Gift Arose from Merger of Family's Corporations; Case Remanded to Consider Challenges to IRS Valuation

(Parker Tax Publishing December 2016)

The First Circuit affirmed the Tax Court's determination that an IRS notice of deficiency assessing gift taxes from the merger of the taxpayers' corporation with their sons' was not arbitrary, despite the IRS's initial failure to appraise the corporations. However, the court held the Tax Court erred in accepting the IRS's valuation of the corporations without first allowing the taxpayers an opportunity to challenge the valuation. Cavallaro v. Comm'r, 2016 PTC 486 (1st Cir. 2016).

Background

In 1979, William and Patricia Cavallaro started Knight Tool Co. (Knight), a contract manufacturing company that made custom tools and machine parts. In 1982, Knight deviated from its traditional business and developed a liquid-dispensing system for adhesives called CAM/ALOT. Although Knight invested substantial resources in CAM/ALOT's development, the product had significant flaws, and profits failed to outpace production costs. As a result, the

Cavallaros decided to refocus on their core business. Their son, Ken, however, continued to believe in the CAM/ALOT technology and along with his two brothers, Paul and James, organized a new corporation, Camelot Systems, Inc. (Camelot), to further develop it.

Everyone who worked on CAM/ALOT systems after Camelot's incorporation, including Ken, remained on the Knight payroll and received all their wages from Knight. In addition, Knight manufactured the CAM/ALOT systems, while Camelot sold and distributed them to third parties.

Camelot also did not have its own bank accounts and, with minor exceptions, Camelot's bills were paid using Knight's funds.

In 1994, the Cavallaros hired both accountants and lawyers to review their estate plan. There was significant friction between these two groups of advisers; the lawyers wanted the Cavallaros to claim that the value of the CAM/ALOT technology was vested in Camelot - and so was already owned by Ken, Paul, and James - whereas the accountants objected to this proposal because it was at odds with the overwhelming evidence that Knight owned the technology and always had. The lawyers' view prevailed, and both groups of professionals suggested that a 1987 transfer of the CAM/ALOT technology be memorialized in affidavits and a confirmatory bill of sale. Members of the Cavallaro family signed these documents in May 1995.

Knight and Camelot subsequently prepared to merge. As part of their preparations, the Cavallaros hired accountant Timothy Maio to determine the respective values of the two companies. Using a market-based approach, Maio valued the proposed combined entity at $70-$75 million and valued Knight's portion at just $13-$15 million. Maio assumed that Camelot owned the CAM/ALOT technology and that Knight was a contractor for Camelot. On December 31, 1995, Knight and Camelot merged in a tax-free merger that left Camelot as the surviving corporation.

In 1998, the IRS opened an examination of Knight's and Camelot's 1994 and 1995 income tax returns, during which the IRS identified a possible gift tax issue in connection with the 1995 merger. The IRS determined - without first having obtained an appraisal - that Camelot had a pre-merger value of $0, and that when Knight merged with Camelot, William and Patricia Cavallaro each made a taxable gift of $23,085,000 to their sons. As a result, the IRS determined each of the Cavallaros incurred an increase in tax liability in the amount of $12,696,750. The IRS also imposed additions to tax for failure to file gift tax returns and fraud penalties. The Cavallaros took their case to the Tax Court.

Tax Court's Analysis

Before the Tax Court, the IRS disclosed that - after the notices of deficiency were issued - it directed accountant Marc Bello to appraise the value of both Knight and Camelot at the time of the merger. Working under the assumption that Knight rather than Camelot owned the CAM/ALOT technology, Bello valued the combined entities at approximately $64.5 million, concluding that Camelot was worth $22.6 million. Because the deficiencies would therefore be lower than those set forth in the original notices, the Cavallaros used the Bello report to argue that the original notices of deficiency were arbitrary and excessive. While noting that it was true that the IRS did not obtain an appraisal before issuing the notices of deficiency, the Tax Court held that there was a sufficient basis for issuing the notices and, thus, that they were not arbitrary.

The Tax Court ultimately concluded that the Cavallaros were deficient in paying the gift tax due for calendar year 1995: William owed $7,652,980 and Patricia owed $8,009,020. The court also determined that no penalties for underpayment were due and that there were no additions to tax due for failure to file a gift tax return because the taxpayers disclosed all the relevant facts regarding Knight and Camelot to their experienced accountants and estate-planning attorneys and followed their advice in good faith. The taxpayers appealed the decision to the First Circuit.

First Circuit's Analysis

On appeal, the Cavallaros renewed their argument that the Tax Court erred in not finding that the original notices of deficiency were arbitrary and excessive. In addition, they argued that the Tax Court improperly concluded that Knight owned all of the CAM/ALOT-related technology, and that the court erred by failing to consider alleged flaws in Bello's valuation of the two companies.

The First Circuit noted the IRS's original deficiency notices assumed that, premerger, Camelot had no value. According to the Cavallaros, the IRS's later realignment with the Bello valuation established that the IRS used no formula and lacked any support at all for that initial $0 valuation; thus, the couple argued that the IRS's assessment was without rational foundation and was excessive. However, the court remarked, the IRS had discovered - prior to issuing the original notices of deficiency - that the Cavallaros had followed the advice of an estate-planning lawyer, Hamel, who advocated disregarding or suppressing facts showing that Knight owned the CAM/ALOT technology in order to memorialize technology transfers financially advantageous to the Cavallaro family. That, the court stated, together with related documents, was a sufficient basis for concluding that Camelot's value was de minimis. Accordingly, the circuit court held that the original deficiency notices were not arbitrary and excessive.

The Cavallaros also challenged the Tax Court's finding that Knight owned all of the CAM/ALOT technology, but the court determined that the record supported the Tax Court's determinations. The court noted that Knight created the first CAM/ALOT system, and, even after Camelot's incorporation, the companies' financial affairs overlapped significantly. Further, the court said, The CAM/ALOT trademark was registered to Knight until the day of the merger, and four patent applications, each filed by William, identified Knight - not Camelot - as his assignee. The court held that the Cavallaros advanced no argument that would warrant overturning the Tax Court's finding that Knight owned all of the CAM/ALOT technology at the time of the merger.

Lastly, the court observed that in challenging the valuation provided by Bello and relied upon by the Tax Court, the Cavallaros argued that the Tax Court erred when it refused to consider their evidence that the Bello valuation was flawed. The Cavallaros attempted to show that the IRS' valuation was arbitrary and excessive by challenging Bello's methodology, but the Tax Court refused to hear those challenges on the grounds that, even if the Cavallaros were right, they could not show the correct amount of their tax liability. The court determined that the Cavallaros should have had the opportunity to rebut the Bello report and to show that the IRS' assessment was "arbitrary and excessive." If they had succeeded in doing so, the court said, the Tax Court should have then determined for itself the correct amount of tax liability rather than simply adopting the IRS's assessment, as it had done. Accordingly, the First Circuit remanded the case so that the Tax Court could evaluate the Cavallaros' arguments that the Bello valuation had methodological flaws that made it arbitrary and excessive.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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