117 T.C. No. 4
UNITED STATES TAX COURT
ILLINOIS TOOL WORKS, INC. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16022-99. Filed July 31, 2001.
P acquired the assets of D and assumed certain liabilities, including the contingent liability for a patent infringement claim. P was subsequently held liable for damages, interest, and court costs.
Held: P’s payment in satisfaction of the patent infringement liability is a cost of acquiring the assets of D and must be capitalized in the year incurred.
James P. Fuller, Jennifer L. Fuller, Laura K. Zeigler,
William F. Colgin, Jr., and Kenneth B. Clark, for petitioner.
Rogelio A. Villageliu, for respondent. - 2 -
COHEN, Judge: Respondent determined deficiencies of
$2,370,750 and $818,812, respectively, in petitioner’s
consolidated Federal income tax for 1992 and 1993.
After concessions, the issue for decision is whether
$6,956,590 of a payment made by petitioner in satisfaction of a
court judgment, based on a patent infringement claim that was
brought against the acquired corporation and assumed as a
contingent liability by petitioner, should be capitalized as a
cost of acquisition or deducted as a business expense. Unless
otherwise indicated, all section references are to the Internal
Revenue Code in effect for the years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference.
Illinois Tool Works, Inc. (petitioner) is a corporation organized
and existing under the laws of the State of Delaware. At the
time of the filing of the petition, petitioner’s principal place
of business was located in Glenview, Illinois. During 1992,
petitioner and its subsidiaries filed a consolidated Federal
income tax return, reported income on a calendar year basis, and
used the accrual method of accounting.
In 1975, the DeVilbiss Co. (DeVilbiss) was a division of
Champion Spark Plug Co. (Champion). On October 9, 1975, - 3 -
Jerome H. Lemelson (Lemelson), an inventor and engineer, sent a
letter to DeVilbiss offering to license certain patents,
including a patent called the “‘431 patent”. In 1978, DeVilbiss
secured a license, from the Trallfa Co. of Norway (Trallfa), to
sell Trallfa robots in North America. Trallfa robots are
computer-controlled hydraulically actuated paint spray devices
that are designed to mimic human arm and wrist motions during
painting operations. On September 17, 1979, attorneys for
Lemelson sent a letter to DeVilbiss asserting that DeVilbiss was
producing certain products in the industrial robot and
manipulator field that might be infringing certain Lemelson
patents including the ‘431 patent. On behalf of DeVilbiss, the
director of robotic operations at DeVilbiss wrote a reply letter
to Lemelson’s attorneys that denied any infringement. On May 23,
1980, DeVilbiss and Trallfa entered into a new license agreement
that gave DeVilbiss the right to manufacture, as well as to sell,
Trallfa robots.
In 1981, Lemelson filed a lawsuit against the United States
of America in the U.S. Court of Claims (Court of Claims lawsuit)
alleging patent infringement for the Federal Government’s
purchase and use of certain robots including the Trallfa robot.
Champion, as owner of DeVilbiss, entered the case as a third-
party defendant. During one court session, the presiding judge
stated that, after reviewing the merits, he did not believe that - 4 -
Lemelson was likely to succeed on his patent infringement claim.
The parties to the Court of Claims lawsuit ultimately reached a
settlement that required the Federal Government to pay $5,000 to
Lemelson. The Federal Government sought indemnification from
Champion.
On May 13, 1985, Lemelson filed a separate lawsuit against
Champion directly, as owner of DeVilbiss, in the U.S. District
Court for the District of Delaware (the Lemelson lawsuit). In
his petition, Lemelson alleged that the manufacture and sale of
the Trallfa robot infringed several of his patents, including the
‘431 patent. The Lemelson lawsuit sought damages for Trallfa
robots that were sold prior to 1986. On August 16, 1989,
Lemelson made an offer to settle the lawsuit for $500,000, which
DeVilbiss rejected.
DeVilbiss retained Mark Curran Schaffer (Schaffer), an
intellectual property attorney, to represent DeVilbiss in the
Lemelson lawsuit. Schaffer reviewed the patents, studied the
patent file histories, performed prior art searches, and compared
Lemelson’s patents with the Trallfa robot. Schaffer concluded
that Lemelson’s patents were not infringed by the Trallfa robot
and that it was unlikely that Lemelson would succeed in proving
infringement. Schaffer communicated his opinion to
representatives of DeVilbiss. - 5 -
Larry Becker (Becker), division counsel and secretary of
DeVilbiss at the time that the Lemelson lawsuit was filed, also
reviewed the Lemelson lawsuit. Although Becker believed that the
Lemelson lawsuit was not worth anything, he and his staff
determined that the range of exposure would be between $25,000
and $500,000.
Prior to 1990, Eagle Industries, Inc. (Eagle), a company
unrelated to petitioner, purchased DeVilbiss from Champion and
subsequently incorporated DeVilbiss under the laws of the State
of Delaware as a wholly owned subsidiary of Eagle. In 1990,
petitioner entered into a purchase agreement to acquire certain
assets relating to the industrial and commercial business
operations of DeVilbiss. Petitioner agreed to pay $126.5 million
for the assets and an additional $12.5 million for a covenant not
to compete. The purchase agreement specified that, at closing,
the buyer assumed certain liabilities of the seller and, in part,
states:
At the Closing, Buyer shall assume:
(a) the Liabilities associated with the Companies whose Stock is being purchased hereunder;
(b) the Liabilities to the extent of the amounts actually reserved for or that are specifically noted on the February 2, 1990 Balance Sheet and the supporting documentation thereto * * *
(c) those Liabilities to the extent specifically provided for in this Agreement or to the extent - 6 -
disclosed on the Schedules or Exhibits to this Agreement;
Closing was to occur after petitioner completed a due
diligence review and other specified events. The purchase
agreement disclosed that DeVilbiss had created a $400,000 reserve
for pending patent liability claims and legal fees expected to be
incurred in litigating the Lemelson lawsuit. After the price was
set for the acquisition and during the due diligence period,
DeVilbiss made disclosure to petitioner of pending lawsuits,
including the Lemelson lawsuit. DeVilbiss provided to petitioner
a schedule containing the following entry:
CDCA STATE DATE CLAIM AMT Lemelson, Jerome v. Champion DE 06/19/85 Open
ACTION Patent infringement claim - Robot Apparatus COMMENTS Latest settlement demand is $500,000. Further discovery and trial pending.
During the due diligence period, Becker expressed his opinion to
representatives of petitioner that he did not believe that the
Lemelson lawsuit was worth anything. Although Champion remained
the named defendant in the Lemelson lawsuit, petitioner became
the party in interest after petitioner acquired the assets of
DeVilbiss.
During the due diligence period, representatives of
petitioner, including Gary F. Anton (Anton), petitioner’s
director of audits; Thomas Buckman (Buckman), petitioner’s vice
president of patents and technology; and John Patrick O’Brien - 7 -
(O’Brien), petitioner’s group technology counsel, also studied
the patents and formed the conclusion that the Lemelson lawsuit
would most likely result in no liability exposure. Anton was the
lead on-site due diligence person for petitioner’s acquisition of
the DeVilbiss assets, and Buckman and O’Brien were attorneys and
members of the patent bar. The representatives of petitioner
estimated that legal fees of approximately $400,000 would be
incurred to defend the lawsuit. The “worst case scenario” that
was contemplated by petitioner’s representatives was that
petitioner could incur a liability of between $1 million and
$3 million. However, they concluded that the likelihood of this
exposure was somewhere between zero and 5 percent. They believed
that there was a 98- to 99-percent chance that petitioner would
prevail in the patent infringement claim.
The reserve for the Lemelson lawsuit, in the course of the
acquisition, was eventually set at $350,000. At the conclusion
of the due diligence review, the purchase price of the DeVilbiss
assets was adjusted from $126.5 million to $125.5 million.
Petitioner and DeVilbiss considered the pending Lemelson lawsuit,
but the lawsuit liability did not affect the adjustment in the
purchase price. The acquisition closed on April 24, 1990.
After the acquisition, petitioner assumed the defense of the
Lemelson lawsuit in the District Court in 1991. On January 17,
1991, the jury returned a verdict against Champion (and, thus, - 8 -
against petitioner as the party in interest), finding that
Champion had willfully infringed the ‘431 patent that was owned
by Lemelson. The jury awarded damages of $4,647,905 for patent
infringement and $6,295,167 for prejudgment interest. The
District Court doubled the $4,647,905 damage award for patent
infringement due to the jury’s finding of willful infringement.
The finding of willfulness was based in part on the failure of
Champion (and on the failure of petitioner as the party in
interest) to secure an authoritative opinion on whether the
Trallfa robot violated the ‘431 patent until 2 months before
trial.
Petitioner appealed the judgment of the District Court to
the U.S. Court of Appeals for the Federal Circuit. On July 13,
1992, the Court of Appeals affirmed without published opinion the
decision of the District Court, Lemelson v. Champion Spark Plug
Co., 975 F.2d 869 (Fed. Cir. 1992). In 1992, after all appeals
were exhausted, petitioner paid the judgment, including
accumulated interest, of $17,067,339. The $17,067,339 judgment
included the damages and prejudgment interest totaling
$15,590,977 that were awarded by the District Court, postjudgment
interest of $1,470,389.92, and court costs of $5,971.74. - 9 -
OPINION
The portion of the $17,067,339 court judgment that is in
issue is $6,956,590 because: (1) Petitioner capitalized
$1 million in its tax return, (2) respondent conceded an
allowance of $2,154,160 for postacquisition interest expense, and
(3) respondent conceded a reduction of $6,956,589 for the
disposal of acquisition assets. We must decide whether the
$6,956,590 in dispute should be capitalized as a cost of
acquisition or deducted as a business expense.
Section 162(a) provides a deduction for a taxpayer when an
expenditure is: (1) An expense, (2) an ordinary expense, (3) a
necessary expense, (4) incurred during the taxable year, and
(5) made to carry on a trade or business. Commissioner v.
Lincoln Sav. & Loan Association, 403 U.S. 345, 352-353 (1971).
An expenditure is a “necessary expense” when it is appropriate or
helpful to the development of a taxpayer’s business.
Commissioner v. Tellier, 383 U.S. 687, 689 (1966). An
expenditure is an “ordinary expense” when it is “normal, usual,
or customary” in the type of business involved. Deputy v.
Du Pont, 308 U.S. 488, 495-496 (1940). Petitioner bears the
burden of proving entitlement to the claimed deduction. Rule
142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
No current deduction is allowed for a capital expenditure.
See sec. 263(a)(1). Section 1.263(a)-2(a), Income Tax Regs., - 10 -
includes as examples of capital expenditures “The cost of
acquisition * * * of buildings, machinery and equipment,
furniture and fixtures, and similar property having a useful life
substantially beyond the taxable year.” (Emphasis added.)
Generally, the payment of a liability of a preceding owner of
property by the person acquiring such property, whether or not
such liability was fixed or contingent at the time such property
was acquired, is not an ordinary and necessary business expense.
David R. Webb Co. v. Commissioner, 708 F.2d 1254, 1257 (7th Cir.
1983), affg. 77 T.C. 1134 (1981); Pac. Transp. Co. v.
Commissioner, 483 F.2d 209 (9th Cir. 1973), vacating and
remanding T.C. Memo. 1970-41; United States v. Smith, 418 F.2d
589, 596 (5th Cir. 1969); M. Buten & Sons, Inc. v. Commissioner,
T.C. Memo. 1972-44. Instead, payment of such a liability is
capitalized and added to the basis of the acquired property.
Petitioner contends that the amount of the payment that was
made in satisfaction of the Lemelson lawsuit should not be added
to the cost basis of the property that was acquired in the asset
acquisition from DeVilbiss because the payment was highly
speculative and unexpected at the time of purchase. Petitioner
relies on the Tax Court’s decision in Pac. Transp. Co. v.
Commissioner, T.C. Memo. 1970-41, vacated and remanded 483 F.2d
209 (9th Cir. 1973). Petitioner’s alternative arguments are:
(1) A payment in satisfaction of an assumed liability, which - 11 -
would have been a deductible expense if it had been paid by
DeVilbiss, the acquired corporation, retains its deductible
character when petitioner, the acquiring corporation, becomes the
party in interest and (2) as a result of petitioner’s efforts in
defending the Lemelson lawsuit, the final judgment amount that
petitioner paid was an ordinary and necessary business expense
that was directly connected to the business operations. In
support of these alternative arguments, petitioner relies on
Nahey v. Commissioner, 196 F.3d 866 (7th Cir. 1999), affg. 111
T.C. 256 (1998).
Respondent maintains that the assets that petitioner
received in exchange for the sales price, which included the
assumed liabilities, produced a substantial benefit to petitioner
in future years as the assets were used in petitioner’s business.
Respondent maintains that the Lemelson lawsuit was a contingent
liability of DeVilbiss that was assumed, in full, by petitioner
as consideration for the acquired assets of DeVilbiss.
Therefore, respondent contends, regardless of whether the final
amount of the liability was unexpected or remote at the time of
acquisition, the total sum of the payment for the assumed
contingent liability must be added to the cost basis of the
property that was acquired in the asset acquisition. Respondent
relies on the Court of Appeals for the Ninth Circuit’s decision - 12 -
in Pac. Transp. Co. v. Commissioner, 483 F.2d 209 (9th Cir.
1973), vacating and remanding T.C. Memo. 1970-41.
Respondent also relies on David R. Webb Co. v. Commissioner,
77 T.C. 1134 (1981), affd. 708 F.2d 1254 (7th Cir. 1983), in
which a taxpayer expressly assumed the obligation to make pension
payments to the widow of a corporate officer for her life as part
of the purchase of the assets and liabilities of a corporation.
Prior to the acquisition of the corporation by the taxpayer, the
corporation made the pension payments and deducted the payments
as ordinary and necessary business expenses. Upon acquisition,
the taxpayer continued to make the pension payments to the widow
and claimed a deduction for the amount of the pension payments.
This Court stated:
It is well settled that the payment of an obligation of a preceding owner of property by the person acquiring such property, whether or not such obligation was fixed, contingent, or even known at the time such property was acquired, is not an ordinary and necessary business expense. Rather, when paid, such payment is a capital expenditure which becomes part of the cost basis of the acquired property. Such is the result irrespective of what would have been the tax character of the payment to the prior owner. United States v. Smith, 418 F.2d 589, 596 (5th Cir. 1969); Portland Gasoline Co. v. Commissioner, 181 F.2d 538, 541 (5th Cir. 1950), affg. on this issue a Memorandum Opinion of this Court; W.D. Haden Co. v. Commissioner, 165 F.2d 588, 591 (5th Cir. 1948). affg. on this issue a Memorandum Opinion of this Court; Holdcroft Transportation Co. v. Commissioner, 153 F.2d 323 (8th Cir. 1946), affg. a Memorandum Opinion of this Court; * * * [Id. at 1137-1138.] - 13 -
On appeal, the Court of Appeals for the Seventh Circuit
dismissed the taxpayer’s argument that a contingent liability
that was insusceptible of present valuation at the time of the
acquisition could not be capitalized as a cost of acquisition.
The Court of Appeals held that, when the actual amount of the
contingent liability is known, the amount can be added to the
cost basis of the purchased property. David R. Webb Co. v.
Commissioner, 708 F.2d 1254, 1258 (7th Cir. 1983), affg. 77 T.C.
1134 (1981).
We conclude that David R. Webb Co., not Nahey v.
Commissioner, supra, is applicable to the facts in this case. In
Nahey, the issue was whether proceeds of litigation prosecuted to
judgment were taxed as capital gains or ordinary income. The
Court of Appeals held that the proceeds were ordinary income to
the buyer of the corporation that had initially held the legal
claim for lost corporate income. In that context, the Court
noted that the character of income did not change as a result of
the acquisition, stating that "what was transferred as part of a
corporate acquisition was an asset that yields ordinary income".
Nahey v. Commissioner, supra at 869. We are not persuaded by
petitioner's attempt to extend this rationale to the present case
in contravention of the consistently applied rule that payment of
liabilities assumed as part of an acquisition must be
capitalized. - 14 -
Because we believe that David R. Webb Co. is the controlling
authority in this case, we need not decide the dispute between
the parties over the status of Pac. Transp. Co. v. Commissioner,
supra. We note, however, that the Court of Appeals, in reversing
our decision, relied on two Supreme Court cases, Woodward v.
Commissioner, 397 U.S. 572 (1970), and United States v. Hilton
Hotels, 397 U.S. 580 (1970), decided after our Memorandum Opinion
was released.
In settling on a final price for the DeVilbiss industrial
and commercial assets, the possibility of incurring a liability
on the patent infringement claim in the Lemelson lawsuit was
considered by both petitioner and DeVilbiss. DeVilbiss, as
seller, disclosed the patent infringement claim that arose from
its activities to petitioner during the due diligence period.
Petitioner, as buyer, was aware of the Lemelson lawsuit and
expressly assumed the contingent liability as part of the
acquisition agreement. Both petitioner and DeVilbiss
contemplated the possible exposure that might result from the
Lemelson lawsuit and sought the opinion of their corporate
officers. Although the liability did not affect the negotiations
or the final established purchase price, the assumed liability of
the Lemelson lawsuit transferred to petitioner pursuant to the
purchase agreement. - 15 -
The Lemelson lawsuit, like the contingent liability in
David R. Webb Co. v. Commissioner, supra, was a contingent
liability that petitioner was aware of prior to the acquisition
of assets and liabilities from DeVilbiss and that petitioner
expressly assumed in the purchase agreement. Additionally, the
status of the Lemelson lawsuit was considered in determining the
final purchase price, and petitioner created a reserve for the
liability arising from the patent infringement claim.
Following David R. Webb Co., we conclude that petitioner’s
payment of the court judgment, which was an obligation of
DeVilbiss and acquired by petitioner, whether or not such
obligation was fixed, contingent, or even known at the time such
property was acquired, was not an ordinary and necessary business
expense. Such payment is a capital expenditure that becomes part
of the cost basis of the acquired property regardless of what
would have been the tax character of the payment to the prior
owner. See David R. Webb Co. v. Commissioner, 77 T.C. at 1137-
1138; see also Meredith Corp. & Subs. v. Commissioner, 102 T.C.
406, 454-455 (1994) (holding that the time at which a contingent
liability that is assumed in an asset acquisition is to be
capitalized occurs when the expense is incurred).
We have considered all of the remaining arguments that have
been made by the parties for a result contrary to that expressed - 16 -
herein, and, to the extent not discussed above, they are
irrelevant or without merit.
To reflect the foregoing and the concessions of the parties,
Decision will be entered
under Rule 155.