Acquiring contingent liabilities.

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 era contingent liability could have a negative effect on the purchase era business.

In 1975 Jerome Lemelson offered to license Iris patent for industrial robotics to the DeVilbiss company, which turned trim down. In 1978 DeVilbiss 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 otter. 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.

TAX NOTES

* The Treasury Department and the IRS proposed regulations in March that would allow--within certain limitations--employers to streamline their retirement plan distribution options (www.treas.gov/press/releases/ reports/js1253reg12830903032304.pdf). Under the regulations companies could eliminate early retirement entitlements, retirement-type subsidies and optional benefits that significantly burden plan administrators or participants with complexities if the changes would not have a significant adverse effect on the rights of any participant. Comments are due June 22.

* In April the Treasury Department and the IRS issued guidance on two kinds of abusive tax-avoidance transactions. One type improperly shifts taxes from S-corporation shareholders to exempt parties such as charities, IRS notice 2004-30 (www.treas.gov/press/releases/reports/ js1292notice200430.pdf) states the service's intent to challenge what it considers "listed transactions" and requires participants to disclose any involvement in them when filing their tax returns. Another class of abusive transactions entails corporations' use of partnerships to obtain inappropriate deductions for interest payments to related entities. IRS notice 2004-31 (www.treas.gov/press/ releases/reports/notice_200431.pdf) stipulates that participants must disclose to the IRS their involvement in such transactions and that promoters must register the transactions with the service and use IRS Form 8886, Reportable Transaction Disclosure Statement, to identify all participants in them. The IRS will amend the form to help with this disclosure.

* The IRS in February began accepting electronic income tax and information returns from corporations and tax-exempt organizations, significantly reducing the time it takes to file forms 1120 and 990 (www.irs.gov/newsroom/article/0,,id=121573,00.html). Tax professionals--using IRS-approved software (www.irs.gov/efile/lists/ 0,,id=119096,00.html)--now can submit such returns to the service through a secure Web site accessible only to registered users. The system employs an industry-standard extensible markup language (XML) process that makes it possible to append portable document format (PDF) attachments to returns, generates easy-to-understand error messages and sends users an electronic acknowledgement that the IRS has received the return and is processing it. To use the system, tax professionals first must register at https://la.www4.irs.gov/e-services /Registration/index.htm. Those who already submit other returns electronically can update their applications to include online submission of forms 1120 and 990.

No Light Matter

State-imposed gas import taxes or other surcharges account for an average of 11.2% of the total amount a taxpayer spends on an electric power bill.

For single-click access to further coverage of the tax stories listed here, visit the Journal of Accountancy Web site at www.aicpa.org/ pubs/jofa/joahome.htm.

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