Questioning the wisdom of patent protection for tax planning.

I. INTRODUCTION

The topic of federal patent protection for tax planning strategies has received considerable attention of late, (1) much of it from a tax bar whose overall incredulity concerning the patentability of tax advice has been transformed into anxiety and disgust by the prospect of infringement actions. (2) In their article Patents, Tax Shelters, and the Firm, (3) Dan Burk and Brett McDonnell approach the subject from a broader perspective by employing theory of the firm principles to evaluate the effects of stronger intellectual property protection in the tax planning arena. While conceding that the possible effects are complex and ambiguous, the authors predict that the introduction of business method patents in the tax planning industry will lead to enhanced mobility in the labor market for tax professionals, to an increase in the creation of tax planning strategies, and to a degree of disintegration within the tax planning community as firms become more specialized. (4)

For the most part, I am less sanguine about the dawn of patents in the tax planning arena. This commentary on Burk and McDonnell's article therefore is offered in the nature of a counterpoint. I begin by addressing an issue to which Burk and McDonnell do not devote a great deal of attention, as it is not central to their analysis: whether innovation in tax planning is socially desirable. (5) I draw on prior scholarship in the tax-shelter context to demonstrate that tax planning creates deadweight loss to society through distortions in taxpayer behavior and transaction costs that do not contribute to the public fisc. I then argue that such deadweight loss likely will be significantly increased if temporal monopolies on tax planning strategies are conferred through the patent system. Next, I offer competing speculation concerning the effects that patentability will have on innovation in tax planning, positing that the ability to patent a tax strategy will not lead to a marked increase in the quality of tax advice and may actually cause it to decline. In keeping with the theme of the symposium, I contend that the ability to patent a tax strategy would not have a meaningful impact on the market in abusive tax shelters, as the success of the shelter industry depends on completing as many transactions as possible before the shelter draws the attention of the Internal Revenue Service (Service). Purveyors of these transactions thus will avoid the public disclosure associated with patent protection, and the field of patented tax strategies likely will be relegated to more traditional, conservative planning. I close by highlighting the potential decrease in client mobility that will come at the expense of the increased mobility of tax advisors that Burk and McDonnell predict.

II. THE SOCIAL COSTS OF TAX PLANNING

With constitutional authorization "to promote the Progress of Science and the useful Arts," (6) Congress has turned to patent law as a means of encouraging innovation. A patent grants the holder the right to exclude others from making, using, or selling the patented item for a period of twenty years from the date the application was filed. (7) This temporal monopoly is designed to ensure that the inventor will receive a return on her investment in the patented technology by allowing the patent holder to sell the item at a price greater than the marginal cost of production otherwise dictated by a competitive market. Thus, Congress has responded to the potential to free ride on the inventor's technology by intentionally creating a market failure in the form of a temporal monopoly on the sale or use of the invention. In order to justify the resulting economic inefficiencies, one would expect the subsidized innovation to be socially beneficial. That is not the case, however, with respect to tax minimization strategies.

In his scholarship in the corporate tax shelter arena, David Weisbach has addressed the social utility of tax planning and has offered a dim assessment: "[T]ax planning, all tax planning, not just planning associated with traditional notions of shelters, produces nothing of value." (8) And that was the charitable part. Weisbach continued in his critique to state that tax planning "is almost positively bad for society--it is worse than worthless." (9) The principal justifications for this assessment are two-fold. First, tax planning produces deadweight loss to society in the form of transaction costs and altered taxpayer behavior that are not offset by additional government revenue. Weisbach illustrates this point by borrowing a lighthearted but effective example originally offered by Daniel Shaviro--the hypothetical back-flip shelter. (10) Suppose that every taxpayer who successfully performs a back-flip before an examining officer receives a 10% reduction on her tax bill. Individuals respond to the incentive by brushing up on their gymnastic skills so that they can perform the back-flip. While each individual may be pleased with the tax savings the shelter produces, society collectively should be disgusted. If all individuals responded to the shelter, the government would be forced to raise nominal tax rates to collect the same revenue. In the end, each individual would have to perform a back-flip for the privilege of paying the same effective tax rate before the shelter was introduced. The deadweight loss to society from tax planning can be found in the distortions in taxpayer behavior, the actual expenses incurred by the taxpayer to qualify for the shelter (e.g., attorney's fees, transaction costs), and the costs to the government of verifying and perhaps litigating the taxpayer's entitlement to the tax savings. (11)

The second reason tax planning is harmful to society is that it effectively imposes an externality on those who do not engage in such behavior. (12) Unlike the simple back-flip hypothetical above, tax planning strategies do not have universal participation. Thus, individuals who undertake the planning will receive a real benefit from the transaction equal to the excess of the tax savings over the expenses of the planning plus the disutility that results from executing the strategy. The welfare gain to the individual undertaking the planning is not matched at the societal level, however, as the burden of the tax saved by the planning is shifted to those who do not engage in the technique. (13) This unilateral redistribution of the tax burden (14) has significance beyond its distributive effects, as it can pose a threat to voluntary compliance with the tax system. Individuals who believe that only a select group possesses access to tax-minimization opportunities may be more inclined to exercise a degree of "self-help" through blatant noncompliance, selecting means of noncompliance that pose the least risk of detection (e.g., failure to report self-employment income). (15)

Given that tax planning generates deadweight loss to society while permitting planners to deflect a portion of their tax burden onto the dutiful portion of society that does not undertake in tax minimization efforts, one could rather easily conclude that tax-reducing strategies are not among the category of "things which are worth to the public the embarrassment of an exclusive patent." (16) Yet in making the case that innovation in tax-reducing strategies is not worthy of subsidization in informal conversations with colleagues, I have been asked some variation of the following: "What about good tax planning?" The concern about "good" tax planning ultimately relates to planning that produces a social benefit by mitigating the deadweight loss otherwise caused by the existing rules. (17) For example, assume that two corporations desire to merge in what would constitute an economically efficient transaction, but the shareholders of each will not approve the plan unless the transaction can be accomplished on a nonrecognition basis. Now suppose an attorney devises a novel application of the reorganization rules, blessed by the Service in a private letter ruling, which enables the transaction to proceed. In this case, the attorney's advice appears laudable, as it has avoided the distortion otherwise caused by the realization rule.