I am writing this memorandum on behalf of my client, Robin Inc. regarding the issue of the amount of ordinary and business expenses reported on my client’s income tax return. My client recently acquired all the assets and gained certain liabilities from Sparrow Inc. during the taxable year. The plaintiff, Sparrow Inc. filed a lawsuit claim in court against my client for patent infringement. A trial was conducted and the jury awarded a judgment of $5 million for nonphysical compensatory damages. My client has agreed to be legally responsible for this claim. At the end of the taxable year, my client deducted the amount of $5 million as an ordinary and business expense. The Internal Revenue Service (IRS) completed an audit on my client’s tax return and found that the payment of $5 million should be reallocated as a capital expenditure.
Issues concerning the tax case explained above are as follows:
(1) Whether the amount of $5 million paid by my client to the plaintiff, which are claimed by my client to be deductible as an ordinary and necessary business expense.
(2) Or whether the payment is a non-deductible capital expenditure incurred by my client in regards to the sale of Sparrow’s assets and certain liabilities to my client under Section 263 of the Internal Revenue Service (IRS).
Analysis of the tax case:
The Internal Revenue Service (IRS) reported that my client incorrectly computed the payment of $5 million as an ordinary and necessary business expense for the following reasons. Section 263(a) of the current Internal Revenue Service (IRS) law states that certain direct and indirect costs are non-deductible. Under Section 263A(a)(1)(B) in general, explains that in the case of any other property, which is in the hands of the taxpayer, shall be capitalized. As in my client’s tax case, this law requires that the property that my client acquired, that is, the patent rights in the hands of my client, should be accounted for as a capital expenditure expense and not a deduction for my client’s tax return.
The Federal tax regulation of Section 1.263(a)-4 also provides rules for applying Section 263(a) to amounts paid to acquire or create intangibles. In Section 1.263(a)-4(c), a taxpayer must capitalize amounts paid to another party to acquire any intangible from that party in a purchase or similar transaction. This transaction occurred in a trial when the jury declared that my client was in fact responsible for patent infringement and was charged with the payment amount of $5 million. The other party, which was Sparrow Inc., received the amount from my client to acquire the intangible patent rights. The IRS requires that my client capitalize this amount in the income tax return. Though these IRS non-deductible capital expenditure regulations may apply to this tax case, my client will determine that this payment of $5 million is a deductible as a business expense.
The expenses that my client incurred were related to a business activity after its acquisition of Sparrow Inc.’s assets and certain liabilities. Most of these expenses were contributed for the use of my client’s business property. My client’s intention was to gain profit and to produce income for the business. Under Section 162(a), my client is allowed to deduct all ordinary and necessary business expenses paid or incurred during the taxable year. This includes payments made as a condition to continue the use for business purposes. Like in every corporation, a company is subject to possession of intangible assets in order for the business to operate smoothly. In this case, my client’s business expense would be considered neither necessary nor