In September, the Tax Court issued its opinion in Cavallaro v. Commissioner, T.C. Memo 2014-189, holding that a merger of two family-owned businesses resulted in a $29.6 million gift from Mr. and Mrs. Cavallaro to their three sons.
Background
Mr. Cavallaro started a tool manufacturing company called Knight Tool Co. (“Knight”). Knight was co-owned by Mr. and Mrs. Cavallaro. As his sons became adults, all three were involved in the business. In the 1980s, Knight developed what turned out to be a valuable technology for applying liquids during the manufacturing process. In the late 1980s, the sons formed Camelot Systems, Inc. (“Camelot”), which would exclusively sell Knight’s products. The Cavallaro sons each owned one-third of Camelot.
In the mid-90s, due to the rise in value of the technology, Mr. and Mrs. Cavallaro sought estate planning advice. The Cavallaros sought advice from their CPA and an estate planning attorney. Both advisors separately recommended merging Knight and Camelot. After the merger, the Cavallaros would own the surviving company, with each shareholder’s ownership proportionate to his or her relative ownership and the value of the shares owned in Knight and Camelot, respectively.
In executing the merger, the estate planning attorney determined that the primary asset of the companies, the liquid-dispensing technology, was owned by Camelot, despite the lack of evidence to support this claim. With a couple of minor exceptions, the technology was treated as owned by Knight: Knight claimed R&D credits related to the technology, Knight paid the salaries of the employees who developed the technology, Knight registered the trademarks related to the technology, and Knight was the designated assignee for the technology on related patent applications.
Notwithstanding the historical treatment of the technology, the estate planning attorney determined that when Camelot was formed and Mr. Cavallaro ceremoniously handed over the books of Camelot to his sons, this act conferred the technology and all related improvements to the technology to Camelot. At the time of the merger, affidavits and a “Confirmatory Bill of Sale” were executed to support this position.
Based on the position of the estate planning attorney, an appraisal was performed which assigned a value to the post-merger company and to Knight and Camelot premerger, for purposes of determining each individual’s ownership in the post-merger company. The post-merger company was valued at $75 million, with Knight being assigned a value of $15 million and Camelot being assigned a value of $60 million based on the fact that Camelot owned the liquid dispensing technology. As a result, the sons were granted an 81% ownership in the post-merger company and Mr. and Mrs. Cavallaro owned 19% of the post-merger company.
The merger occurred in 1995. In January 1998, the IRS opened an audit of Knight and Camelot, and in February the IRS opened a gift tax audit of the Cavallaros for the 1995 tax year. In July 2005, the Cavallaros filed gift tax returns for the 1995 tax year, reporting no taxable gifts and no gift tax liability. In November 2010, the IRS issued its notice of deficiency to the Cavallaros, asserting a $12.9 million gift tax liability based on its determination that, at the time of the merger, Camelot had zero value. The notice of deficiency also asserted failure to file and fraud penalties.
The Tax Court Opinion
Due to the lack of evidence supporting the position that Camelot owned the liquid-dispensing technology, the Tax Court concluded that Camelot did not own the technology and therefore the Cavallaros’ appraisals based on this premise were disregarded in their entirety. Because the appraisal reports were disregarded, the Cavallaros did not meet their burden on the valuation issue. As a result, the IRS expert’s report, which valued the post-merger company at $64.5 million (approximately $10 million lower than the taxpayers’ report) was accepted, with 65% of the post-merger company value attributed to Knight and 35% of the post-merger company value assigned to Camelot. Based on this valuation, the difference between the value of 81% of the post-merger company that the sons received (81% x $64.5 million, or $52.2 million) and the premerger value of Camelot (35% x $64.5 million, or $22.6 million) resulted in total taxable gifts of $29.6 million. The fraud penalty was conceded by the IRS prior to trial. The Tax Court excused the failure-to-file penalty and the accuracy-related penalty (which was asserted by the IRS after the fraud penalty was conceded), concluding that Mr. and Mrs. Cavallaro reasonably relied on their advisors and therefore had reasonable cause.
We can wonder why the Cavallaros did not submit an appraisal based on the premise that Knight owned the technology. It could be that the IRS expert’s report was as favorable an outcome as the Cavallaros could hope for and, therefore, they strategically decided not to submit their own appraisal based on this assumption. What we do know, given the outcome of this case, is that if an assumption as to asset ownership is not supported by corporate and legal formalities, the appraisal will bear little weight with the Tax Court.