Noose Tightened Further on Patented Tax Strategies

The Treasury this week issued proposed regulations that would add patented transactions to the list of reportable transactions. As noted in our July 20, 2007 post, Congress is moving towards making tax planning techniques unpatentable. While classifying a transaction as a reportable transaction does not make it incorrect or illegal, the fact that a taxpayer must report a transaction has a chilling effect on taxpayers entering into such transactions. After all, who wants to face the resources of the government to prove they have properly reported a transaction, no mater how defensible their reporting might be?

Under Code Sec. 6011 and its regulations, taxpayers must disclose their participation in reportable, tax-shelter-type transactions by attaching an information statement to their income tax returns. And, just in case the taxpayer fails to report the transaction, Code Sec. 6111 requires material advisors who are involved to disclose reportable transactions to the IRS.

The government explains its adding of patented transactions to those that must be disclosed by claiming concern for taxpayers who might interpret a patent for tax advice or a tax strategy as IRS approval for the transaction. That, in turn, could somehow impede the IRS’ efforts to obtain information on tax avoidance transactions and impact the IRS’ effective tax administration. Thus, it has proposed adding patented transactions as a new category of reportable transactions.

As proposed, a “patented transaction” would be a transaction for which a taxpayer pays (directly or indirectly) a fee in any amount to a patent holder or the patent holder's agent for the legal right to use a tax planning method that the taxpayer knows or has reason to know is the subject of the patent. A patented transaction also would include a transaction for which a taxpayer (the patent holder or the patent holder's agent) has the right to payment for another person's use of a tax planning method that is the subject of the patent. [Excluded from the definition are patents for mathematical calculations or mechanical assistance in the preparation of tax returns, which would exclude patent-protected tax preparation software or other tools used to perform or model mathematical calculations or to provide mechanical assistance in the preparation of tax or information returns.] For this purpose, a patent includes not only a patent that has been issued, but also pending patents.

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 or patent holder's agent). A taxpayer also would be considered to have participated in a patented transaction if he is the patent holder or the patent holder's agent and the taxpayer's tax return reflects a tax benefit in relation to obtaining a patent for a tax planning method (including any deduction for amounts paid to the United States Patent and Trademark Office as required by title 35 of the United States Code and attorney's fees) or reflects income from a payment received from another person for the use of the tax planning method that is the subject of the patent.

The proposed regulations also describe when a person is a material advisor regarding a patented transaction under Code Sec. 6111. Because of the nature of patented transactions and how they are marketed, the threshold amount as described in Code Sec. 6111(b) would be reduced from $50,000 to $250 and from $250,000 to $500.

Once the proposed regulations become final, they would apply transactions entered into after Sept. 25, 2007. The material advisor reporting requirements would apply to transactions for which a material advisor makes a tax statement after that same date.

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