Swygert, Chief Judge, Cummings, Circuit Judge, and Grant, District Judge.*fn1
This is a suit for refund of $382,353.12, representing taxes and interest which the Anchor Coupling Company, Inc. paid after the Commissioner of Internal Revenue disallowed a $600,000 deduction on taxpayer's federal income tax return for its fiscal year ending June 30, 1962. The issue is whether the district court correctly ruled that the $600,000 paid by taxpayer in settlement of litigation seeking specific performance of an alleged contract for the sale of Anchor's assets to the Borg-Warner Corporation was deductible as an ordinary and necessary business expense rather than a nondeductible capital expenditure. We hold that the $600,000 payment was a nondeductible capital expenditure and, therefore, reverse.
Anchor Coupling Company is an Illinois corporation having its principal office in Libertyville, Illinois. The founders of the company were Charles Conroy and Walter Fritsch. In 1956 Conroy and Fritsch owned approximately ninety per cent of Anchor's outstanding stock. Early in that year they entered into negotiations for the sale of Anchor's assets to Borg-Warner. On February 20 BorgWarner wrote Anchor setting forth a proposed agreement which gave BorgWarner a sixty-day option to purchase Anchor's assets. On February 29 Anchor replied, stating in substance that its assets could be purchased for $4,025,000, provided suitable assurance was given that Anchor's lower level executive personnel would be retained by Borg-Warner. The letter was characterized by the Illinois Supreme Court as a "counter offer."
Thereafter it became apparent that Borg-Warner intended upon consummation of the sale to reduce the salaries and responsibilities of certain executives and that some of the executives intended to seek employment elsewhere. As a result Conroy, over the opposition of Fritsch, decided to terminate the negotiations and to resist, by litigation if necessary, Borg-Warner's efforts to acquire Anchor's assets.
On November 3, 1956 Borg-Warner filed a complaint in the Circuit Court of Lake County, Illinois against Fritsch, Conroy, and Anchor, alleging that the intercompany correspondence between Anchor and Borg-Warner constituted a contract for the sale of Anchor's assets and seeking specific performance. In May 1957 the Circuit Court dismissed the complaint on the grounds that Borg-Warner failed to allege a completed contract and that the alleged negotiations, even if they constituted a contract, were unenforceable by reason of the statute of frauds. Borg-Warner filed an amended complaint which was dismissed on similar grounds. On appeal the Illinois Supreme Court reversed, holding that the amended complaint stated a cause of action and remanded the case for trial to determine whether the parties had entered into a binding contract. Borg-Warner Corp. v. Anchor Coupling Co., Inc., 16 Ill. 2d 234, 156 N.E. 2d 513 (1958).
Trial before the court commenced on May 24, 1961, but was adjourned for the summer after two days of testimony. On July 5, 1961 Fritsch died. His son, John, and William Funck, as executor of the estate, became representatives of the Fritsch interests in Anchor. Thereafter, Anchor contacted Borg-Warner concerning a possible settlement of the litigation. In October 1961 a settlement was reached. In return for relinquishing all claim to Anchor's assets and dismissing its suit, Borg-Warner received $1,000,000. As between the several representatives of the taxpayer, Conroy paid $150,000, the Fritsch estate $250,000, and Anchor $600,000.
Anchor deducted the $600,000 payment as an ordinary and necessary business expense on its federal income tax return for its fiscal year ending June 30, 1962. The Commissioner of Internal Revenue disallowed the deduction on the ground that the payment was a nondeductible capital expenditure. Anchor paid the tax and interest due as a result of the disallowed deduction and filed a claim for refund. The claim was disallowed, and the present suit followed.
The district court found that the pendency of the Borg-Warner litigation, from October 1956 to November 1961, had "an adverse effect upon plaintiff's [Anchor] day-to-day operations." Specifically the court determined that as a result of the litigation Anchor's sales and income "remained stagnant" and its competitive position "deteriorated" during a time of "rapidly increasing demand" when Anchor, because of the suit, "curtailed necessary expenditures." As a result the court concluded that:
Plaintiff's $600,000 payment to Borg-Warner was made in good faith and was reasonable in amount. The payment was made with a present business purpose to free plaintiff from the constraints imposed upon its business operations by the pendency of the litigation. The $600,000 payment in question bore a direct and proximate relationship to plaintiff's operations and to the production of income from such operations and was made to conserve and protect property held by plaintiff for the production and generation of income.
Accordingly, the court held that the payment to Borg-Warner of $600,000 was an ordinary and necessary business expense and ordered the Government to pay Anchor $382,353.12 plus interest from September 15, 1966. This appeal followed.
The only question in this appeal is whether the $600,000 settlement of the Borg-Warner litigation was an ordinary and necessary business expense deductible from current income under section 162(a)*fn2 of the Internal Revenue Code of 1954, or a nondeductible capital expenditure under section 263 of the Code.*fn3 In holding that the settlement payment was an ordinary and necessary business expense, the district court relied primarily upon two factors: (1) the effect of the Borg-Warner claim and litigation on Anchor's operations and the possible consequences of not settling the claim on taxpayer's business; and (2) Anchor's primary motivation in making the settlement was to avoid the consequences noted in (1) and to improve its earnings from current operations. Under the "primary purpose" test applied in previous cases these factors may be relevant in determining whether or not expenditures are deductible as payments made to protect ownership or to defend title to a capital asset. Rassenfoss v. Commissioner of Internal Revenue, 158 F.2d 764 (7th Cir. 1946); see generally, cases collected in 4A, J. Mertens, Law Of Federal Income Taxation §§ 25.24, 25A. 16 (1966 ed.). The Government urges that the primary purpose test is no longer the appropriate test in light of the Supreme Court's decisions in United States v. Gilmore, 372 U.S. 39, 83 S. Ct. 623, 9 L. Ed. 2d 570 (1963); Woodward v. Commissioner of Internal Revenue, 397 U.S. 572, 90 S. Ct. 1302, 25 L. Ed. 2d 577 (April 20, 1970); and United States v. Hilton Hotels Corp., 397 U.S. 580, 90 S. Ct. 1307, 25 L. Ed. 2d 585 (April 20, 1970). We agree and hold that the district court erred in considering the possible consequences of the failure to settle on Anchor's current operations and the taxpayer's motives in entering into the settlement.
In Gilmore the Supreme Court was asked to determine whether litigation expenses were deductible business expenses or nondeductible personal expenses. The taxpayer and his wife were engaged in a hotly contested divorce proceeding. The taxpayer believed that loss of the divorce proceeding would threaten his controlling stock interest in an auto dealership and, by damaging his reputation, would endanger his ability to renew his General Motors franchise. He, therefore, deducted over $40,000 in legal expenses as an ordinary and necessary business expense. The Commissioner denied the deduction, but the Court of Claims held that eighty per cent of the expenses were deductible as defending community property claims against the taxpayer's stockholdings. The Supreme Court reversed, holding that the Court of Claims had applied the wrong test in determining whether the legal expenses of the taxpayer were personal expenses or ordinary and necessary business expenses. The Court stated the proper test as follows: "The origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was 'business' or 'personal' and hence whether it is deductible or not under § 23(a)(2)." [Section 212 of the 1954 Code.] United States v. Gilmore, supra, 372 U.S. at 49, 83 S. Ct. at 629.
In the Woodward and Hilton Hotels cases the Court was asked to determine whether expenses in connection with appraisal litigation were capital expenditures incurred in the acquisition or disposition of a capital asset. In Woodward taxpayers controlled a majority of common stock in an Iowa publishing corporation. In 1960 the taxpayers voted their controlling shares in favor of perpetual extension of the corporate charter. Under Iowa law the majority shareholders were required to purchase the stock of shareholders who voted against renewal of the charter. The Eighth Circuit held that these expenses were nondeductible capital expenditures, Woodward v. Commissioner of Internal Revenue, 410 F.2d 313 (1969). The Hilton Hotels case concerned litigation expenses incurred pursuant to New York law in connection with the valuation of the shares of persons objecting to the merger of Hilton Hotels Corporation and Hotel Waldorf-Astoria Corporation. This court applied the primary purpose test announced in Rassenfoss v. Commissioner of Internal Revenue, 158 F.2d 764 (7th Cir. 1946), and held that "the proceeding was not necessary to the consummation of the merger nor did it function primarily to permit the acquisition of the objecting holders' shares," and ...