Appeals Court Confirms Treatment of Assumed Liabilities

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.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.