Ill. Tool Works and Subsidiaries v. C.I.R.

• Decision Date: 21 January 2004
• Docket Number: No. 02-1239.,02-1239.
• Citation: 355 F.3d 997
• Parties: ILLINOIS TOOL WORKS INC. AND SUBSIDIARIES, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

355 F.3d 997

ILLINOIS TOOL WORKS INC. AND SUBSIDIARIES, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 02-1239.

United States Court of Appeals, Seventh Circuit.

Argued September 12, 2003.

Decided January 21, 2004.

Thomas C. Durham (argued), Mayer, Brown, Rowe & Maw, Chicago, IL, for Petitioner-Appellant.

Michael J. Haungs (argued), Department of Justice, Tax Division, Appellate Section, Washington, DC, for Respondent-Appellee.

Before BAUER, KANNE, and EVANS, Circuit Judges.

KANNE, Circuit Judge.

Illinois Tool Works Inc. and its subsidiaries ("ITW") appeal from the tax court's determination that $6,956,590 of a more than $17 million court judgment paid by ITW should be capitalized as a cost of acquiring certain assets of the DeVilbiss Co. rather than deducted as an ordinary business expense. The judgment at issue was the result of a jury verdict in a patent infringement suit filed against DeVilbiss's former owner, Champion Spark Plug, Inc. ITW assumed the pending lawsuit, and its defense, upon its acquisition of DeVilbiss in 1990. ITW acknowledges that at least a portion of the judgment should be capitalized as a cost of acquisition, but disputes the amount. We agree with the determination of the tax court and affirm.

I. History

The facts are not in dispute. DeVilbiss was a division of Champion in the 1970s. In 1975, Jerome H. Lemelson, an inventor and engineer, wrote DeVilbiss and offered to license it certain of his patents, including the "`431 patent." DeVilbiss, fatefully, did not take Lemelson up on the offer.

Instead, in 1978, DeVilbiss acquired a license from a Norwegian company named Trallfa to sell its computer-controlled paint-spray robots. Attorneys for Lemelson contacted DeVilbiss in 1979, notifying it that certain of its products in the robot and manipulator field might be infringing on Lemelson's patents, including the `431 patent. DeVilbiss's director of robotic operations replied, summarily denying any infringement. Thereafter, in 1980, DeVilbiss and Trallfa entered a new license agreement whereby DeVilbiss gained the right to manufacture, as well as to sell, Trallfa robots.

The first of two relevant patent infringement suits brought by Lemelson followed in 1981. Lemelson launched that suit in the U.S. Court of Claims ("Court of Claims lawsuit") against the United States, alleging that its purchase and use of certain robots, including the Trallfa robot, infringed his patents. Champion, owner of DeVilbiss, entered as a third-party defendant. The government ultimately settled that suit for $5000 and sought indemnification from Champion. Notably, the presiding judge in that action told the parties prior to settlement that based on his view of the merits, Lemelson was unlikely to succeed.

Lemelson filed the second patent infringement suit in 1985 against Champion directly ("Lemelson lawsuit"), alleging as he had before that the Trallfa robot infringed on several of his patents, including the `431 patent. He sought damages relating to the sale of Trallfa robots prior to 1986. That case was stayed shortly after filing, pending the resolution of the 1981 Court of Claims lawsuit.

DeVilbiss retained counsel to represent it in the Lemelson lawsuit. That attorney, Mark C. Schaffer, specialized in intellectual property law. In his estimation the case was meritless, and he communicated the same to DeVilbiss. Larry Becker, division counsel and secretary of DeVilbiss at the time the Lemelson lawsuit was filed, also evaluated the case and came to the same conclusion. But, he set a range of exposure between $25,000 and $500,000 for internal purposes. In 1989, before ITW purchased DeVilbiss, Lemelson offered to settle for $500,000. DeVilbiss rejected the offer, countering with $25,000. Although not clear from the record, settlement discussions apparently stalled, and, in any event, no settlement was reached at that time.

ITW acquired DeVilbiss in 1990.¹ In the purchase agreement, ITW agreed to assume certain liabilities of the seller, which included the pending Lemelson lawsuit. ITW became aware of the Lemelson lawsuit prior to closing, during the due diligence phase of the sale, which ITW conducted over a ten-to-fourteen-day period. As part of the due diligence review, DeVilbiss disclosed all of its pending litigation, including the Lemelson lawsuit. Although the damages claimed by Lemelson were described as "open" on the schedule provided to ITW, Becker reiterated his opinion that the lawsuit was meritless. ITW representatives, including its director of audits, vice president of patents and technology, and group technology counsel (the latter two patent attorneys), reviewed the Lemelson case and agreed with Becker. They ascribed a 98-to-99 percent chance of prevailing at trial, with a worst case scenario exposure of $1 million to $3 million. They also negotiated a $350,000 cash reserve to cover the attorneys' fees expected to be incurred in defending the suit. Except for the accountants, Arthur Andersen, and Schaffer, the outside counsel retained by DeVilbiss, the record reveals no other outside analysts brought in to examine the risk represented by the Lemelson lawsuit.

As a result of ITW's due diligence findings, the agreed purchase price for DeVilbiss was lowered from $126.5 million to $125.5 million. The Lemelson lawsuit was not a factor in this decision.

After the deal closed, the Lemelson lawsuit was reopened, and ITW assumed the defense as the real party in interest, although Champion remained named in the caption. ITW continued to employ Schaffer, the outside counsel initially hired by DeVilbiss, to represent it. At various points prior to and during trial, Lemelson offered to settle the case. The last offer, for more than $1 million, came after most of the evidence had been heard and at the urging of the trial court. ITW rejected the settlement offer and did not counter.

In January 1991, a jury returned a verdict in favor of Lemelson. It awarded $4,647,905 for patent infringement and $6,295,167 in prejudgment interest. The district court doubled the patent infringement award because the jury found that not only had the `431 patent been infringed, it had been willfully infringed. The willfulness finding was based in part on Champion's failure to secure an authoritative opinion on whether the Trallfa robot infringed the `431 patent until two months before trial. ITW was, to say the least, stunned by the $15,590,977 verdict.

ITW appealed and lost. It finally paid the judgment in 1992, which, with accumulated interest, totaled $17,067,339. On its 1992 tax return, it capitalized $1 million of the judgment as a cost of acquiring DeVilbiss and deducted the remaining $16 million as an ordinary business expense. The reason for the bifurcation, as explained in ITW's Form 8275-R Disclosure Statement that accompanied its 1992 return, was that since it could have settled the Lemelson lawsuit for $1 million, the remaining $16 million liability resulted from the post-acquisition business decision to reject the settlement offer and chance it in court. In essence, ITW contended that its gamble on a jury trial caused it to incur significant additional expenditures over $1 million (the perceived worth of the lawsuit based on the last settlement offer) — not the acquisition of DeVilbiss and its contingent liability in the form of the Lemelson suit. As such, ITW reasoned that the amount of the judgment attributable to its bad decisions should be deducted as an ordinary business expense rather than capitalized as a cost of acquisition. The Commissioner of Internal Revenue and the tax court rejected this novel mea culpa argument and so do we.²

II. Analysis

This case revolves around the difference between capital and ordinary business expenses as expressed in the Internal Revenue Code. The Code allows the immediate deduction of "all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." 26 U.S.C. § 162(a); INDOPCO v. Commissioner, 503 U.S. 79, 83, 112 S.Ct. 1039, 117 L.Ed.2d 226 (1992). The opposite is true of capital expenses, which the Code defines as "an amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." 26 U.S.C. § 263(a)(1); INDOPCO, 503 U.S. at 83, 112 S.Ct. 1039. Ordinary business expenses, then, are generally incurred to meet a taxpayer's immediate or current business needs within the present taxable year. See id. at 85, 112 S.Ct. 1039. Capital expenses are generally incurred for the taxpayer's future benefit. Id. at 90, 112 S.Ct. 1039 (noting that generally an expense is characterized as capital when "the purpose for which the expenditure is made has to do with the corporation's operations and betterment ... for the duration of its existence or for the indefinite future or for a time somewhat longer than the current taxable year." (quotations omitted)).

The practical result of labeling an expense "ordinary" or "capital" is that generally a taxpayer can take an immediate, full deduction for ordinary business expenses and realize an immediate corresponding reduction in taxable income, while capital expenses generally result in smaller yearly deductions over time through amortization and depreciation. As summarized by the Supreme Court:

The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer's cost recovery While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. See U.S.C. §§ 167(a) and 336(a); Treas. Reg. § 1.167(a), 26 C.F.R. § 1.167(a). Through provisions such as these, the Code endeavors to match expenses with the revenues of the taxable...