                            117 T.C. No. 4



                     UNITED STATES TAX COURT



     ILLINOIS TOOL WORKS, INC. & SUBSIDIARIES, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16022-99.               Filed July 31, 2001.



          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.
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     COHEN, Judge:   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.

                         FINDINGS OF FACT

     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,
                               - 3 -


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
                                - 4 -


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.
                                 - 5 -


     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
                                    - 6 -


     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:

     CDCA                           STATE     DATE      CLAIM AMT
     Lemelson, Jerome v. Champion     DE    06/19/85      Open

     ACTION     Patent infringement claim - Robot Apparatus
     COMMENTS   Latest settlement demand is $500,000. Further
                discovery and trial pending.

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
                               - 7 -


(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,
                               - 8 -


against petitioner as the party in interest), finding that

Champion had willfully infringed the ‘431 patent that was owned

by Lemelson.   The jury awarded damages of $4,647,905 for patent

infringement and $6,295,167 for prejudgment interest.    The

District Court doubled the $4,647,905 damage award for patent

infringement due to the jury’s finding of willful infringement.

The finding of willfulness was based in part on the failure of

Champion (and on the failure of petitioner as the party in

interest) to secure an authoritative opinion on whether the

Trallfa robot violated the ‘431 patent until 2 months before

trial.

     Petitioner appealed the judgment of the District Court to

the U.S. Court of Appeals for the Federal Circuit.   On July 13,

1992, the Court of Appeals affirmed without published opinion the

decision of the District Court, Lemelson v. Champion Spark Plug

Co., 975 F.2d 869 (Fed. Cir. 1992).    In 1992, after all appeals

were exhausted, petitioner paid the judgment, including

accumulated interest, of $17,067,339.   The $17,067,339 judgment

included the damages and prejudgment interest totaling

$15,590,977 that were awarded by the District Court, postjudgment

interest of $1,470,389.92, and court costs of $5,971.74.
                                - 9 -


                               OPINION

     The portion of the $17,067,339 court judgment that is in

issue is $6,956,590 because:   (1) Petitioner capitalized

$1 million in its tax return, (2) respondent conceded an

allowance of $2,154,160 for postacquisition interest expense, and

(3) respondent conceded a reduction of $6,956,589 for the

disposal of acquisition assets.   We must decide whether the

$6,956,590 in dispute should be capitalized as a cost of

acquisition or deducted as a business expense.

     Section 162(a) provides a deduction for a taxpayer when an

expenditure is:   (1) An expense, (2) an ordinary expense, (3) a

necessary expense, (4) incurred during the taxable year, and

(5) made to carry on a trade or business.   Commissioner v.

Lincoln Sav. & Loan Association, 403 U.S. 345, 352-353 (1971).

An expenditure is a “necessary expense” when it is appropriate or

helpful to the development of a taxpayer’s business.

Commissioner v. Tellier, 383 U.S. 687, 689 (1966).     An

expenditure is an “ordinary expense” when it is “normal, usual,

or customary” in the type of business involved.   Deputy v.

Du Pont, 308 U.S. 488, 495-496 (1940).   Petitioner bears the

burden of proving entitlement to the claimed deduction.     Rule

142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).

     No current deduction is allowed for a capital expenditure.

See sec. 263(a)(1).   Section 1.263(a)-2(a), Income Tax Regs.,
                               - 10 -


includes as examples of capital expenditures “The cost of

acquisition * * * of buildings, machinery and equipment,

furniture and fixtures, and similar property having a useful life

substantially beyond the taxable year.”    (Emphasis added.)

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 time such property

was acquired, is not an ordinary and necessary business expense.

David R. Webb Co. v. Commissioner, 708 F.2d 1254, 1257 (7th Cir.

1983), affg. 77 T.C. 1134 (1981); Pac. Transp. Co. v.

Commissioner, 483 F.2d 209 (9th Cir. 1973), vacating and

remanding T.C. Memo. 1970-41; United States v. Smith, 418 F.2d

589, 596 (5th Cir. 1969); M. Buten & Sons, Inc. v. Commissioner,

T.C. Memo. 1972-44.    Instead, payment of such a liability is

capitalized and added to the basis of the acquired property.

     Petitioner contends that the amount of the payment that was

made in satisfaction of the Lemelson lawsuit should not be added

to the cost basis of the property that was acquired in the asset

acquisition from DeVilbiss because the payment was highly

speculative and unexpected at the time of purchase.    Petitioner

relies on the Tax Court’s decision in Pac. Transp. Co. v.

Commissioner, T.C. Memo. 1970-41, vacated and remanded 483 F.2d

209 (9th Cir. 1973).    Petitioner’s alternative arguments are:

(1) A payment in satisfaction of an assumed liability, which
                             - 11 -


would have been a deductible expense if it had been paid by

DeVilbiss, the acquired corporation, retains its deductible

character when petitioner, the acquiring corporation, becomes the

party in interest and (2) as a result of petitioner’s efforts in

defending the Lemelson lawsuit, the final judgment amount that

petitioner paid was an ordinary and necessary business expense

that was directly connected to the business operations.   In

support of these alternative arguments, petitioner relies on

Nahey v. Commissioner, 196 F.3d 866 (7th Cir. 1999), affg. 111

T.C. 256 (1998).

     Respondent maintains that the assets that petitioner

received in exchange for the sales price, which included the

assumed liabilities, produced a substantial benefit to petitioner

in future years as the assets were used in petitioner’s business.

Respondent maintains that the Lemelson lawsuit was a contingent

liability of DeVilbiss that was assumed, in full, by petitioner

as consideration for the acquired assets of DeVilbiss.

Therefore, respondent contends, regardless of whether the final

amount of the liability was unexpected or remote at the time of

acquisition, the total sum of the payment for the assumed

contingent liability must be added to the cost basis of the

property that was acquired in the asset acquisition.   Respondent

relies on the Court of Appeals for the Ninth Circuit’s decision
                             - 12 -


in Pac. Transp. Co. v. Commissioner, 483 F.2d 209 (9th Cir.

1973), vacating and remanding T.C. Memo. 1970-41.

     Respondent also relies on David R. Webb Co. v. Commissioner,

77 T.C. 1134 (1981), affd. 708 F.2d 1254 (7th Cir. 1983), in

which a taxpayer expressly assumed the obligation to make pension

payments to the widow of a corporate officer for her life as part

of the purchase of the assets and liabilities of a corporation.

Prior to the acquisition of the corporation by the taxpayer, the

corporation made the pension payments and deducted the payments

as ordinary and necessary business expenses.   Upon acquisition,

the taxpayer continued to make the pension payments to the widow

and claimed a deduction for the amount of the pension payments.

This Court stated:

          It is well settled that the payment of an
     obligation of a preceding owner of property by the
     person acquiring such property, whether or not such
     obligation was fixed, contingent, or even known at the
     time such property was acquired, is not an ordinary and
     necessary business expense. Rather, when paid, such
     payment is a capital expenditure which becomes part of
     the cost basis of the acquired property. Such is the
     result irrespective of what would have been the tax
     character of the payment to the prior owner. United
     States v. Smith, 418 F.2d 589, 596 (5th Cir. 1969);
     Portland Gasoline Co. v. Commissioner, 181 F.2d 538,
     541 (5th Cir. 1950), affg. on this issue a Memorandum
     Opinion of this Court; W.D. Haden Co. v. Commissioner,
     165 F.2d 588, 591 (5th Cir. 1948). affg. on this issue
     a Memorandum Opinion of this Court; Holdcroft
     Transportation Co. v. Commissioner, 153 F.2d 323 (8th
     Cir. 1946), affg. a Memorandum Opinion of this Court;
     * * * [Id. at 1137-1138.]
                             - 13 -


     On appeal, the Court of Appeals for the Seventh Circuit

dismissed the taxpayer’s argument that a contingent liability

that was insusceptible of present valuation at the time of the

acquisition could not be capitalized as a cost of acquisition.

The Court of Appeals held that, when the actual amount of the

contingent liability is known, the amount can be added to the

cost basis of the purchased property.    David R. Webb Co. v.

Commissioner, 708 F.2d 1254, 1258 (7th Cir. 1983), affg. 77 T.C.

1134 (1981).

     We conclude that David R. Webb Co., not Nahey v.

Commissioner, supra, is applicable to the facts in this case.     In

Nahey, the issue was whether proceeds of litigation prosecuted to

judgment were taxed as capital gains or ordinary income.   The

Court of Appeals held that the proceeds were ordinary income to

the buyer of the corporation that had initially held the legal

claim for lost corporate income.   In that context, the Court

noted that the character of income did not change as a result of

the acquisition, stating that "what was transferred as part of a

corporate acquisition was an asset that yields ordinary income".

Nahey v. Commissioner, supra at 869.    We are not persuaded by

petitioner's attempt to extend this rationale to the present case

in contravention of the consistently applied rule that payment of

liabilities assumed as part of an acquisition must be

capitalized.
                              - 14 -


     Because we believe that David R. Webb Co. is the controlling

authority in this case, we need not decide the dispute between

the parties over the status of Pac. Transp. Co. v. Commissioner,

supra.   We note, however, that the Court of Appeals, in reversing

our decision, relied on two Supreme Court cases, Woodward v.

Commissioner, 397 U.S. 572 (1970), and United States v. Hilton

Hotels, 397 U.S. 580 (1970), decided after our Memorandum Opinion

was released.

     In settling on a final price for the DeVilbiss industrial

and commercial assets, the possibility of incurring a liability

on the patent infringement claim in the Lemelson lawsuit was

considered by both petitioner and DeVilbiss.   DeVilbiss, as

seller, disclosed the patent infringement claim that arose from

its activities to petitioner during the due diligence period.

Petitioner, as buyer, was aware of the Lemelson lawsuit and

expressly assumed the contingent liability as part of the

acquisition agreement.   Both petitioner and DeVilbiss

contemplated the possible exposure that might result from the

Lemelson lawsuit and sought the opinion of their corporate

officers.   Although the liability did not affect the negotiations

or the final established purchase price, the assumed liability of

the Lemelson lawsuit transferred to petitioner pursuant to the

purchase agreement.
                              - 15 -


     The Lemelson lawsuit, like the contingent liability in

David R. Webb Co. v. Commissioner, supra, was a contingent

liability that petitioner was aware of prior to the acquisition

of assets and liabilities from DeVilbiss and that petitioner

expressly assumed in the purchase agreement.   Additionally, the

status of the Lemelson lawsuit was considered in determining the

final purchase price, and petitioner created a reserve for the

liability arising from the patent infringement claim.

     Following David R. Webb Co., we conclude that petitioner’s

payment of the court judgment, which was an obligation of

DeVilbiss and acquired by petitioner, whether or not such

obligation was fixed, contingent, or even known at the time such

property was acquired, was not an ordinary and necessary business

expense.   Such payment is a capital expenditure that becomes part

of the cost basis of the acquired property regardless of what

would have been the tax character of the payment to the prior

owner.   See David R. Webb Co. v. Commissioner, 77 T.C. at 1137-

1138; see also Meredith Corp. & Subs. v. Commissioner, 102 T.C.

406, 454-455 (1994) (holding that the time at which a contingent

liability that is assumed in an asset acquisition is to be

capitalized occurs when the expense is incurred).

     We have considered all of the remaining arguments that have

been made by the parties for a result contrary to that expressed
                               - 16 -


herein, and, to the extent not discussed above, they are

irrelevant or without merit.

     To reflect the foregoing and the concessions of the parties,

                                         Decision will be entered

                                    under Rule 155.
