News Notes
AICPA Asks Court to Nullify Tax Patents • IRS Allows Penalty-Free Withdrawal of Stimulus Payments from IRAs • IRS Provides Guidance on Return Preparer Penalties • Taxpayer Must File Jointly to Qualify as Innocent Spouse • Government Loses Son of Boss Tax Shelter Case
Alistair M. Nevius, J.D.
AICPA Activities
AICPA Asks Court to Nullify Tax Patents
The AICPA has submitted an amicus brief in the patent case of In re Bilski, No. 2007-1130 (Fed. Cir., filed 2/15/08). The Federal Circuit heard oral arguments in the case on May 8, 2008.
The case involves the patentability of business processes, which have been eligible to receive patent protection ever since the Federal Circuit’s decision in State St. Bank & Trust Co. v. Signature Fin. Group, Inc., 149 F3d 1368 (Fed. Cir. 1998). Tax strategy patents are a subset of business process patents (see Ransome and Sherr, “Patenting Tax Ideas,” 38 The Tax Adviser (August 2007): 456).
Specifically, in Bilski the court is addressing the questions of what standard should govern in determining whether a process should be patentable under 35 USC Section 101; whether the claimed subject matter is not patent eligible because it constitutes an abstract idea or mental process; when a claim that contains both mental and physical steps constitutes patent-eligible subject matter; whether a method must result in a physical transformation of an article or be tied to a machine to be patent-eligible subject matter; and whether it is appropriate to reconsider State St. Bank &Trust and AT&T Corp. v. Excel Commc’ns, Inc., 172 F3d 1352 (Fed. Cir. 1999).
The AICPA’s brief urges the court to hold that tax strategies are not patentable. The AICPA made three main arguments: tax strategy patents (1) preempt the public’s use of provisions of the tax law; (2) do not meet the Supreme Court’s criteria for patentable processes; and (3) do not “promote the progress of useful arts.”
Just as laws of nature, physical phenomena, and abstract ideas are not patentable, the AICPA argued that tax laws are “part of the storehouse of knowledge” and that compliance with those laws must be “free to all men and reserved exclusively to none” (quoting Funk Bros. Seed Co. v. Kalo Inoculant Co., 333 US 127, 130 (1948)).
In Diamond v. Diehr, 450 US 175, 184 (1981), the Supreme Court stated that “transformation and reduction of an article to a different state or thing is a clue to the patentability of a process claim that does not include particular machines.” The AICPA argued that under this standard, tax strategies should not be patentable because they do not transform anything. The judges’ questions in the Bilski case’s oral arguments focused on the question of what a transformation is and how much transformation is needed for a process to move from the realm of abstract ideas to patent-eligible subject matter.
Finally, the Patent Clause of the U.S. Constitution (art. I, §8, cl. 8) directs Congress to provide patent protection to “promote the Progress of . . . useful Arts.” The Federal Circuit recently said that progress of useful arts means “the process today called technological innovation” (In re Comiskey, 499 F3d 1365, 1375 (Fed. Cir. 2007)). The AICPA argued in its brief that tax strategies are not technological or scientific innovations but are merely based on interpreting the tax law in a way to minimize taxpayers’ tax liability. Further, the AICPA argued, patent protection is not needed to encourage the creation of new tax strategies; taxpayers already have an economic incentive to minimize their tax liability.
From the IRS
IRS Allows Penalty-Free Withdrawal of Stimulus Payments from IRAs
The law of unintended consequences has ensnared some taxpayers who had their “economic stimulus” payments directly deposited into tax-favored retirement accounts, such as IRAs. Many taxpayers choose to have their refunds deposited directly into their bank accounts or into other accounts. What many taxpayers probably did not realize when they made that choice on their returns this year was that their advance refunds under the Economic Stimulus Act of 2008, P.L. 110-185, would also be directly deposited into the account they chose.
For ordinary bank accounts, this should normally present the taxpayer with no difficulty, but direct deposits into tax-favored accounts may cause a problem because such accounts usually have early withdrawal penalties attached to them. Taxpayers might want to spend their economic stimulus payment—that, after all, was the ostensible purpose of the payments in the first place—but will be faced with a penalty and taxes if they withdraw the money.
As a result, the IRS has announced that taxpayers who had their economic stimulus payments deposited directly into a tax-favored account can generally withdraw amounts up to the amount of that payment tax free and penalty free until the due date of their 2008 income tax return, including extensions (Announcement 2008-44).
Eligible accounts include traditional and Roth IRAs, health savings accounts, Archer medical savings accounts, Coverdell education savings accounts, and qualified tuition programs (529 plans).
Regular refunds deposited into such accounts are not eligible for this treatment. Taxpayers who elected to have their refunds directly deposited into more than one account will not be affected; they will receive their economic stimulus payment in the form of a paper check.
For a detailed discussion of the act, see Jones, “The Economic Stimulus Act of 2008,” p. 443.
IRS Provides Guidance on Return Preparer Penalties
The IRS has provided guidance (Notice 2008-46) on the implementation of the return preparer penalties under Sec. 6694, which were amended by the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA).
SBWOTA replaced the prior-law Sec. 6694 requirement—applicable to income tax return preparers who knew or reasonably should have known of an undisclosed return position—that there be a realistic possibility that the position will be sustained on its merits, with a requirement that there be a reasonable belief that the position’s tax treatment was more likely than not the proper treatment. SBWOTA also expanded the scope of the return preparer penalties to include preparers of estate and gift tax returns, employment and excise tax returns, and returns of exempt organizations.
Notice 2008-13, issued by the Service in December 2007, describes categories of returns and other documents to which Sec. 6694 could apply. The notice lists specific tax and information returns and other documents that the IRS considers to be within or specifically outside the scope of Sec. 6694.
Notice 2008-46 adds to the lists of returns in Notice 2008-13. Among the tax returns added to the list of returns subject to Sec. 6694 are Form 1040NR, U.S. Nonresident Alien Income Tax Return, and several returns in the Form 1120 series. Included in the list of information returns are Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 5471, Report by Shareholders of a Foreign Corporation.
The preparation of certain forms outside the scope of Sec. 6694(a) may subject a preparer to a Sec. 6694(b) willful or reckless conduct penalty if the forms are prepared willfully to understate a tax liability on a return or claim for refund or recklessly or with intentional disregard of rules or regulations. The only forms of this type that Notice 2008-46 adds to the list of documents are Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests, and Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests.
The notice is effective as of April 16, 2008.
In the Courts
Taxpayer Must File Jointly to Qualify as Innocent Spouse
The Ninth Circuit has held that to be eligible for innocent spouse relief under Sec. 6015, a taxpayer must have filed a joint return with his or her spouse and that Sec. 6015’s equitable relief provision also requires that a joint return had been filed (Christensen, No. 06-71881 (9th Cir. 4/22/08)).
The taxpayer in the case requested innocent spouse relief from tax liabilities assessed against him for the years 1989–1992. The deficiencies arose from improper income reporting by his wife’s check-cashing business, and the taxpayer argued that since he was not involved in the business, the deficiencies should not be attributed to him.
The Service denied the taxpayer’s request on the grounds that innocent spouse relief is available only to joint filers, and the taxpayer had filed separately from his wife during the years at issue. The Tax Court granted summary judgment for the IRS on the issue, and the taxpayer appealed to the Ninth Circuit.
In its own words, Sec. 6015 applies to “an individual who has made a joint return” and provides procedures for relief from “liability applicable to all joint filers.” The few prior cases have consistently held that a joint return is required (see Raymond, 119 TC 191 (2002); Alt, 101 FedAppx 34 (6th Cir. 2004)).
However, the taxpayer argued that equitable relief was available under Sec. 6015(f) for taxpayers who live in community property states and do not file jointly. He argued that if Sec. 6015(f) requires joint filing, then it is redundant with Sec. 6015(b), which sets forth the procedures for relief of liability applicable to joint filers. Courts should avoid interpreting statutes in ways that make statutory provisions redundant (Spencer Enters., Inc. 345 F3d 683 (9th Cir. 2003)).
While paragraph (f) does not specifically mention joint filers, the court looked to the language of Sec. 6015 as a whole, including its title, “Relief from joint and several liability on joint return,” and to congressional intent to conclude that Sec. 6015(f) applies only to joint filers. Sec. 6015 was enacted as part of the IRS Restructuring and Reform Act of 1998, P.L. 105-206, along with Sec. 66(c), which addresses treatment of community income. Taken together, the court said, it was clear that Congress intended for Sec. 6015 to apply in cases of joint returns and for Sec. 66 to apply in cases in which spouses face joint liability under community property laws.
Furthermore, the court distinguished Sec. 6015(f) from Sec. 6015(b) to hold that they are not redundant, despite both requiring a joint return. Sec. 6015(b) provides relief where the spouse shows a lack of knowledge about the understatement; Sec. 6015(f) requires no showing of lack of knowledge.
In a rare tax shelter loss for the IRS, a federal district court has allowed a taxpayer to offset income with losses from a “son of boss” transaction (Sala, No. 05-cv-00636-LTB (D.C. Colo. 4/22/08)).
The taxpayer in the case had over $60 million in income in 2000 but claimed losses on various long and short options on foreign currencies that virtually eliminated his tax liability. The Service sought to characterize these transactions as fraudulent but lost on that issue in an earlier round of litigation (Sala, No. 05-cv-00636-LTB-PAC (D.C. Colo. 5/1/07)). The IRS then sought to use the Sec. 752 regulations to portray the transactions as lacking in business purpose and having no profit potential.
The Service focused on one portion of the investments in one year (2000) to argue that the taxpayer entered into the transactions purely as a tax dodge. However, the court disagreed. The court looked at all the taxpayer’s transactions over a five-year period—including transactions that had no tax benefit—and held that the taxpayer had a “reasonable possibility of profits beyond the tax benefits” and had a “business purpose other than tax avoidance.”
Furthermore, the court held that the government could not retroactively apply the Sec. 752 regulations to the taxpayer’s case (the regulations were finalized in 2003). Under Sec. 7805, regulations may be applied retroactively only in very specific situations. Instead, the court found the Sec. 752 regulations to be “overly broad” and not to be legislative regulations requiring deference under Chevron U.S.A., Inc. v. Natural Resource Defense Council, Inc., 467 US 837 (1984). The court characterized the Sec. 752 regulations as “Treasury’s attempt to legislate” and “an attempt to bootstrap the government’s litigating position with respect to ‘Son of Boss’ cases.” The court therefore held Regs. Sec. 1.752-6 to be unlawful and set it aside. (However, the regulations had earlier been upheld by the Seventh Circuit in Cemco Investors LLC, No. 07-2220 (7th Cir. 2/7/08).)
Not surprisingly, IRS Chief Counsel Donald Korb has announced that the Sala case will not affect the Service’s (generally successful) litigation strategy in tax shelter cases (2008 TNT 80-1, Doc. 2008-9063).
