In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 02-1239
ILLINOIS TOOL WORKS INC. and subsidiaries,
Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
____________
Appeal from the United States Tax Court.
No. 16022-99—Mary Ann Cohen, Judge.
____________
ARGUED SEPTEMBER 12, 2003—DECIDED JANUARY 21, 2004
____________
Before BAUER, KANNE, and EVANS, Circuit Judges.
KANNE, Circuit Judge. Illinois Tool Works Inc. and
its subsidiaries (“ITW”) appeal from the tax court’s determi-
nation 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 infringe-
ment 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
2 No. 02-1239
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 indemnifi-
cation 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.
No. 02-1239 3
Lemelson filed the second patent infringement suit in
1985 against Champion directly (“Lemelson lawsuit”), al-
leging 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 res-
olution 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 agree-
ment, 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
1
Prior to ITW’s purchase of DeVilbiss, Champion had sold it to
Eagle Industries, who then sold it to ITW. The Lemelson lawsuit
was pending throughout these transactions.
4 No. 02-1239
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 coun-
ter.
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 authorita-
tive opinion on whether the Trallfa robot infringed the ‘431
No. 02-1239 5
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 ex-
plained 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 expendi-
tures 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 cap-
ital and ordinary business expenses as expressed in the
2
Only $6,956,590 of the $17 million judgment is at issue on
appeal because (a) ITW capitalized $1 million in its tax return; (b)
the Commissioner conceded an allowance of $2,154,160 for post-
acquisition interest and expenses; and (c) the Commissioner
conceded a reduction of $6,956,589 due to the sale of certain
DeVilbiss assets acquired in the 1990 purchase.
6 No. 02-1239
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.” 16 U.S.C. § 162(a); INDOPCO v. Commis-
sioner, 503 U.S. 79, 83 (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.
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. Capital
expenses are generally incurred for the taxpayer’s future
benefit. Id. at 90 (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 imme-
diate, 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 de-
preciation. As summarized by the Supreme Court:
The primary effect of characterizing a payment as
either a business expense or a capital expenditure con-
cerns 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
No. 02-1239 7
to match expenses with the revenues of the taxable
period to which they are properly attributable, thereby
resulting in a more accurate calculation of net income
for tax purposes.
INDOPCO, 503 U.S. at 83-84.
“Whether a taxpayer is required to capitalize particular
expenses is a question of law, and our review is therefore de
novo.” U.S. Freightways Corp. v. Commissioner, 270 F.3d
1137, 1139 (7th Cir. 2001); see also Wells Fargo & Co. v.
Commissioner, 224 F.3d 874, 880 (8th Cir. 2000). We note
that ITW, who argues that the majority of the Lemelson
judgment should be labeled ordinary business expenses,
hence fully and immediately deductible, bears the burden
of proving entitlement to the claimed deduction. U.S.
Freightways, 270 F.3d at 1145. This is because income tax
deductions are a matter of legislative grace and the excep-
tion to the norm of capitalization. Id.; INDOPCO, 503 U.S.
at 84.
ITW’s burden is particularly heavy because, as recog-
nized by the tax court, our prior precedent states that there
is a “well-settled general rule that when an obligation is
assumed in connection with the purchase of capital assets,
payments satisfying the obligation are non-deductible
capital expenditures.” David R. Webb Co., Inc. v. Commis-
sioner, 708 F.2d 1254, 1256 (7th Cir. 1983). ITW acknowl-
edged the force of this rule when it capitalized a portion of
the Lemelson judgment as attributable to the obligation (in
the form of the pending lawsuit) assumed upon acquiring
DeVilbiss.
Relying on A.E. Staley Mfg. Co. v. Commissioner, 119 F.3d
482 (7th Cir. 1997), though, ITW argues that the tax court
erred by applying the rule articulated in Webb inflexibly
and eschewing the pragmatic, “real life” inquiry advanced
in Staley. Had it approached ITW’s challenge properly, ITW
8 No. 02-1239
posits, the tax court would have found that except for ITW’s
mishandling of the lawsuit after acquisition, the value of
the Lemelson lawsuit would have been “capped” at $1
million. Thus, anything above $1 million should be attribut-
able to decisions made in the course of defending the
litigation and deducted as an ordinary business expense.
See, e.g., Commissioner v. Tellier, 383 U.S. 687 (1966) (legal
expenses incurred in defending against securities fraud
charges deductible under § 162(a)); Commissioner v.
Heininger, 320 U.S. 467 (1943) (legal expenses incurred in
disputing adverse postal designation deductible as ordinary
and necessary business expenses). We find fault with ITW’s
argument on several levels.
A. ITW misreads the tax court’s approach to Webb.
First, the tax court did not apply Webb inflexibly. ITW
reads the tax court’s opinion to state that “any payment in
satisfaction of a contingent liability acquired in a capital
transaction is always a capital expenditure.” (Appellants’
Opening Br. at 19). We do not read the tax court’s opinion
so restrictively. Rather, we note the opinion accurately cites
Webb for the proposition that “[g]enerally, the payment of
a liability of a preceding owner of property by the person
acquiring such property, whether or not such liability was
fixed or contingent at the time such property was acquired,
is not an ordinary and necessary business expense.” Illinois
Tool Works, Inc. v. Commissioner, 117 T.C. 39, 44-45 (2001)
(emphasis added). The tax court’s language analyzing ITW’s
case in light of the above general principle does not fore-
close in every circumstance an outcome different than the
one reached; rather, it simply notes that ITW’s arguments
for treating all but $1 million of the judgment as an ordi-
No. 02-1239 9
nary business expense are not persuasive in “the present
case.” Id. at 47.3
B. Webb controls
Next, we agree with the tax court that the facts of this
straightforward case do not dictate a departure from Webb.
In Webb, the taxpayer acquired a wood veneer company
that many years ago agreed to pay an employee’s widow,
Mrs. Grunwald, a lifetime pension of $12,700 annually. 708
F.2d at 1255. The taxpayer knowingly assumed the liability
to Mrs. Grunwald as part of the purchase agreement. Id. In
tax years thereafter it attempted to deduct, as an ordinary
and necessary business expense, the $12,700 paid to Mrs.
Grunwald. The Commissioner determined that the $12,700
was not an ordinary business expense, but a capital one,
which the tax court upheld. Id. at 1255-56.
We affirmed, observing that because the taxpayer agreed
to assume the pension payments as part of its purchase
agreement for the wood veneer business, the payments were
more properly attributed to that capital investment, not its
current business operations. Id. at 1256. In essence, the
agreement to pay the debt to the widow served as part of
the purchase price for the business. Id. (“Assumption of the
obligation to make pension payments to Mrs. Grunwald was
in theory and in fact, part of the cost of acquiring the assets
of the wood veneer business from the taxpayer’s predeces-
sor.”) Because the purchase of the wood veneer business
was meant to enhance the taxpayer’s operations into the
future, the expenses to acquire it—which included the
discharge of the annual debt to Mrs. Grunwald—had to be
3
ITW argued for deductibility on several different grounds before
the tax court, abandoning all but its reliance on Staley on appeal.
10 No. 02-1239
capitalized. Id. (stating that generally “when an obligation
is assumed in connection with the purchase of capital
assets, payments satisfying the obligation are non-deduct-
ible capital expenditures”).
Similarly, ITW knowingly assumed the Lemelson lawsuit
as part of the purchase agreement for the DeVilbiss assets.
Because ITW agreed to pay that contingent liability in
exchange for DeVilbiss, that contingent liability formed part
of the purchase price. Because the DeVilbiss acquisition
was meant to benefit ITW into the future, the expenses to
acquire it—including the Lemelson lawsuit, once assigned
a value through the judgment—must be capitalized.
ITW attempts to distinguish Webb based on the parties’
expectation of the ultimate value of the Lemelson lawsuit
and on ITW’s alleged ability, post-acquisition, to negatively
impact the liability amount. In Webb, the acquiring com-
pany knew that it owed an annual liability of $12,700 and
that it would end when Mrs. Grunwald passed. Therefore,
ITW argues, the parties in Webb had a complete under-
standing of the scope of the contingent liability at stake in
the deal, unlike in the case before us where the parties to
the transaction failed to grasp the risk represented by the
Lemelson lawsuit. ITW also urges that since the taxpayer
in Webb could do nothing to affect the amount of the lia-
bility, unlike here where the failure to accept a settlement
offer increased the debt exponentially, Webb should be
ignored.
ITW’s attempts to distance itself from Webb are unavail-
ing. ITW agreed to assume the Lemelson defense and pay
any judgment, whatever it may be. Although we have no
doubt the parties earnestly believed the case was meritless,
ITW cannot dispute that it acknowledged some risk, albeit
minimal, and did not take steps to mitigate that risk. It
could have lowered the purchase price or inserted an
No. 02-1239 11
indemnification clause in the purchase agreement to recoup
any losses not anticipated by the parties. That a contingent
liability, once fixed, exceeded the parties’ expectations does
not render it any less a part of the purchase price. See
Pacific Transport Co. v. Commissioner, 483 F.2d 209, 213
(9th Cir. 1973) (noting that a taxpayer’s failure to realize
the substance or amount of a contingent liability assumed
when acquiring property does not change its tax treat-
ment—the payment must be capitalized); but see Nahey v.
Commissioner, 196 F.3d 866, 870 (7th Cir. 1999) (criticizing
Pacific Transport in dicta). In this case, protection from an
aberrant jury verdict needed to be sought during contract
formation, not after the fact in the form of an immediate tax
deduction.
Moreover, ITW’s entire premise that its actions after
assuming the liability should be examined for the effect it
had on increasing the amount of the ultimate indebtedness
strays from the inescapable fact that, like the taxpayer in
Webb, it accepted the indebtedness in order to acquire what
it perceived to be a future benefit—DeVilbiss. Part of ITW’s
process of valuing the DeVilbiss assets and arriving at the
purchase price included evaluating the Lemelson lawsuit.
In that due diligence phase, ITW assessed a value to the
suit based on how it foresaw the litigation unfolding once it
took control of the defense. Its ability to affect the outcome
of the Lemelson lawsuit was therefore already factored in.
That things did not go according to plan, and that, in
retrospect, it should have paid far less for DeVilbiss to
account for size of the judgment assigned, does not change
the tax character of the judgment in this case.
C. Staley’s Application
Finally, Staley does not warrant a different outcome, as
ITW insists. In Staley, this Court reversed the tax court’s
12 No. 02-1239
determination that fees paid to investment bankers to
unsuccessfully ward off a hostile takeover had to be cap-
italized by the defending company, rather than deducted as
an ordinary business expense. 119 F.3d at 483. The
tax court, in determining that these incidental fees were
part of the capital transaction ultimately resulting in the
taxpayer’s hostile acquisition by a corporate raider, pur-
ported to follow the Supreme Court’s decision in INDOPCO
v. Commissioner, 503 U.S. 79 (1992). Id. at 485. The
INDOPCO case also involved investment banking fees,
but in the context of a friendly, as opposed to hostile, take-
over of National Starch by Unilever. There the Court
found that the money paid to the investment bankers by
National Starch was for the purpose of facilitating a favor-
able merger with Unilever, thus changing the corporate
structure for the benefit of future operations—a capital
expense. INDOPCO, 503 U.S. at 88-90.
In disagreeing with the tax court’s application of
INDOPCO, we found it significant that the majority of
the fees paid in Staley were for the purpose of defending
against what the company perceived to be an unfavorable,
hostile takeover. Staley, 119 F.3d at 491. Because defending
a company against attack is considered a necessary and
ordinary business expense, designed to benefit current
operations, id. at 487, we remanded the case to the tax
court. We asked it to allocate the fees paid between those
activities that were considered in defense of the company,
an ordinary expense immediately deductible, and those that
facilitated the ultimate merger, a capital expense meant to
benefit the company into the future. Id. at 492-493.
Our analysis in Staley was based on the recognition that
distinguishing between ordinary expenses and those that
must be capitalized can sometimes be difficult. Id. at 487
(“As the Supreme Court has noted, ‘the cases sometimes
appear difficult to harmonize,’ and ‘each case turns on its
No. 02-1239 13
special facts.’ ” (quoting INDOPCO, 503 U.S. at 86)). When
faced with this challenge, we observed that “distinguishing
between ordinary and capital costs often requires a rather
pragmatic approach.” Id. Staley was such a case, with its
factual similarities to the INDOPCO decision and turning
on incidental, rather than direct, costs of an acquisition.
Therefore, we specifically applied a “pragmatic assessment”
to the underlying facts in order to decipher whether the fees
incident to the hostile takeover were for current defense of
the company or for an ultimate corporate change with
benefits lasting into the future. See id. at 487-92.
Our task here is easier than in Staley. The taxpayer
points us to no decision in conflict with Webb, where pay-
ments made to satisfy an obligation directly assumed as
part of a bargained-for acquisition have not been capitalized
as part of the purchase price of the asset. Regardless,
applying the pragmatic approach called for in Staley results
in the same outcome, and is implicit, if not explicit, in the
tax court’s opinion.4 The record consists of three sets of
stipulated facts with dozens of attendant exhibits and
a day-long trial transcript in which ITW presents seven
witnesses. The tax court’s opinion coalesced that testimony
4
We find it curious that ITW would choose to attack Judge Cohen
for failing to engage in the appropriate open-minded, fact-based
inquiry advocated in Staley. Judge Cohen, who served as trial
judge in the Staley case, as well as here, dissented from the tax
court opinion from which the Staley appeal was taken. A.E. Staley
Mfg. Co. v. Commissioner, 105 T.C. 166, 210 (1995) (Cohen, J.,
dissenting). It was her dissent that this Court cited favorably in
its ruling reversing the tax court. See Staley, 119 F.3d at 491 n.8.
And, in her closing instructions to the parties about their post-
trial briefs in the present matter, she discusses Staley and its
possible implications, describing her involvement in that case. (Tr.
at 214-15.)
14 No. 02-1239
and documentary evidence into findings of fact, which ITW,
by its own admission, embraces. From those facts and the
arguments advanced by the parties, the tax court deduced
that this was not a case in which the general rule articu-
lated in Webb would not apply.
Looking at the facts, we agree. The ultimate goal of the
pragmatic assessment advanced by Staley is to decode
whether an expenditure is ordinary or capital in nature.
Although ITW argues that paying $16 million more than
the Lemelson lawsuit was allegedly worth could have no
positive impact on the future of the company, it loses sight
of the fact that what it got in exchange for its obligation to
pay the judgment was the DeVilbiss assets. In this way, the
Lemelson judgment was “ ‘incurred for the purpose of
changing the corporate structure for the benefit of future
operations’ ” and must be capitalized. Staley, 119 F.3d at
489 (quoting INDOPCO, 503 U.S. at 89). As stated by the
court in United States v. Smith, observing that the sub-
stance, not the form of the transaction governs when deter-
mining tax treatment of a settlement paid to a former
employee:
If the corporation at its inception assumed a contingent
obligation to pay [the employee], it is that assumption
of liability which obligated the corporation and not any
subsequent legitimate business purpose. In other
words, the corporation did not have to pay because of
the unfavorable judgment or because its directors
deemed payment advisable but rather the corporation
paid because it assumed the obligation when it became
incorporated.
418 F.2d 589, 596 (5th Cir. 1969); see also Staley, 119 F.3d
at 491 (noting that “the substance of the transaction, not its
form, is controlling” (citing Clark Oil & Refining Corp. v.
United States, 473 F.2d 1217, 1220-21 (7th Cir. 1973)). So
too here it was not ITW’s failure to accept the settlement
No. 02-1239 15
offer that obligated it to pay the jury award, but its assump-
tion of the lawsuit in order to acquire DeVilbiss.
If we examine the events post-acquisition, as ITW urges,
the result is still the same. ITW focuses our attention
primarily on its missed opportunity to settle the case,
contending that had it only taken Lemelson up on his final
$1 million offer, instead of staunchly placing its faith in its
own valuation of the case, then the liability it acquired
along with the DeVilbiss assets would not have increased
exponentially. It states, “[t]hus, a ‘pragmatic,’ ‘real-life’
assessment of the facts demonstrates that ITW’s decision,
made in the ordinary course of its business, to reject
Lemelson’s settlement offers was the proximate cause of the
amount ultimately owed to Lemelson.” (Appellant’s Opening
Br. at 32.) Yet, the patent suit claimed damages for infring-
ing robots sold from 1979 to 1985, years before ITW ac-
quired DeVilbiss. ITW’s predecessor failed to accept
Lemelson’s $500,000 settlement offer in 1989. And, as noted
by the patent trial court in upholding the jury’s finding of
willfulness: “Defendant’s entire course of conduct from its
total disregard of Plaintiff’s 1975 letter to its unexplained
failure to secure an authoritative opinion until two months
before trial, demonstrates an utter lack of concern over
Plaintiff’s patent rights.” (Tr. Ex. 19-J ¶ 23.) A pragmatic
assessment of this case leads to the conclusion that the
Lemelson lawsuit was mishandled from the outset, arriving
in ITW’s hands fully formed. ITW’s mistakes and missed
opportunities had little to do with the ultimate valuation
placed on the matter by the jury.
III. Conclusion
For the foregoing reasons, the decision of the tax court is
AFFIRMED.
16 No. 02-1239
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—1-21-04