MegaCorp, Inc. purchased all of the assets of Little, Inc. As part of this acquisition, MegaCorp also acquired some of Little’s liabilities.

MegaCorp, Inc. purchased all of the assets of Little, Inc. As part of this acquisition, MegaCorp also acquired some of Little’s liabilities. In particular, Little was involved in a particularly nasty patent infringement case whereby another company (Ideas, Inc.) was alleging that Little had violated its patents and, therefore, owed that company a substantial amount of money. MegaCorp agreed that it would be legally responsible for any judgment that Little would have to pay Ideas in the lawsuit. As part of this process, the opinions of various experts determined that the likelihood that a significant contingent liability would arise from this obligation was quite remote (between 0% and 5%). Unfortunately for MegaCorp, a jury disagreed. After hearing evidence in the case, the jury concluded that Little did indeed infringe Ideas’ patent and awarded Ideas $5 million in damages. As agreed, MegaCorp paid Ideas the $5 million judgment and deducted this payment as an ordinary and necessary business expense under § 162. Upon audit, the IRS has disagreed with this characterization. The IRS reclassified the $5 million payment as a capital expenditure under § 263 and disallow the deduction. MegaCorp has come to you for advice. Is the IRS correct, or is MegaCorp entitled to the deduction?MegaCorp, Inc. purchased all of the assets of Little, Inc. As part of this acquisition, MegaCorp also acquired some of Little’s liabilities. In particular, Little was involved in a particularly nasty patent infringement case whereby another company (Ideas, Inc.) was alleging that Little had violated its patents and, therefore, owed that company a substantial amount of money. MegaCorp agreed that it would be legally responsible for any judgment that Little would have to pay Ideas in the lawsuit. As part of this process, the opinions of various experts determined that the likelihood that a significant contingent liability would arise from this obligation was quite remote (between 0% and 5%). Unfortunately for MegaCorp, a jury disagreed. After hearing evidence in the case, the jury concluded that Little did indeed infringe Ideas’ patent and awarded Ideas $5 million in damages. As agreed, MegaCorp paid Ideas the $5 million judgment and deducted this payment as an ordinary and necessary business expense under § 162. Upon audit, the IRS has disagreed with this characterization. The IRS reclassified the $5 million payment as a capital expenditure under § 263 and disallow the deduction. MegaCorp has come to you for advice. Is the IRS correct, or is MegaCorp entitled to the deduction?

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