Megacorp, Inc Tax File Memorandum

July 17, 2013

TAX FILE MEMORANDUM

FROM: Faye Jackson

SUBJECT: MegaCorp, Inc. IRS Audit Notice

MegaCorp is seeking my help in determining the Internal Revenue's ruling that $5million paid to Ideas Inc. in the behalf of Little, Inc is to be classified as a capital expenditure and not a deduction.

FACT : MegaCorp purchased all of the assets of Little, Inc. Mega Corp also acquired some of Little's liabilities which included an alleged patent violation by Idea's Inc. Because of new ownership, MegaCorp agreed it would be legally responsible for any judgment that little would have to pay ideas. A jury awarded ideas $5million in damages for infringement. 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: According to the IRS tax code section 162(a) of the Tax Record Code 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 Tool Works 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, a 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 sates, "...our prior precedent states that there is a...