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During the past several years, patents have been issued for various tax-related strategies. Tax practitioners and the IRS have raised a number of policy issues in Congress with respect to such patents.

In response to concerns that tax strategy patents often involve the marketing of aggressive tax shelters or otherwise mislead taxpayers about expected results, the IRS recently issued proposed regulations that will add a new category of reportable transactions involving patented tax strategies or structures. In addition, on Sept. 7, the House of Representatives approved H.R. 1908, the Patent Reform Act of 2007, which would deem tax planning strategies to be unpatentable subject matter. This legislation is responsive to a request the American Institute of Certified Public Accountants submitted to Congress calling for the prohibition on the issuance of such patents.

Generally, inventors can obtain patents on processes, machines, manufacturers and compositions of matter that are useful, novel and non-obvious. The genesis of tax strategy patents can be traced to the 1998 decision in State Street Bank & Trust Co. v. Signature Financial Group Inc., in which the Federal Circuit held that methods of doing business could be patented. The State Street Bank case involved a data processing system for a partnership structure of mutual funds that had advantageous tax consequences. To date, the U.S. Patent and Trademark Office (USPTO) has issued numerous other tax-related patents that have encompassed a variety of strategies involving insurance products, financial instruments, executive compensation, like-kind exchanges and wealth transfer planning. There is much disagreement within the patent bar about whether patents should even be issued for business methods or strategies.

In addition to the concern raised by the IRS that patented tax strategies often involve aggressive tax planning schemes, other concerns about tax strategy patents include the question of whether exclusive proprietary rights can be granted at all for methods of compliance with the tax law and the fear that tax strategy patents might burden tax practitioners and taxpayers with trying to determine whether a given structure or strategy might infringe on an issued patent or pending patent application.

There is also a fear that by promoting a tax strategy as having been patented, there will be the misconception on the part of unsuspecting taxpayers that the government has approved the tax strategy. Finally, there is concern about the practical implications of enforcing tax strategy patents, such as trying to identify how and when the infringement is deemed to incur (e.g., When the transaction is structured, when the transaction is reported on a filed tax return.)

If the Patent Reform Act of 2007 is passed by the Senate in its current form and signed by the president, the issue of tax strategy patents should be conclusively resolved. Until such time, it appears that the most effective way of restricting the use of tax strategy patents is the one followed in the recently published proposed regulations by expanding the definition of a reportable transaction to include a “patented transaction.”

Under Internal Revenue Code Section 6011, taxpayers must disclose their participation in any “reportable transaction” by attaching an information statement to their income tax returns. Similarly, under Section 6111, material advisers must disclose reportable transactions in which they participate, and Section 6112 requires material advisers to prepare and maintain lists of participants in such reportable transactions. Significant penalties are imposed if a taxpayer or material adviser fails to comply with these disclosure and list-keeping requirements.

Under existing regulations, a reportable transaction includes a “listed transaction” (i.e., a transaction that has been specifically identified by the IRS as abusive) and five other categories of transactions, including “confidential transactions.” For this purpose, a “confidential transaction” is defined to include any transaction offered to a taxpayer under conditions of confidentiality.

Accordingly, under the existing regulations, a tax advisor who wishes to protect a “proprietary” tax strategy must enter into a confidentiality agreement with the taxpayer restricting disclosure of the strategy so that other taxpayers or advisers may not copy it. However, the consequence of obtaining such confidentiality is the requirement that the transaction be treated as a reportable transaction subject to the disclosure and list-keeping requirements of code sections 6011, 6111 and 6112. However, to the extent a patent, rather than a confidentiality agreement, protects the confidentiality of a tax strategy, the transaction would no longer constitute a confidential transaction and would not be treated as a reportable transaction.

To close this perceived loophole, the recently issued proposed regulations add a new category of reportable transaction known as a “patented transaction,” which is defined as a transaction for which a taxpayer pays a fee to a patent holder for the legal right to use a tax planning method that the taxpayer knows or has reason to know is the subject of a patent. A patented transaction would also include a transaction for which a patent holder has the right to payment for another person’s use of a tax planning method that is the subject of a patent. A tax planning method is defined as any plan, strategy, technique or structure designed to impact any federal income, gift, estate, employment or excise tax.

The proposed regulations exclude methods of mathematical calculations or mechanical aids for the preparation of tax returns from the patented transaction category of reportable transactions. Therefore, a patented transaction will not include tax return preparation software or programmed calculators.

Under the proposed regulations, a taxpayer would be considered to have participated in a patented transaction if his return reflects a tax benefit from the transaction (including a deduction for fees paid in any amount to the patent holder). A taxpayer also would be considered to have participated in a patented transaction if he is the patent holder and the taxpayer’s tax return reflects a tax benefit related to obtaining a patent for a tax planning method (including any deduction for amounts paid to the USPTO) or reflects payments received from another person for the use of the tax planning method that is the subject of the patent.

The proposed regulations also expand the scope of who will be considered a material advisor in a patented transaction. Generally, a material adviser is any person who provides material aid, assistance or advice with respect to organizing, promoting, selling, implementing or carrying out a reportable transaction and who derives gross income in excess of $250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to individuals) for such aid, assistance or advice. The proposed regulations reduce these thresholds from $250,000 to $500 and from $50,000 to $250.

Subject to the adoption of the proposed regulations as final regulations, the proposed regulations would apply to transactions entered into after Sept. 25.

Mark L. Silow is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.

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