WHEN AGENCIES COLLIDE - THE IRS TESTIFIES TO CONGRESS IN OPPOSITION TO TAX STRATEGY PATENTS: A few weeks ago, the Select Revenue Measures Subcommittee of the House Ways & Means Committee held a hearing on "tax strategy patents." The problem? Patents on tax planning were creating a Hobson's choice for tax professionals: use one method for sheltering taxable income, and you run the risk of breaking the law; use another method, and you could be held liable for patent infringement.

BusinessWeek ran an interesting article about John Rowe, who's the executive chairman of health insurer Aetna. Rowe set up two trusts and funded them with nonqualified stock options per the suggestion of his advisers. The so-called "Grantor Retained Annuity Trust" (GRATs) would pay Rowe an annual income for a specific time and reserve whatever is left for family members to avoid a significant amount of gift taxes. One estimate valued Rowe's funds at $28.5 million.

Earlier this year, a company called Wealth Transfer Group sued Rowe in U.S. District Court in New Haven CT, claiming that he infringed US Patent 6,567,790, titled "Establishing and managing grantor retained annuity trusts funded by nonqualified stock options." The patent was filed in December 1, 1999 and was granted May 20, 2003. Claim 1 of the '790 patent reads as follows:

1. A method for minimizing transfer tax liability of a grantor for the transfer of the value of nonqualified stock options to a family member grantee, the stock options having a stated exercise price and a stated period of exercise, the method performed at least in part within a signal processing device and comprising:

establishing a Grantor Retained Annuity Trust (GRAT);

funding said GRAT with assets comprising stock options, the stock options having a determined value at the time the transfer is made;

setting a term for said GRAT and a schedule and amount of annuity payments
to be made from said GRAT; and

performing a valuation of the stock options as each annuity payment is made
and determining the number of stock options to include in the annuity
payment.

While Rowe admitted that a law firm and a financial planner were involved in the creation of the accused GRAT, neither was named in the suit.

So far, the PTO lists 43 issued patents, and 62 patent applications related to tax planning. As of mid-year, fiscal year 2006, the allowance rate for business method applications (which include tx planning) was approximately 20%, which is lower than the overall USPTO patent allowance rate of approximately 54% at mid-year. In fiscal year 2005, the USPTO hired 36 patent examiners in the business method area for a total of 132 examiners. The goal for fiscal year 2006 is to have a total of 160 examiners in this area by the end of the year.

The IRS claims to have reviewed many of the tax patents and applications and concluded that they were not "abusive" tax strategies that would invite further IRS scrutiny (and potentially invalidate the patent under the rarely-used "illegal" or "immoral" utility requirement). However, the IRS was very explicit in pointing out that a US patent on tax strategy does not carry with it an IRS "seal of approval."

Needless to say, The IRS has many concerns for such patents, noting that patent protection on tax strategies will limit the use of approaches used by taxpayers that are simply trying to comply with the law. Put simply, the IRS believes that taxpayers and their advisors should not have to perform due diligence to determine how they can legally file a tax return.

It is doubtful that the IRS's testimony will sway Congress to act in any meaningful way on tax-strategy patents. As this article points out, the IP landscape is rife with patents that deal directly with methods and products that are regulated by safety/emissions, FCC, and FDA laws. Many different types of patentable inventions involve a manner of complying with the law, but they are not prohibited from being patented for that reason.

See Bloomberg Wealth Manager article from May 2005 on tax planning patents here.

Testimony on the Wealth Transfer Group patent here.

Patent Prospector blog take on IRS testimony here.