Merger of family businesses results in gift tax

By Laura Jean Kreissl, Ph.D., and Darlene Pulliam, CPA, Ph.D.

Penalties are denied upon the taxpayers’ showing of reasonable-cause reliance on professionals.

The Tax Court held that a merger of a family’s two businesses resulted in a $29.6 million transfer from the parents to their three sons and a gift tax deficiency. However, the court denied failure-to-file penalties on the gift due to the taxpayers’ reliance on a “competent professional.”

Facts: In 1979, William and Patricia Cavallaro started Knight Tool Co., a contract manufacturing firm that developed and held trademark and patent applications for a machine for use in manufacturing electronic circuit boards. In 1987, their three sons incorporated Camelot Systems Inc. to market and sell the machines. The companies operated out of the same building, shared payroll and accounting services, and collaborated in further development of the machine. Knight funded the operations of both companies. In 1992, while providing tax advice, an accounting firm determined the machine’s technology belonged to Knight.

In 1994, the parents sought estate planning advice from an attorney who advised that the value of the machine’s technology belonged to Camelot, based on William Cavallaro’s handing his eldest son a minute book for Camelot at the company’s formation meeting and saying, “Take it; it’s yours.” The accountants then prepared amended returns for both Camelot and Knight disclaiming R&D tax credits taken by Knight for development of the machine and claiming them for Camelot.

In 1995, the two companies merged, with Camelot as the surviving entity. The accountants proposed valuing the combined entity at between $70 million and $75 million, with Knight’s portion valued at $13 million to $15 million. Following professionals’ valuation advice, the Cavallaros accepted a disproportionately low number of shares for the new company, and their sons accepted a disproportionately high number of shares. In 1996, an outside company, Cookson America Inc., purchased the merged company for $57 million. On the basis of stock ownership, the Cavallaros received $10.8 million, and their sons each received $15.39 million.

Issue: In 1998, the IRS opened a gift tax examination of the merger transaction and concluded that the Cavallaros had transferred Knight’s property to their sons for less than adequate value and the merger was not a bona fide transaction made at arm’s length and free from donative intent. In 2010, the IRS issued statutory notices of deficiency to the Cavallaros for 1995, determining that premerger Camelot had zero value and that they had made a taxable gift of $46.2 million to their sons in the merger. Also, the IRS determined additions for failure to file timely gift tax returns (Sec. 6651(a)(1)).

Holding: Based on an IRS expert’s valuation, the Tax Court redetermined the gift amount as $29.6 million. However, the court agreed that the Cavallaros made the requisite showing of reasonable cause and denied the failure-to-file and accuracy-related penalties. The Cavallaros had no advanced education and in good faith relied upon advisers who were competent professionals with sufficient expertise to justify reliance. There was no evidence that they provided any false or incomplete information to the advisers.

By Laura Jean Kreissl, Ph.D., associate professor of accounting, the School of Business and Economics, Thompson Rivers University, Kamloops, British Columbia, Canada, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, the College of Business, West Texas A&M University, Canyon, Texas.

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