- Proposed IRS Rules Target Patented Tax Strategies
- December 3, 2007 | Authors: Joan M. Roll; Timothy J. Leska
- Law Firm: Pepper Hamilton LLP - Philadelphia Office
Under recently issued proposed regulations,1 taxpayers and their advisors would be required to disclose to the IRS their participation in transactions that use patented tax strategies.2 These regulations were prompted by IRS concerns that taxpayers may interpret a patent for a tax strategy as approval by the IRS and Treasury Department of the transaction, which might impede the government’s collection of information and negatively impact effective tax administration.3 Once finalized, the proposed regulations would be effective for transactions entered into on or after September 26, 2007.4
Transactions Required to be Disclosed
For a taxpayer to have a disclosure obligation under the proposed rules, there must be both a “patented transaction” and “participation” in a patented transaction.
Patented Transactions. The proposed regulations provide that a “patented transaction” can occur in one of two ways. First, a patented transaction occurs if the taxpayer pays, directly or indirectly, a fee 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.5 Second, a patented transaction occurs if the taxpayer is the patent holder6 or the patent holder’s agent7 and has the right to payment for another person’s use of a tax planning method that is the subject of the patent.8 Where amounts are paid in settlement of, or as the award of damages in, a suit for infringement of the tax patent, a patented transaction is considered to have occurred with respect to the recipient of the amounts, but not with respect to the payor.
A “tax planning method” is defined broadly to mean any plan, strategy, technique, or structure designed to affect federal tax. However, patents issued for 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 do not constitute tax planning methods.9 A tax planning method is considered the subject of a patent not only where a patent has been granted, but also where a patent has been applied for but not yet granted.10
Participation in a Patented Transaction. A taxpayer will be considered to have participated in a patented transaction if the taxpayer’s tax return reflects a tax benefit from the transaction, including a deduction for fees paid to the patent holder or its agent. A patent holder or its agent will be considered to have participated in a patented transaction if its return reflects a tax benefit in relation to obtaining a patent for a tax planning method (e.g. deductions for amounts paid to the Untied States Patent and Trademark Office or for 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.11 Material advisors who provide tax advice in connection with a patented transaction and who derive gross income in excess of a specified threshold amount also would be required to report the transactions and participants to the IRS and maintain certain lists of information relating to the transaction.12 Under the proposed regulations, the threshold fees for material advisors are very low,13 such that virtually any tax advisor14 will be subject to the disclosure rules.
Although a legislative prohibition on tax patents has been proposed,15 patents for tax strategies do exist under current law. Accordingly, taxpayers should be aware that engaging in a patented tax strategy will subject them to the disclosure requirements discussed herein if and when these regulations become final. This disclosure obligation can span several years. Failing to disclose can result in a $10,000 or $50,000 penalty, depending upon whether the taxpayer is a natural person, and also may subject taxpayers to higher accuracy related penalties. Finally, taxpayers who are patent holders or their agents also should recognize that they could be treated as material advisors, and therefore subject to disclosure and list maintenance obligations, that each carry penalties for noncompliance.
1 72 FR 54615, REG-129916-07 (September 26, 2007).
2 The participating taxpayer will disclose its participation using Form 8886, and the advisor to the taxpayer will make its disclosure using Form 8918. Treas. Reg. § 1.6011-4 and § 301.6111-3. Advisors also will have a list maintenance obligation under IRC § 6112.
3 Preamble to 72 FR 54615, REG-129916-07.
4 Prop. Treas. Reg. § 1.6011-4(h)(2); Prop. Treas. Reg. § 301.6111-3(i)(2).
5 Prop. Treas. Reg. § 1.6011-4(b)(7)(i).
6 See Prop. Treas. Reg. § 1.6011-4(b)(7)(ii)(C) (providing that a person is a patent holder if (1) the person is a holder as defined in Treas. Reg. § 1.1235-2(d) and (e), (2) the person would be a holder as defined in Treas. Reg. § 1.1235-2(d)(2) if the phrase S corporation or trust was substituted for the word partnership and the phrase shareholder or beneficiary was substituted for the words member and partner, (3) the person is an employer of a holder as defined in Treas. Reg. § 1.1235-2(d) and the holder transferred to the employer all substantial rights to the patent as defined in § 1.1235-2(b), or (4) the person receives all substantial rights to the patent as defined in Treas. Reg. § 1.1235-2(b) in exchange (directly or indirectly) for consideration in any form.
7 See Prop. Treas. Reg. § 1.6011-4(b)(7)(ii)(D) (providing that a patent holder’s agent is any person who has the permission of the patent holder to offer for sale or exchange, to sell or exchange, or to market a tax planning method that is the subject of the patent).
8 Prop. Treas. Reg. § 1.6011-4(b)(7)(i).
9 Prop. Treas. Reg. § 1.6011-4(b)(7)(ii)(F).
10 Prop. Treas. Reg. § 1.6011-4(b)(7)(ii)(B).
11 Prop. Treas. Reg. § 1.6011-4(c)(3)(i)(F).
12 IRC §§ 6111, 6112; Prop. Treas. Reg. § 301.6111-3.
13 Under Treas. Reg. § 301.611-3(b)(3)(i)(A), the threshold amount of gross income is generally $50,000 in cases where the tax benefits of the transaction are provided to natural persons, and is $250,000 for all other transactions. Under the proposed regulations, these amounts are reduced to $250 and $500 respectively.
14 Under the proposed regulations, the patent holder or the patent holder’s agent can be considered a material advisor with respect to the patented transaction. See Prop. Treas. Reg. § 301.6111-3(treating any statement made or provided by the patent holder or the patent holder’s agent that concerns the tax planning method that is the subject of the patent to be advice).
15 H.R. 1908.