Illinois Tool Works, Inc. & Subsidiaries v. Comm'r of Internal Revenue, 16022–99.
| Decision Date | 31 July 2001 |
| Docket Number | No. 16022–99.,16022–99. |
| Citation | 117 T.C. No. 4,117 T.C. 39 |
| Parties | ILLINOIS TOOL WORKS, INC. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Corporate taxpayer petitioned for redetermination of deficiency arising from deducting expenses of lawsuit assumed in asset acquisition. The Tax Court, Cohen, J., held that satisfaction of lawsuit liability was cost of acquiring assets, which was a capital expense.
Decision for IRS. 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.
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.
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, 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 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.
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 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:
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 (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, against petitioner as the party in interest), finding that Champion had willfully infringed the '431 patent that was...
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