It often is difficult to determine the existence of a contingent liability. Even when the potential liability is known, it’s not easy to correctly value it. Failure to properly consider the tax impact of a contingent liability could have a negative effect on the purchase of a business.
In 1975 Jerome Lemelson offered to license his patent for industrial robotics to the DeVilbiss company, which turned him down. In 1978 De-Vilbiss acquired a license from a Norwegian company for robotic paint sprayers. The next year Lemelson notified DeVilbiss that he felt it was violating his patent, a charge the company denied. Lemelson filed a patent infringement suit against DeVilbiss in 1985. The company hired an attorney who specialized in intellectual property law. The attorney concluded Lemelson’s case was without merit. In-house counsel agreed, but still estimated the company’s potential liability exposure at between $25,000 and $500,000. Lemelson offered to settle for $500,000. DeVilbiss rejected his offer.
Illinois Tool Works Inc. (ITW) acquired DeVilbiss in 1990. The patent infringement suit was disclosed during the due diligence process prior to the purchase. ITW attorneys estimated the company had a 98% to 99% chance of winning the suit. Following the purchase Lemelson offered to settle the claim for $1 million. ITW rejected his offer. In 1991 a jury returned a verdict in Lemelson’s favor in the amount of $4,647,905, plus prejudgment interest of $6,295,167. ITW appealed and lost. In 1992 ITW paid $17,067,339 to settle the judgment. ITW capitalized $1 million of the payment (the amount it could have paid Lemelson earlier to settle the claim) and deducted the remainder. The IRS objected to the deduction. The Tax Court ruled for the IRS and the taxpayer appealed.
Result. For the IRS. ITW’s attempt to deduct payment of the contingent liability conflicted with the well-established principle that a company must capitalize the total cost, including contingencies, it incurs to acquire assets. To overcome this general rule, the company argued the Tax Court misapplied the precedent established in Webb and that the specific facts of this case overrode the general rule requiring capitalization.
Under Webb an acquirer generally must capitalize the payment of a prior owner’s liabilities. The fact the debt was contingent is immaterial. The Tax Court did not say all payments must be capitalized, as the taxpayer argued. Instead it ruled these payments generally must be capitalized and in this case the taxpayer did not present facts to justify an exception.
The Seventh Circuit Court of Appeals agreed the case did not justify an exception to the general rule. The fact the taxpayer could have settled the lawsuit for $1 million but paid $16 million was not determinative. ITW acquired valuable assets when it assumed the contingent liability. That the total payments could have been less didn’t change what the taxpayer actually paid. It is not what you should have paid for an asset but what you actually paid.
Given the court’s decision it is highly unlikely any taxpayer will succeed in deducting a contingent liability payment that is part of an asset acquisition. The fact the actual final payment greatly exceeds all estimates of the liability at acquisition is immaterial. If this happens taxpayers either should negotiate a reimbursement from the seller or be prepared to capitalize the expenditure.
Illinois Tool Works Inc. v. Commissioner, CA-7, Jan. 2004.
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.