INTELLECTUAL PROPERTY LAW & PLANNING STRATEGIES
TRADE SECRETS

Protecting Information

Proprietary information can be more valuable to a business enterprise than physical assets.

Sometimes, the value of information depends on its being known only to its developer. If the information constitutes a trade secret, it may be protected by law. This presents the basics of California trade secret law—

  • what a trade secret is; and
  • what constitutes misappropriation of a trade secret

WHAT IS A TRADE SECRET?

Trade secrets are a form of intellectual property. According to the law of most U.S. states, a trade secret may consist of any formula, pattern, physical device, idea, process or compilation of information that both:

  1. provides the owner of the information with a competitive advantage in the marketplace, and
  2. is treated in a way that can reasonably be expected to prevent the public or competitors from learning about it, absent improper acquisition or theft.

Some examples of potential trade secrets include:

  • the formula for coca cola
  • survey methods used by professional political pollsters
  • cake recipes
  • a new invention for which a patent application has not yet been filed
  • marketing strategies
  • wine ingredients and blending varieties percentages
  • manufacturing techniques, and
  • computer programs.

Unlike other forms of intellectual property, such as patents, copyrights, and trademarks, which generally require registration in order to be fully effective, trade secrets are essentially a “do-it-yourself” form of protection.

You do not register with the government to secure your trade secret; you most simply keep the information confidential and hidden away from third persons outside the company but for advisors. Trade secret protection lasts for as long as the secret is kept confidential without any statutory limitations period. However, once a trade secret is made available to the public, trade secret protection ends.

UTSA Definition

Under CC §3426.1(d), a trade secret is information that

Is not generally known in the industry, to the public, or to others who can realize economic value from its disclosure or use;
Has independent economic value, whether actual or potential, that derives from its secrecy (see §1.6); and
Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy (see §1.9).

See DVD Copy Control Ass’n v Bunner (2003) 31 C4th 864, 874. “Information” includes, among other things, formulas, patterns, compilations, programs, devices, methods, techniques, and processes. CC §3426.1(d); American Paper & Packaging Prods., Inc. v Kirgan (1986) 183 CA3d 1318, 1322. See §§1.3–1.5.

NOTE: The UTSA breaks the definition into two categories, with the first and second above combined, but the three elements are better understood if analyzed separately.

Tax Law and Trade Secrets

Do “trade secrets” or “know-how” constitute “property” under the tax laws? Why does it matter?

It matters because property is treated differently for tax purposes than non property.

One of the more challenging aspects of trade secret taxation is the threshold issue of defining “trade secrets” or “know-how” for tax purposes. Neither term is defined in either the Internal Revenue Code (Title 26, USC) or the Treasury Regulations (Title 26, CFR). In general, favorable tax treatment depends on a determination that the particular “trade secret” or “know-how” constitutes “property” within the meaning of various tax provisions, including, e.g., the provisions that provide nonrecognition treatment on the transfer of “property” to a corporation or partnership in exchange for stock or an interest in the partnership under certain conditions (see IRC §§351, 721).

If not “property,” then “services.” Because a taxpayer’s services are often instrumental in creating a particular process, invention, technique, or trade secret, a determination that the item in question does not rise to the level of “property” for tax purposes will often mean that any consideration received by a taxpayer with respect to that item will be characterized as payments for services.

IRS definitions of “trade secrets” and “know-how.” In a series of pronouncements, the IRS has enunciated a position with respect to the definitions of “trade secrets” and “know-how” for tax purposes. First, the terms “trade secrets” and “know-how” are essentially identical for tax purposes. Second, to be considered a trade secret or know-how for tax purposes, the information in question must be secret and must be afforded substantial legal protection against unauthorized disclosure and use under applicable state or federal law. See Rev Rul 55–17, 1955–1 Cum Bull 388; Rev Rul 64–56, 1964–1 Cum Bull 133; Rev Proc 69–19, 1969–2 Cum Bull 301; Rev Rul 71–564, 1971–2 Cum Bull 179.

Case law consistent with IRS. Case law is generally consistent with the IRS definitions. The Court of Claims established the following definition in E.I. Du Pont de Nemours & Co. v U.S. (Ct Cl 1961) 288 F2d 904, 911:

A trade secret is any information not generally known in a trade. It may be an unpatented invention, a formula, pattern, machine, process, customer list, customer credit list, or even news.… It is truly valuable only so long as it is a secret, for only so long does it provide an advantage over competitors. It follows that the essential element of a trade secret which permits ownership and which distinguishes it from other forms of ideas is the right in the discoverer to prevent unauthorized disclosure of the secret.

Trade secrets under California law should qualify as “property.” In general, it would appear that any information that qualifies as a trade secret under the California Uniform Trade Secrets Act (UTSA) (CC §§3426–3426.11) should satisfy the foregoing requirements of the IRS and case law and will therefore be considered “property” for income tax purposes.

TIP: Although the law appears to be largely settled with regard to the nature of trade secrets as “property” for income tax purposes, there is a dearth of case law and agency rulings that deal specifically with the tax treatment of trade secrets beyond this threshold determination. Accordingly, the tax practitioner must often apply other law developed for similar types of property, such as patents, or law applicable to categories of property that may include trade secrets. See, e.g., Pickren v U.S. (5th Cir 1967) 378 F2d 595 (trade secrets sufficiently similar to patents to apply decisions on patents in cases involving trade secret transfers). In advising a client who uses or owns trade secrets, the practitioner must have a general understanding of the framework of tax law relevant to a particular situation and evaluate the various possible sources of law that may apply. Many laws that apply to classes of property not defined as “trade