Lessons to be learned by Valuators from Cavallaro v. Commissioner
Cavallaro v. Commissioner holds some valuable lessons for valuation experts. Following a tax-free merger of two companies owned between different family members, the children of the petitioners (and owners of one of the companies, pre-merger) received 81 percent of the stock in the merged entity. Differences arose between one set of accountants and Hale & Dorr, the law firm that assisted the founders with estate planning. The key issue was whether valuable technology was owned by the company controlled by the parents or the company owned by the children. The U.S. Tax Court found that the parentsâ€™ company owned the technology and concluded that the share allocation was disproportionate and that a gift tax return should have been filed following the merger. Further, the court found that despite not having filed a gift tax return, the parents were not liable for the IRC Â§6651 additions or accuracy-related penalties under IRC Â§6662 because they followed professional advice.
The Tax Court in T.C. Memo 2014-189, filed September 17, 2014, styled William Cavallaro, Donor, Petitioner v. Commissioner of the Internal Revenue, Respondent and Patricia Cavallaro, Donor, Petitioner v. Commissioner of Internal Revenue, Respondent handed the taxpayers a large loss.
The primary issues before the court were one, whether an IRS notice of deficiency, alleging a transfer by gift to the sons of the petitioners, should be upheld; and two, whether a merger valuation in which the sons received 81 percent of the stock based on a valuation should be respected. If a gift occurred, the court also had to decide whether penalties applied for non-filing of the gift tax return.
Taxpayers William and Patricia Cavallaro started their own business in1976 calling it Knight Tool Co. (hereinafter â€śKnightâ€ť), which they later incorporated in1979. Knightâ€™s primary business was to design and build tools under contract from customers.
Taxpayers wanted to diversify their business to include manufacturing of their own products to become less dependent on tool design. In 1982, the petitioners, along with their eldest son, developed a liquid dispensing machine for use in manufacturing that later would be used by companies manufacturing computer circuit boards, calling the machine CAM/ALOT.
Taxpayers William and Patricia Cavallaro did not attend college or have formal business training. Yet they relied on attorneys and accountantsâ€”including a Big 4 accounting firmâ€”for advice on legal and accounting matters, the court concluded.
In testimony, petitioners said the development cost of CAM/ALOT caused Knight to go into debt and that Patricia Cavallaro insisted Knight return to toolmaking and â€ścall it quits on CAM/A LOT.â€ť
In 1987, the three sons formed a new corporation with their parentsâ€™ permission calling it â€śCamelot Systems, Inc.â€ť The purpose of this new entity was to continue work on CAM/A LOT and to manage sales of the machine. They invested $1,000 in the new corporation, but Knight continued paying the salaries and providing access to engineers for development of the CAM/ALOT. â€śCamelot had no employees from 1987 to 1995.â€ť The sons were ages 23 to 26 at the time of incorporation and were not â€śengineers, inventors or machinistsâ€ť per the court.
Per the U.S. Tax Court record, petitioners consulted accountants and attorneys in late 1994 about their estate plan and concluded there was significant exposure to estate taxes under the then values, particularly the business value. The accountants for Knight thought that the CAM/A LOT technology was owned by Knight, not Camelot.
On December 31, 1995, Knight and Camelot merged in a tax-free merger with shareholdersâ€”the children in Camelot were allocated 81 percent of the resulting company using a valuation prepared by Ernst and Young using a market-based approach and based on affadavits and a â€śConfirmatory Bill of Saleâ€ť document from a Hale & Dorr partner, Louis Hamel, asserting that the technology had been transferred to Camelot in 1987.
The U.S. Tax Court quoted a Knight accountant that took issue with the Hale & Dorr affidavits. This accountant replied to Hale & Dorr, stating in part that â€ś[h]istory does not formulate itself, the historian has to give it form without being discouraged by having to squeeze a few embarrassing facts into the suitcase by force.â€ť According to the court, the embarrassing fact in this case is that Knight owned the technology, not Camelot.
The issue for the valuator is difficult since we, as valuators, rely on attorneys to establish legal title. We are not, in general, attorneys and do not practice law. Still, our objectivity standards require us to raise issues of fact if material to our valuation. The court stated â€ś[t]he accountants initially objected to Mr. Hamelâ€™s proposal that the CAM/A LOT technology had been transferred in1987. They explained that Mr. Hamelâ€™s idea was at odds with all the evidence and that it was at odds with Knightâ€™s recent amended returns claiming R&D credits for the engineering work on the CAM/A LOT machine.â€ť
The court concluded taxpayers made a $29.6 million dollar gift to their sons when they made a disproportionate allocation of the shares in the merged entity. This disproportionate allocation meant that the parents had made a gift and should have filed a gift tax return. This fact did remove the proposed accuracy related penalty, saying the taxpayers relied on tax professionals.
As business valuators, we must consider indirect gifts when valuing mergers of family owned enterprises.
To read the case, click here.
Joseph D. Brophy, MBA, CPA/ABV, CVA, ABAR, CM&AA, is a former member of the AICPA IRS Practice and Procedures Committee and former chair of the Texas Society of CPAsâ€™ Relations with the IRS Committee. He is frequent writer for tax and valuation publications. He can be reached at email@example.com or (214) 522-3722.