The expression on most lawyers' faces when they first learn that tax strategies can be patented is predictable — a sort of bemused scowl. You can see the wheels turning: How can this be possible? Aren't all taxpayers created equal? Is it possible that an enterprising taxpayer (and his or her lawyer) could come up with an imaginative scheme for reducing taxes, only to be sued for patent infringement?
It's not only possible, it's happening right now. One U.S. government body — elected representatives in Congress — enacts laws that (either intentionally or through unanticipated "loopholes") grant taxpayers advantages and opportunities to minimize their taxes. Another U.S. government body — the Patent and Trademark Office — grants patents for tax strategies, giving "inventors" the ability to control (or even deny) the access of taxpayers to tax-saving methods.
As tax-strategy patents proliferate, taxpayers will face situations in which they cannot simply take advantage of the opportunities the tax laws provide. Instead, they will have to choose among these unappealing options:
foregoing the tax-saving opportunity altogether.
About tax-strategy patents
Tax-strategy patents (TSPs) are business method patents that cover tax strategies and techniques over a wide range of subjects, from simple tax return preparation software to complicated and potentially abusive tax shelters.
Right now, there are more than 50 issued patents for tax strategies and more than 80 published patent applications. Since patent applications are not published upon filing, it is not possible to estimate how many additional applications are in the pipeline.
TSPs have been granted for strategies involving charitable giving, like-kind exchanges, estate and gift taxes, deferred compensation and financial products.
Even lawyers who are not patent attorneys are aware of patent buzzwords like "novel" and "nonobvious." Patents shouldn't be granted on business methods that are obvious applications of known principles.
Unfortunately, that doesn't appear to be the case with TSPs. Just ask John W. Rowe, the chairman of Aetna, Inc., who was sued in 2006 for patent infringement in federal District Court in Connecticut. The TSP in question was granted for an estate-planning strategy that used nonqualified stock options to fund grantor-retained annuity trusts (GRATs).
For estate tax practitioners, there is nothing "novel" about funding a GRAT with a nonqualified stock option. Nonqualified stock options can be valued favorably for estate and gift tax purposes, and their use as a funding mechanism for GRATs is quite obvious.
Tax practitioners who were concerned about the impact and proliferation of TSPs watched the case (known as the SOGRAT case) carefully, hoping that the District Court would rule that tax strategies are unpatentable subject matter.
Unfortunately, the case settled in March on terms that are not satisfactory to practitioners. In a consent final judgment based on stipulations of the parties, the court declared that the SOGRAT patent was valid and enforceable, and that the parties had entered into a confidential patent license agreement.
As a result, the SOGRAT case has done nothing to allay the concerns of tax practitioners about a growing area of malpractice and patent infringement liability exposure.
Problems with TSPs
TSPs are problematic for several reasons, but the two obvious issues that directly affect taxpayers (and the practitioners who advise them) can be summarized as follows:
First, if the PTO issues a TSP, taxpayers will reasonably conclude that the patented strategy has been approved by the U.S. government. This is not the case.
The U.S. Treasury Department and the Internal Revenue Service have made it very clear that a TSP has no bearing on the legitimacy or effectiveness of a tax strategy.
This issue highlights a serious problem with TSPs. PTO examiners are usually engineers, and they do not have the expertise in U.S. tax law that is necessary to evaluate TSP applications against the complex and confusing mass of data that constitutes "prior art."
The SOGRAT patent is evidence that the PTO presently lacks the expertise to determine that a tax strategy is novel and nonobvious.
Interestingly, both the IRS and the Tax Section of the American Bar Association have arranged training sessions for PTO examiners in tax law and tax research. That's a start, but seasoned tax practitioners know that evaluating the utility and novelty of a tax strategy is a daunting task that is further complicated by the fact that much of the prior art can only be found in the files of tax practitioners that are unavailable to the public for a number of reasons, including client confidentiality.
Second, TSPs interfere with Congress' authority to use the tax system to manage revenues and shape economic policy. TSPs force taxpayers to choose between paying a royalty to the patent holder and paying higher taxes because the taxpayer can't take advantage of the strategy without being accused of patent infringement.
Holders of TSPs become gatekeepers who control the access of taxpayers to tax-saving opportunities that Congress intends to be available to all.
In spite of these issues, TSPs are proliferating and tax practitioners must take steps to minimize the malpractice and patent infringement exposure that TSPs present.
In testimony before a congressional subcommittee, Dennis Belcher, an officer of the American College of Trust and Estate Counsel, said that the vast majority of experienced estate planning lawyers who attended the college's conference, during which the SOGRAT patent was discussed, indicated that they would not recommend the use of a GRAT funded with nonqualified stock options to any client without disclosing the existence of the SOGRAT patent, and they would be reluctant to advise a client to use this strategy without the permission of the patent holder.
Professional organizations and Congress respond
The American Institute of Certified Public Accountants and the ABA have aggressively opposed the proliferation of TSPs. The ABA has recommended that a new category of "reportable transaction" be created for transactions that utilize TSPs. The certified public accountants' institute has recommended that either the PTO or the patent holder, or both, be required to notify the Internal Revenue Service when a TSP is issued.
The institute has also urged Congress to enact legislation that either bars TSPs or provides immunity from TSP infringement liability for taxpayers and practitioners.
The recommendations of the institute regarding legislation are being followed at this point. On Feb. 17, Sens. Carl Levin, Norman Coleman and Barak Obama introduced legislation (S. 681) that would prohibit the PTO from issuing TSPs.
On May 17, Reps. Rick Boucher, Steve Chabot and Bob Goodlatte introduced legislation (H.R. 2365) that would eliminate civil actions for infringement, injunctive relief, damages and attorneys' fees with respect to infringement of TSPs.
Furthermore, the Bureau of National Affairs has reported that, on July 18, the House Judiciary Committee approved an amendment to H.R. 1908, a patent reform bill. The amendment characterizes tax planning methods as "unpatentable subject matter" for which a patent may not be obtained.
BNA reports that the bill has significant support in the House and could see action before the August congressional recess.
Until some type of protective legislation is passed (or U.S. courts declare tax strategies to be unpatentable subject matter), tax practitioners must pay attention to the increasing risk of malpractice liability for themselves and patent infringement liability for themselves and their clients.
Malpractice liability can arise if a tax practitioner fails to detect a TSP that covers a strategy that is recommended to a client or fails to refer a client to a patent expert if advice is required on the impact of a TSP.
Patent infringement liability for a practitioner can arise if the practitioner induces or plays a key role in the infringement of a TSP by his or her client.
The due diligence issue is complicated by the fact that the patent law grants punitive damages for willful infringement. If a taxpayer is aware that a tax strategy is covered by a TSP and nevertheless proceeds to implement the strategy without a good-faith belief that the implementation is noninfringing, the taxpayer (and his or her lawyer) can be held liable for treble damages.
Of course, this added wrinkle should not deter tax practitioners from seeking assurance that a proposed course of action does not infringe a TSP.
In order to limit these exposures, practitioners may wish to implement some of the following due diligence procedures proposed by the American Institute of Certified Public Accountants:
August 6, 2007
