Appeals Court Confirms Treatment of Assumed Liabilities

Article excerpt

The Seventh Circuit Court of Appeals recently upheld a Tax Court ruling (see "Acquiring Contingent Liabilities," JofA, June04, page 73) that a corporation must capitalize its payment of an assumed liability. The appeals court's analysis offers a warning to other taxpayers that it's unlikely this type of expenditure ever will be deductible.

In 1975 Jerome Lemelson offered to license some of his patents to the DeVilbiss Co. DeVilbiss declined and acquired licenses from a Norwegian company for similar computer-controlled paint-spray robots. In 1978 Lemelson's attorney told DeVilbiss it was violating his client's patents. The company denied the charge and Lemelson instituted a suit for patent infringement.

DeVilbiss' attorney said the suit was without merit and capped the company's total exposure at $500,000. Illinois Tool Works Inc. (ITW) acquired DeVilbiss in 1990 and assumed all lawsuit-related liabilities. Internally ITW also viewed the suit as without merit with a maximum exposure of $3 million. During the trial Lemelson offered to settle for $1 million. Although the trial judge urged settlement, ITW refused. In 1991 the jury returned a verdict in Lemelson's favor for $4,647,905 plus interest of $6,295,167. Following an appeal ITW paid the judgment, capitalized $1 million (the original settlement offer) and deducted the rest. The IRS concluded the entire expenditure should have been capitalized. The Tax Court sided with the IRS. The taxpayer appealed.

Result. For the IRS. The basic question involves the difference between deductible and capitalizable expenditures. Since tax deductions are the result of legislative grace, taxpayers must prove they are entitled to them.

In this case the burden of proof was extremely heavy since the precedent was against deduction. In David Webb Co. the Seventh Circuit articulated the general rule: Companies must capitalize the payment of an assumed liability connected with the acquisition of an asset. The Tax Court applied this rule in denying the deduction to ITW.

ITW argued the Tax Court was wrong in its approach to Webb, applying it in an inflexible manner; Webb permits a flexible, pragmatic approach. In this instance the size of the judgment was due to ITW's actions after it assumed the liability, making any expenditures resulting from those actions deductible. ITW further argued the pragmatic approach was the correct one based on the A. …