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.E. Staley Mfg. Co. decision.

The Seventh Circuit found the reference to Staley not relevant. Staley allowed a corporation to deduct expenses related to defending against a hostile takeover. It did not apply to assumed liabilities. Webb does, and requires capitalization as a general rule.

The Seventh Circuit then said that even if it had used the pragmatic approach urged by the taxpayer, the expenditure still would have had to be capitalized. The fact the assumed liability was contingent and not fixed as in Webb was not relevant. The fact ITW grossly understated the amount also was not relevant. What matters was the taxpayer had assumed the liability as part of an acquisition designed to generate future benefits. Paying this obligation was part of that acquisition. Therefore the company had to capitalize the payment, not deduct it.

A direct reading of the opinion leads to the simple conclusion that companies must capitalize liabilities assumed in asset acquisitions. Errors in judgment and valuation are not relevant. Taxpayers can and should protect themselves against these risks with appropriate reimbursement provisions in the acquisition contract. Since ITW was unable to find any cases that did not apply Webb , this makes it highly unlikely a future taxpayer will be able to convince a court not to apply the Webb rule.

One fact in this case may offer taxpayers a small degree of hope: The jury found the patent infringement was willful. That ITW never got an outside opinion on the infringement until two months before trial led the Seventh Circuit to conclude the sizable judgment was the result of the company’s mismanagement of the suit rather than a jury valuation issue. This leaves open the slight chance that if a future taxpayer can prove its postacquisition activities determined the amount paid to settle the assumed debt, it could deduct this amount. However, it would be advisable for taxpayers to assume the amount they pay to settle an obligation will have to be capitalized as part of the cost of acquiring the assets.

Illinois Tool Works Inc. v. Commissioner 355 F3d 997 (CA-7).

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

1. They must be made pursuant to a divorce agreement.

2. The agreement must not specify different tax treatment.

3. The spouses must not be members of the same household.

4. The payor must not be liable to make additional or substitute payments after the payee spouse dies.

Richard Hawley and Jane Gilbert entered into an agreement and order of support that required Hawley to pay biweekly amounts to support Gilbert and their three children. The separation agreement did not specify the allocation of payments between alimony to Gilbert and child support.

On their individual 1993 to 1995 tax returns, Hawley deducted the payments and Gilbert did not include them in her gross income. To avoid being “whipsawed”—having different tax treatments for each party result in its collecting no tax—the IRS inconsistently determined that Hawley could not deduct the payments and that Gilbert must include them in her gross income. Hawley and Gilbert petitioned the Tax Court, challenging the IRS assessments.

The Tax Court consolidated the two cases and held the payments were not alimony, meaning Hawley could not deduct them. He appealed the decision to the Third Circuit Court of Appeals. To again avoid a whipsaw situation where Hawley could deduct the payments but Gilbert would not be required to include them in her income, the IRS also appealed the Gilbert decision.

Result. For the IRS. Hawley and Gilbert met the first three requirements for the payments to be considered alimony. The fourth requirement of section 71(b)(1)—that alimony payments cease with a payee’s death—was the only one in dispute. Hawley argued the Pennsylvania Supreme Court had decided an unallocated support order terminates upon the death of the ex-spouse by relying on a Pennsylvania rule of civil procedure. That meant state law would end Hawley’s payments if Gilbert died.

The Third Circuit judge pointed out the ruling came too late to help the taxpayers for tax years 1993 to 1995—the Pennsylvania decision wasn’t converted into legal procedure until 2000 and there was no clear evidence of retroactive application. Therefore, the new procedure had no impact on this case.

The judge also said that although the technical obligation to make payments to Gilbert would have ended at her death, the obligation to make substitute payments would have continued because Hawley still would have been required to support his children. Consequently, he still would have had to make substitute payments—violating the fourth requirement of section 71(b)(1)—if Gilbert died. The payments, therefore, were not alimony.

Individuals involved in a divorce should make certain the divorce and separation agreements carefully specify the amounts to be considered alimony and child support. Arguments to treat a portion of unallocated payments as alimony are almost impossible to support.

Hawley v. Commissioner, 93 AFTR2d 2004-1821, 4/16/2004.

Prepared by Sharon Burnett, CPA, PhD, assistant professor of accounting, and Darlene Pulliam, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.

American Bankers Insurance Group (ABIG), a Florida corporation, purchased interstate and international long-distance and intrastate long-distance phone service from AT&T in Florida, Georgia, Ohio and Oklahoma from October 1998 through March 2002. ABIG paid a uniform toll rate that varied only by the country to which the calls were being placed. It filed claims with the IRS for refunds totaling $361,763, contending that federal law imposed an excise tax only on long-distance calls that varied in rate based on the call’s distance.

In a case with essentially the same facts, OfficeMax purchased long-distance phone service from MCI WorldCom Communications and MCI Telecommunications Corp. OfficeMax paid $380,296 in excise taxes and filed a refund claim with the IRS based on the same contention as ABIG’s. OfficeMax maintained the toll charges were based on each call’s duration, the type of access provided or the time of day and that distance was never a factor.

Result. For the IRS in ABIG ; for OfficeMax in the other case. In both cases the critical question was whether the phone services the companies purchased were within the statutory definition of “toll telephone service” in IRC section 4252(b)(1). Toll phone service is defined as “a telephonic quality communication” for which the toll charge “varies in amount with the distance and elapsed transmission time” of each individual communication and is paid “within the United States.” Each court viewed the word “and” in the definition differently.

In ABIG the district court ruled the word “and” was ambiguous and could mean the tax applied to toll phone service based on distance or time or both. The court concluded that, given this ambiguity, the congressional intent was to tax all long-distance phone service, regardless of whether it varied based on distance or time or both, and this intent would be thwarted under ABIG’s contention.

In OfficeMax , however, the district court ruled the same word was not ambiguous. Since both distance and time were factors in determining toll charges when Congress enacted section 4252(b)(1), “it intended for the word ‘and’ to be read conjunctively to mean that a charge must vary by both distance and elapsed transmission time, and not by one or the other.”

Given the differing conclusions of the district courts and the sizable amount of potential refunds, the IRS likely will challenge any future claims for refunds until the issue is resolved through appeals or legislation.

American Bankers Insurance Group v. United States (DC FL, 1/29/2004), 93 AFTR2d 2004-1435.

OfficeMax, Inc. v. United States (DC OH, 2/13/2004), 93 AFTR2d 2004-1190.

Prepared by Michael H. Brown, CPA, PhD, assistant professor of accounting, Millikin University, Decatur, Illinois.