Upon remand from the First Circuit, the Tax Court held that a disguised gift originally was valued incorrectly and deducted $6.9 million from the original valuation.
Facts: William and Patricia Cavallaro founded Knight Tool Co. Inc. (Knight) in 1979 as a machine shop and contract manufacturer. Their three sons worked in the family business at various times. The company developed a liquid-adhesive dispensing machine prototype that they named CAM/ALOT. The three sons later started their own company called Camelot Systems Inc. (Camelot). The arrangement between the two companies was that Knight would manufacture the CAM/ALOT machines and Camelot would sell them. In 1994, the Cavallaros and their sons decided to merge the two companies.
Issues: The Cavallaro family hired a law firm and accounting firm to advise them on the merger. The law firm insisted that the valuation be prepared on the basis that Camelot, not Knight, owned the CAM/ALOT technology. Upon this foundation, the accounting firm valued the merged company as worth between $70 million and $75 million. Post-merger, William and Patricia Cavallaro owned 19% of the new company, and their sons each owned 27%. The Cavallaros did not file gift tax returns, on the basis that this transaction was a bona fide sale.
In 1998, the IRS opened an examination of Knight's and Camelot's 1994 and 1995 income tax returns. The IRS determined that the merger of the two companies constituted a disguised gift and thus warranted a gift tax examination. In 2005, the Cavallaros each filed gift tax returns for the 1995 tax year that showed no taxable gifts and no gift tax liability. The IRS conducted a gift tax examination and made drastic revaluations to the two companies. The IRS determined that Knight — not Camelot — owned the CAM/ALOT technology. Upon this conclusion, the IRS performed its own valuation and determined that William and Patricia each had made taxable gifts of more than $23 million to their sons, which resulted in corresponding gift tax liabilities.
In the original 2014 ruling, the Tax Court found that Knight owned the CAM/ALOT technology but that the Cavallaros had the burden of proof on the valuation issue. However, the Cavallaros did not present any evidence of the values of the corporation and had only argued that the IRS's valuation was fatally flawed, so they did not meet their burden of proof. Thus, the court accepted the IRS's revaluation of the taxable gifts as $14,538,300 for William Cavallaro and $15,131,700 for Patricia Cavallaro — for a total of $29,670,000 (Cavallaro, T.C. Memo. 2014-189; see also "Tax Matters: Merger of Family Businesses Results in Gift Tax," JofA, Feb. 2015).
The Cavallaros appealed the Tax Court's decision to the First Circuit, which affirmed the Tax Court's findings in all matters except one. The First Circuit held that the Tax Court made errors regarding the Cavallaros' burden of proof on the issue of valuation. The Tax Court should have considered the Cavallaros' arguments about the flaws in that valuation, the First Circuit held. The First Circuit therefore remanded the case to the Tax Court to consider arguments regarding the valuation of Knight and Camelot (Cavallaro, 842 F.3d 16 (1st Cir. 2016)).
Holding: Upon remand, the Tax Court rejected all of the Cavallaros' arguments regarding the valuation of the two companies except for one. Part of the valuation included normalizing the profits between Knight and Camelot, which necessitated a profit margin calculation. The IRS's profit margin calculation put both Knight and Camelot in the 90th percentile for all distributors in their industry. The Cavallaros argued that the method the IRS used to compute this percentile was not statistically reliable. The recalculation performed by the Cavallaros, accepted by the Tax Court, put Camelot in the 88.3rd percentile and not the 90th percentile. This seemingly small error had a big impact on the valuation of the taxable gifts. The new calculation reduced the total value of the taxable gifts by $6,879,640, from $29,670,000 to less than $22.8 million.
- Cavallaro, T.C. Memo. 2019-144
— By Stuart M. Friedman, CPA, partner, and David R. Silversmith, CPA, CFP, CFE, tax manager, both of Crowe LLP.