case of a tax-related strategy patent, patentee detection can be difficult due to the confidential nature of tax returns.

Possible Implications for Stakeholders

Opponents of tax strategy patents, including Ellen P. Aprill, tax lawyer and Associate Dean at Loyola Law School (Los Angeles), fear that the practice of giving tax advice may become more expensive and difficult. Due diligence and ethical considerations may require practitioners to determine whether a tax strategy is patented and whether to disclose that information to the taxpayer. The additional billable hours increase the cost to the taxpayers. Due to potential licensing costs and fear of lawsuits, some tax advisors may decide not to recommend patented tax strategies to their clients, negating the intent of tax policy and limiting the taxpayer’s ability to legally reduce taxes. In theory, proponents argue, good tax policy should disclose to taxpayers how to comply with the law, and only non-obvious, unforeseeable tax strategies would be eligible for a patent. Consequently, the intended effects of tax policy would not be hampered.

Critics reply that tax strategy patents promote unequal treatment of “similarly situated taxpayers” and violate a fundamental tenet of the U.S. law. The Supreme Court stated, in Thor Power Tool Co. v. Com’r [439 U.S. 522 (1979)], that the tax system is designed to “ensure as far as possible that similarly situated taxpayers pay the same tax,” also known as the principle of “horizontal equity.” If one taxpayer has access to a patented strategy and the other does not, they will pay unequal taxes. Furthermore, a basic tenet of the U.S. legal system is to allow equal applicability to all. Critics contend that patentees of tax strategy patents can legally restrict a taxpayer’s ability to comply with the tax laws.

The effect on the free transfer of information within the tax profession is another disquieting issue. Tax preparers may become reluctant to share new ideas and strategies because doing so will make their ideas less novel and non-obvious, jeopardizing the ability to obtain a patent. As a result, the dissemination of tax knowledge might be significantly reduced.

The possibility that the government will encourage tax avoidance is another concern. As suggested by Ellen P. Aprill in her testimony before the Subcommittee on Select Revenue Measures, since tax strategy patents will likely be promoted through marketing, a corresponding reduction in tax revenues may ensue, placing a heavier burden on other taxpayers. Consequently, opponents have questioned the usefulness—a core requirement of patentability—of these types of patents, because the loss of tax revenues may result in a loss to society as a whole. On the other hand, it could be argued that legitimate patented tax strategies are beneficial to society, because they enable taxpayers to pay only the amount required by law.

By conferring a patent on a tax strategy, taxpayers may construe that the strategy is sanctioned by the government—after all, one branch of government, USPTO, has legitimized it. In his hearing before the House Ways and Means Subcommittee on Select Revenue Measures in July 2006, former IRS Commissioner Mark Everson stated that this mixed message is a major concern of the IRS.

An additional concern is that a tax shelter promoter can use the patenting process to avoid the reportable transaction regulations under Treasury Regulations section 1.6011-4. These regulations require that taxpayers participating in a reportable transaction must disclose the nature of the transaction in an attachment to their tax return. This notification allows the IRS to scrutinize the transaction. Confidential transactions, where a tax advisor requires the taxpayer to keep the details of the tax strategy confidential and is paid a minimum fee, are considered reportable transactions and must be disclosed. The patenting process allows a tax advisor to lift its confidentiality requirement, receive the assurance that no one can benefit from the tax maneuver, and bypass the disclosure requirement.

In September 2007, the IRS issued proposed regulations adding a new “patented transaction” category of reportable transactions requiring users of tax strategy patents to document their transactions. The transaction threshold amounts in Treasury Regulations section 301.6111-3(b)(3)(i)(A) are reduced from $50,000 to $250 and from $250,000 to $500 [see proposed Treasury Regulations section 1.6011-4, REG-129916-07, 72 FR 54615 (9/26/2007)].

Opponents of tax strategy patents proclaim that gathering complete prior art to determine novelty and non-obviousness is nearly impossible. Tax returns—the major source of evidence of prior art—are unavailable because of confidentiality. If a taxpayer is sued for infringement, she will find it difficult to invalidate a patent on the grounds that it is obvious and lacking novelty because tax-return evidence showing prior use cannot be obtained. Because the USTPO also lacks access to tax-return data, it cannot improve the quality of tax strategy patents. It should also be noted that the USTPO typically hires staff with engineering backgrounds, who may not have the general business and tax expertise to search other existing literature and other forms of prior art.

Proponents of tax strategy patents say that innovation is spurred by incentivizing inventors. With a patent, a tax strategy developer can be rewarded for developing a unique and valuable way to reduce taxes by charging others for using their ideas. In addition, because, in theory, these strategies are unknown prior to the issuance of the patent, the patenting process can help publicize knowledge and make these tax-saving techniques available to others. Opponents argue that tax innovation is encouraged by the tax savings themselves and fees advisors receive for tax services, making patents unnecessary.

Proposed Solutions: Statutory

In spite of the arguments for tax strategy patents, many in the accounting and legal professions, as well as regulatory agencies, have serious concerns and are currently seeking solutions. Because patents are established by laws, only an act by Congress can change the patentability of tax strategies. The AICPA, the American Association of Attorney-CPAs (AAA-CPA), the American Bar Association Section of Taxation, and some state accounting and legal associations have expressed their concerns in letters to the House and Senate judiciary and tax committees.

In February 2007, the AICPA proposed that Congress eliminate the consequences of tax strategy patents by either restricting the issuance of patents for tax strategies or providing tax preparers and taxpayers protection from patent infringement liability. In May 2007, Senators Carl Levin (D-Mich.), Norm Coleman (R-Minn.), and Barack Obama (D-Ill.) introduced section 303 of the Stop Tax Haven Abuse Act (S. 681). Representative Lloyd Doggett (D-Texas) introduced H.R. 2136 (the House version of the act). Section 303 of both versions would stop tax strategy patents by prohibiting the USPTO from issuing patents for inventions “designed to minimize, avoid, defer, or otherwise affect liability for Federal, State, local, or foreign tax.” Commentators have observed that the language in the proposed statute is broad, and could extend to business method patents that have a primary purpose other than tax avoidance, such as tax preparation software.

In May 2007, Representative Rick Boucher (D-Va.) introduced H.R. 2365, a bill intended to limit monetary damages and other remedies, including injunctions, with respect to patents for tax-planning methods. If the bill were to be passed, infringement under subsection (a) or (b) of section 271, and the provisions of sections 281, 283, 284, and 285 would not apply against the taxpayer, the tax preparer, or any related professional organization.

Limiting remedies is a solution borrowed from the medical profession, which suffered from a bout of lawsuits in the mid-1990s, when patent law threatened doctors performing patented medical procedures. The medical profession was successful in obtaining the Physicians Immunity Statute, which removed all remedies, both monetary and injunctive, against licensed medical practitioners in the performance of a medical activity that infringed on a patent. It is interesting to note that the statute did not make medical processes, surgical devices, and related methods ineligible subject matter for patents—the Stop Tax Haven Abuse Act would make tax strategies ineligible for patents.

In July 2007, the House Judiciary Committee approved a patent reform bill (H.R. 1908) which included a provision that would make tax planning techniques unpatentable. The wording of the provision is more specific than the Stop Tax Haven Abuse Act. Rep. Boucher proposed the amendment, which provides that a patent may not be obtained for “a tax planning method”—a plan, strategy, technique, or scheme designed to reduce, minimize, or defer a taxpayer’s tax liability, or that, when implemented, has that effect. An unpatentable tax-planning method does not, however, include the use of tax preparation software or other tools used solely to perform or model mathematical calculations or prepare tax or information returns. The provision would cover tax planning with regard to any federal, state, county, city, municipality, or other governmental levy, assessment, or imposition (whether measured by income, value, or otherwise) from the enactment date. On September 7, 2007, H.R. 1908 was passed by the House. At the time of this writing, the Senate version of the bill, S. 1145, does not include this provision, and it has not been brought to a vote.

On the other hand, S.2639, introduced on November 15, 2007, will amend Title 35 to specifically state that “tax planning inventions are not patentable.” In this bill, the term “tax planning invention” is defined as “a plan, strategy, technique, scheme, process, or system that is designed to reduce, minimize, avoid, or defer, or has, when implemented, the effect of reducing, minimizing, avoiding, or deferring, a taxpayer’s tax liability or is designed to facilitate compliance with tax laws, but does not include tax preparation software and other tools or systems used solely to prepare tax or information returns.”

Proposed Solutions: Procedural

The ABA-IPL section proposed reforming the patenting process to increase patent quality and disclosure to the IRS. These reforms include publishing all patent applications (so others can dispute its claims to novelty and non-obviousness and the IRS can judge its validity), extending the time a patent claim can be disputed, and expanding USPTO review of prior art.

To give the IRS more data to evaluate the potential concerns of tax strategy patents, the ABA Section of Taxation has proposed requiring taxpayers to report their use of patented tax strategies and their use of tax advisors, including the name of the patentee, to the IRS. This would be done by expanding the existing disclosure requirements.

The IRS has instituted procedures to assist the USPTO in developing the resources to determine “prior art” in the area of tax strategies. According to former IRS Commissioner Everson, the IRS has formed a task force with members from both agencies and conducted a workshop designed to update the USPTO on the latest sources of information. To avoid sanctioning a particular tax strategy, however, the IRS is opposed to directly taking on responsibility for reviewing prior art from the USPTO. In response, the USPTO plans to hire more professionals with broad tax, finance, and business knowledge. The IRS has also asked tax professionals to supply the USPTO with useful information on business methods and tax strategies for consideration as prior art.

Complications for Reform

Determining the right policy for dealing with tax strategy patents is complicated by the conflicting goals of enforcing tax compliance and encouraging tax strategy innovation. The implementation of general tax policy, on one hand, requires that all taxpayers have equal access to tax reduction strategies. On the other hand, innovation requires that developers of knowledge be rewarded with the power to restrict access and collect licensing fees or damage awards.

Increasing tax strategy innovation is an exciting notion; however, having to pay a user fee for each use, complicating an already complex tax system, living with the possibility of infringement for simple compliance, having taxpayers unable to reduce their taxes because they are unable to pay fees, and having taxpayers subjected to increased IRS scrutiny for using it, represent a very high price for tax innovation.

Given the recent proliferation of bills that would eliminate or weaken the effects of tax strategy patents and a President who is sympathetic to a ban, it would appear likely that Congress will eventually eradicate tax strategy patents. Right up until that day occurs, however, the applications and patents will likely continue at increasing rates, further complicating the tax system and taxpayers’ ability to comply with both tax and patent laws.

The controversy over the patentability of tax strategies may be far from a resolution, and more dialogue from affected members of society is needed. Unless and until a change in the law eliminates the patentability of tax strategies or exculpates taxpayers and preparers from patent infringement, tax advisors should consider learning how to search for tax strategy applications and patents; rendering prior art for tax strategy applications; documenting and retaining evidence of their business practices and tax strategies; and retaining patent law attorneys when needed. Engaging in the debate by contacting government representatives is another way to get the profession’s concerns heard.

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