July 28, 2012
TAX FILE MEMORANDUM
SUBJECT: MegaCorp, Inc. IRS Audit Notice Today I met with MegaCorp to discuss the IRS audit notice they received regarding the reporting of $5million in damages paid to Ideas, Inc. FACTS: MegaCorp purchased all of the assets of Little, Inc. MegaCorp also acquired some of Little’s Liabilities which included an alleged patent violation by Ideas Inc. MegaCorp agreed it would be legally responsible for any judgment that Little would have to pay Ideas. A jury awarded Ideas $5 million in damages. MegaCorp reported the payment as a deduction under §162. ISSUE: Upon audit, the IRS reclassified the payment as a capital expenditure under §263 and disallowed the deduction. Is MegaCorp entitled to the deduction? CONCLUSION: MegaCorp is not entitled to the deduction and should add the judgment payment to the basis of acquiring Little, Inc. ANALYSIS: Section 162(a) of the TRC allows for the deduction of “all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”. Section 263 of the Code allows no deduction for a capital expenditure, an “amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate”. In Illinois ToolWorks Inc. et al v. Commissioner, the court opinion stated, “Generally, 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 [pg. 45] time such property was acquired, is not an ordinary and necessary business expense… Instead, payment of such a liability is capitalized and added to the basis of the acquired property.” In 93 AFTR 2d 2004 - 548 (355 F.3d 997), the court states, “…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...
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