T.C. Memo. 2014-189
UNITED STATES TAX COURT
WILLIAM CAVALLARO, DONOR, Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent
PATRICIA CAVALLARO, DONOR, Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent
Docket Nos. 3300-11, 3354-11. Filed September 17, 2014.
In 1979 Ps started Knight Tool Co. (“Knight”), a contract
manufacturing company that made tools and machine parts. In 1982
P-H and Ps’ eldest son developed an automated liquid-dispensing
machine they called CAM/ALOT. In 1987 Ps’ three sons
incorporated Camelot Systems, Inc. (“Camelot”), a business dedicated
to the selling of the CAM/ALOT machines made by Knight. The two
companies operated out of the same building, shared payroll and
accounting services, and collaborated in further development of the
CAM/ALOT product line. Knight funded the operations of both
companies and paid the salaries and overhead costs for both.
In 1994 Ps sought estate planning advice. The professionals
they consulted advised Ps that the value of the CAM/ALOT
technology resided in Camelot (the sons’ company) and not in Knight
(the parents’ company) and that they should adjust their estate
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[*2] planning accordingly. Ps and their sons merged Knight and
Camelot in 1995, and Camelot was the surviving entity. Valuing the
two companies in accordance with the advice their professionals had
given, Ps accepted a disproportionately low number of shares in the
new company and their sons received a disproportionately high
number of shares.
After examining the merger, R issued notices of deficiency to
Ps determining for each a gift tax liability and an I.R.C. sec. 6651
failure-to-file addition to tax (as well as an I.R.C. sec. 6663 fraud
penalty that R eventually conceded). Ps timely petitioned this Court
for redetermination. Respondent later conceded the fraud penalties
and asserted, in the alternative, accuracy-related penalties under
I.R.C. sec. 6662(a).
Held: The Camelot shares that Ps received in the merger in
exchange for their shares of Knight were not full and adequate
consideration; therefore, in 1995 Ps made a $29.6 million gift to their
sons.
Held, further, because they followed professional advice, Ps
had reasonable cause for failing to timely file gift tax returns and are
not liable for the I.R.C. sec. 6651 additions to tax, and Ps likewise
had reasonable cause for their underpayments of gift tax and are not
liable for I.R.C. sec. 6662 accuracy-related penalties.
Andrew Good, Phillip Cormier, and Edward DeFranceschi, for petitioners.
Carina J. Campobasso and Derek W. Kelley, for respondent.
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[*3] CONTENTS
FINDINGS OF FACT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Petitioners’ backgrounds.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Formation of Knight Tool Co. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Development of the liquid-dispensing machine. . . . . . . . . . . . . . . . . . . . . . . 9
Incorporation of Camelot Systems, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Continuation of CAM/ALOT production. . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Relationship between Knight and Camelot. . . . . . . . . . . . . . . . . . . . . . . . . 16
Allocation of income and expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Ownership of CAM/ALOT technology. . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
The accountants’ early consideration of merger.. . . . . . . . . . . . . . . . . . . . . 25
Different advice from the lawyers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Falling into line. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Later consideration of merger. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Merger on December 31, 1995. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Sale to Cookson America, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
The IRS’s examination and notices of deficiency. . . . . . . . . . . . . . . . . . . . 35
Petitioners’ experts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
The Commissioner’s expert. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Petitioners’ critiques of the Commissioner’s expert.. . . . . . . . . . . . . . . . . . 43
OPINION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
I. Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
II. Burden of proof. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
A. “New matter”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
1. New matter relating to liability for tax . . . . . . . . . . . . . . . . . . 47
2. New matter relating to liability for penalty . . . . . . . . . . . . . . .49
B. “[E]xcessive and arbitrary”.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
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[*4] III. Gift tax liability.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
A. General gift tax principles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
B. Lack of arm’s-length character. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
C. Company valuations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
IV. Failure-to-file additions to tax under section 6651(a)(1) and
accuracy-related penalties under section 6662. . . . . . . . . . . . . . . . . . . . . . . 61
A. Applicability of failure-to-file additions to tax. . . . . . . . . . . . . . . . . 62
B. Applicability of accuracy-related penalties. . . . . . . . . . . . . . . . . . . . 62
C. Reasonable cause defenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
1. Reasonable cause for failure to file. . . . . . . . . . . . . . . . . . . . . 64
2. Reasonable cause for the underpayment. . . . . . . . . . . . . . . . . 65
3. The Cavallaros’ reliance on professional advice. . . . . . . . . . . 66
MEMORANDUM FINDINGS OF FACT AND OPINION
GUSTAFSON, Judge: By statutory notices of deficiency dated
November 18, 2010, the Internal Revenue Service (“IRS”) determined for each of
petitioners William and Patricia Cavallaro a deficiency in the Federal gift tax for
the year 1995, plus an addition to tax under section 6651(a) for failure to file a gift
tax return and a fraud penalty under section 6663.1 As an alternative to the fraud
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code (26 U.S.C., “the Code”) in effect for the year at issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure. Some of the
amounts stated in this opinion have been rounded. These consolidated cases
(continued...)
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[*5] penalties, respondent, the Commissioner of the IRS, asserted in his answers
accuracy-related penalties under section 6662. The Commissioner conceded the
fraud penalty after trial, and the issues remaining for decision are:
(1) whether the 19% interest Mr. and Mrs. Cavallaro received in Camelot
Systems, Inc., in 1995 in exchange for their shares of Knight Tool Co., Inc., in a
tax-free merger was full and adequate consideration (we find that it was not), and,
if not, how much excess value was conferred on their sons through the merger as a
taxable gift (we find that there was a gift in the total amount of $29.6 million);
(2) whether Mr. and Mrs. Cavallaro are liable for additions to tax under
section 6651(a)(1) for failure to file gift tax returns for 1995, or whether instead
the failure to file was due to “reasonable cause” (we find that petitioners had
reasonable cause for that failure); and
(3) whether there are underpayments of gift tax attributable to a gift tax
valuation understatement for purposes of the accuracy-related penalty imposed by
section 6662, and, if so, whether any portions of the underpayments were
1
(...continued)
involve separate liabilities for each petitioner, but the issues are the same in each
case. We therefore decide them in tandem, and each petitioner will owe his or her
share of the gift tax liability in proportion to his or her ownership in Knight Tool
Co., Inc.,--i.e., 49% for Mr. Cavallaro and 51% for Mrs. Cavallaro.
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[*6] attributable to “reasonable cause” under section 6664(c) (we find a gross gift
tax valuation understatement for which there was reasonable cause).
For the reasons explained hereafter, we will sustain the determinations of
liability for gift tax (though in amounts less than the IRS determined in the notices
of deficiency); and because we find reasonable cause and good faith on the part of
the Cavallaros, we will not sustain the IRS’s determinations as to the
accuracy-related penalties and the failure-to-file additions to tax.
FINDINGS OF FACT
At the time they filed their petitions, the Cavallaros resided in New
Hampshire.
Petitioners’ backgrounds
Mr. Cavallaro’s background and occupation was that of a toolmaker. He
finished school through eighth grade, attended ninth grade in which he had some
difficulty, and transferred to the Haverhill Trade School Machine Shop program,
from which he graduated in 1957. He is able to read, but he does so with
difficulty; at trial he benefited from having documents read aloud to him.
Mr. Cavallaro never attended college or obtained a post-high-school degree.
During trade school Mr. Cavallaro began working part time as a janitor at
Northeastern Tool Co. After graduating, he continued working there as an
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[*7] apprentice, and he worked his way up to production manager. Other than his
own businesses discussed hereafter, Mr. Cavallaro never worked at any other
business.
Mrs. Cavallaro graduated from Haverhill High School in 1958. She
attended a year of secretarial courses at college but did not obtain a post-high-
school degree. She did clerical work for Bell Labs in North Andover for about a
year. The Cavallaros were married in 1960, and at that time Mrs. Cavallaro
stopped working outside her home.
Formation of Knight Tool Co.
In 1976 Mr. and Mrs. Cavallaro met around their kitchen table with their
sons, Ken (then age 15), Paul (13), and James (12), and informed their sons that
they had decided to go into business for themselves. In that year Mr. Cavallaro
left Northeastern Tool Co., and he and Mrs. Cavallaro started Knight Tool Co.,
which they co-owned. In 1979 they incorporated Knight Tool Co., Inc.
(“Knight”). Mr. Cavallaro owned 49% of Knight’s stock, and Mrs. Cavallaro
owned 51%. In 1993, Knight elected S corporation status.
Knight was a machine shop, and its early years were dedicated to
manufacturing tools and parts that were used by other companies in the assembly
of their own products. Knight was thus a contract manufacturer, and its principal
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[*8] customers were defense, aerospace, and industrial companies. Knight’s work
included typical contract jobs in which the customer provided plans and
specifications, as well as “design and build” work.
Mr. Cavallaro’s principal work was making and selling the products of the
tool business. He led the manufacturing operations at Knight, including entering
the competitive bidding process for various jobs, supervising employees during all
phases of production, and working with a team of engineers to design particular
machines. Mrs. Cavallaro learned how to handle the paperwork, the money, and
the phones. She paid the bills and prepared original-entry journals of their receipts
and expenses, and she handed those over to an accountant who prepared their
financial statements and tax returns. Though she had no formal training as an
accountant or bookkeeper, she contributed her services in that role for many years.
The Cavallaros’ three sons also worked in the family business--part time
when they were in school, and eventually full time. Ken Cavallaro graduated from
college in 1983 with a degree in marketing and management and then began
working at Knight full time. Paul Cavallaro graduated from college in 1985 with a
degree in finance, worked for a bank for about three years, and returned to Knight
in 1988. James Cavallaro graduated from high school in 1982 and then began
working full time at Knight as an apprentice machinist.
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[*9] Development of the liquid-dispensing machine
The nature of Knight’s work was to build a single custom tool at the request
of a customer. That is, Knight was not a manufacturing operation with an
assembly line. After about five years in operation, Knight began to feel the
financial pressures associated with the cyclical nature of customer-dependent
contract manufacturing and job shop work. Mr. and Mrs. Cavallaro sought outside
funding from various sources, and they began looking for ways to break out of the
contract manufacturing mold. Mr. Cavallaro envisioned Knight developing its
own product that could be sold regularly.
By this time Ken Cavallaro was working full time for Knight in a sales and
marketing role. On one occasion when Mr. Cavallaro and Ken visited a potential
customer, they observed an opportunity. They saw an operation for the production
of computer circuit boards, in which workers engaged in a messy and unreliable
process of manually squirting liquid adhesive from tubes shaped like ketchup
bottles in order to attach parts to the boards. The Cavallaros thought that a
computerized machine could be devised to do this process neatly and repetitively,
and that Knight might be able to mass-produce such a machine.
In 1982 Knight engineers and employees collaborated with Mr. Cavallaro
and Ken Cavallaro to create the first liquid-dispensing machine prototypes for use
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[*10] in through-hole mounting schemes. Knight began selling the machine under
the name “CAM/ALOT”, invoking the acronym for “computer assisted machine”
and reflecting the hope that it would be used “a lot”. Knight invested substantial
time and attention into the machine--so much so that this activity was undertaken
at the expense of Knight’s traditional business. In its early versions, the machine
had a relatively unstable cantilevered arm for dispensing the glue; it could move
only along the X and Y axes; it used a stepper motor incapable of making a
perfectly smooth arc; and it employed legacy Apple computer technology and
software that was not easy to program.
In 1986 Knight hired Salesmark, a sales and marketing consulting company,
to advise it how best to market and sell the CAM/ALOT machines. The Salesmark
report confirmed the weaknesses present in the CAM/ALOT liquid-dispensing
machine technology; however, its conclusion was that “Knight Tool Company
appears to have what every job shop firm covets--a viable product!” Though
Knight was able to sell some of the early CAM/ALOT models, profit from sales
was not outpacing the cost of production, and the machine’s recognizable flaws
needed correction before the idea would be a sustainable revenue-producing
product for Knight. Because Knight had spent a significant sum on the
development of the CAM/ALOT product, the company needed either a vital
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[*11] infusion of capital or a change in corporate structure (which would facilitate
the purchase of an equity interest by a third-party investor) to maintain ongoing
operations.
In January 1987 Knight sought advice on how best to solve its working
capital problems. Knight hired a consulting firm “to explore the advisability of
splitting off the CAM/ALOT Liquid Dispensing Systems from Knight Tool
Company, Inc. to form a separate affiliated corporation”. The firm reviewed
Knight’s financial statements and spoke with Knight principals (including Mr.
Cavallaro) and concluded that the proposed two-company structure would be at
risk for potential conflicts due to shifting economic benefits between them (as
when a customer who was initially interested in the CAM/ALOT machine would
want to “trade up” to a more specialized Knight machine). The firm was also
concerned not only that removing the CAM/ALOT line of revenue would cause
Knight to operate at a loss, but also that there would not be enough revenue from
CAM/ALOT products to sustain a fledgling, stand-alone enterprise. Knight was
thus advised not to start a new affiliated company that would be solely the sales
arm of Knight, but rather to increase its operating margins by adjusting various
expenses and thus increasing net income. Knight’s working capital situation did
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[*12] not improve, however, and from June 30 to December 30, 1987, Knight’s
bank debts increased from $58,000 to $352,000.2
Knight’s thin capitalization was especially troublesome to Mrs. Cavallaro,
who finally insisted that Knight revert to its original tool-making business. Mr.
Cavallaro acknowledged that his real strength lay in the traditional business of
tool-making, and he told Mrs. Cavallaro that it was time for Knight to call it quits
on CAM/ALOT. The CAM/ALOT production equipment and remaining
inventory were put into a single room. However, as we will show, manufacturing
of the CAM/ALOT dispensing machines soon resumed, and little changed at
Knight.
Incorporation of Camelot Systems, Inc.
Ken Cavallaro was not willing to give up on CAM/ALOT. He continued to
believe they could develop a successful liquid-dispensing machine and find a
market for it. He approached his parents and asked if he and his brothers could do
so. The Cavallaros assented. However, no document was ever prepared
conferring on the sons or their planned new company any rights--much less
exclusive rights--to produce or sell the liquid-dispensing machine. To organize a
2
The consulting firm found that in 1987 Knight had substantial equity
positions in both its real estate and manufacturing plant and equipment but that it
was operating at a break-even position on a cashflow basis.
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[*13] new corporation, Mr. and Mrs. Cavallaro referred their sons to Fred Cirome,
the attorney they had used for their own legal needs.
After Mr. Cirome had prepared the documents for incorporating Camelot
Systems, Inc. (“Camelot”), all five of the Cavallaros went to his office, and the
Cavallaro sons signed the articles of incorporation. At its incorporation Camelot
had a total of 150 shares issued, and each son owned 50 shares. When Camelot
was incorporated on November 30, 1987, Ken was 26 years old, Paul was 24, and
James was 23.
At a meeting in Mr. Cirome’s office, Mr. Cirome started to hand the new
Camelot corporate minute book to Mr. Cavallaro; but Mr. Cavallaro deflected the
suggestion that Camelot was his corporation and immediately handed the minute
book instead to Ken Cavallaro, saying, “‘Take it; it’s yours.’” (As we explain
below, an estate planning lawyer later construed this event to constitute a transfer
of CAM/ALOT technology, but this construction is not corroborated by the record
or any other testimony.)
The three sons jointly contributed a modest total of $1,000 to start the
corporation--i.e., $333.33 each--and that was the total capital investment they
made in the company during its entire existence. Consequently, they did not
believe that success would come from their capital investment alone. Rather, they
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[*14] expected to develop value by their opportunity to develop Knight’s
CAM/ALOT line of business, by Knight’s continued support of the product, by
creating a niche market for the liquid-dispensing product, and by the investment of
their time. Each of the sons and their parents understood that Ken Cavallaro
would be the driving force behind the CAM/ALOT product, as the one with the
most relevant expertise and the one who would expend the most labor on the
project. (Initially Paul Cavallaro was not working for either Knight or Camelot,
but at the bank.) However, the Cavallaro sons subjectively valued equally the
potential contributions of each other. They did not make any attempt to determine
a market value of each brother’s expected contribution but rather expected that, by
virtue of their equivalent stock ownership in Camelot, each brother would profit
equally from any success of the venture.
Continuation of CAM/ALOT production
After the incorporation of Camelot, Ken Cavallaro--working on the Knight
payroll--began exploring ways to improve the CAM/ALOT dispensing product.
He attended industry trade shows and talked with Knight customers who had
purchased the machines. Ken Cavallaro then worked with Knight engineers, and
they made changes to the design of the CAM/ALOT machines in an effort to
eliminate the problems of which customers had complained.
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[*15] The improved models of the CAM/ALOT dispensing machines
incorporated a gantry mechanism rather than a cantilever, the use of servo motors
rather than stepper motors, and the use of DOS-based computer programming.
These additions gave the machine the ability to move along the Z axis and to
dispense liquids in an arc, and they facilitated programming. Later models
incorporated prefabricated components bought directly from third parties, and the
machines became an amalgamation of third-party products and Knight-
manufactured pieces, all undergoing final assembly at Knight’s shop. Various
sizes of CAM/ALOT dispensing machines were developed to accommodate
different customers’ assembly line needs; and as the technology improved, the
machines’ dispensing speed and precision increased. Ken Cavallaro remained
focused on traveling to sales expos and meeting with customers; he was
committed to fine-tuning the product and attempting to forecast industry needs and
trends. His efforts were timely, and they coincided with a relative boom in the
liquid-dispensing industry as surface-mount technology largely replaced through-
hole technology in circuit board and electronics manufacturing.
However, Ken Cavallaro was not an engineer, inventor, or machinist.
Though Ken Cavallaro certainly knew his way around a machine shop, it was
other Knight personnel--both Mr. Cavallaro and those under his direction--who
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[*16] continued to make the CAM/ALOT dispensing machines and to effect the
ideas and meet the needs that Ken Cavallaro brought in from the field.
Relationship between Knight and Camelot
Knight manufactured the CAM/ALOT machines and Camelot sold and
distributed them to third parties. Although it is Mr. and Mrs. Cavallaro’s position
that Camelot should be seen as the manufacturer of the machines and Knight as its
contractor, the contemporaneous documents (including the companies’ own
financial statements3 and filed tax returns4 until 1994) overwhelmingly
3
For example, the combined financial statement for Knight and Camelot,
for the year ending December 31, 1991 (prepared on March 11, 1992), states:
Organization - Knight Tool Company, Inc. was incorporated in
1976. Its principal business activity is the manufacturing of machine
parts and tools according to industry and government specifications
and is the sole provider of machines sold by Camelot Systems, Inc.
Camelot Systems, Inc. was incorporated in 1987. Its principal
business activity is the selling of computerized liquid dispensing
machines. [Emphasis added.]
As we note later, when the IRS requested the financial statements in 1998,
Knight’s accountant Kevin McGillivray doctored the narrative to state instead that
Knight was “the sole provider of machines owned by Camelot” (emphasis added),
in order to be consistent with the Cavallaros’ position that pre-merger Camelot
was not a mere sales agent but rather had owned the technology and was the
manufacturer of the machines (with Knight as its contractor).
4
On Knight’s original Forms 1120, “U.S. Corporation Income Tax Return”,
(continued...)
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[*17] characterize Knight as the manufacturer of the machines and Camelot
merely as the seller. As late as 1995 an agreement was reached with Cognex
Corp. (“Cognex”) for the purchase of hundreds of “vision systems” to be used in
CAM/ALOT machine production, and the agreement was drawn up between
Cognex and Knight (not Camelot), consistent with the reality that Knight
manufactured the CAM/ALOT liquid-dispensing machines on its own account and
used Camelot as its sales agent.
Camelot received a purchase order from a customer and then submitted an
order (either oral or written) to Knight for the requested model of CAM/ALOT
machine, including any customer-requested specifications or modifications.
Knight’s personnel, facilities, and manufacturing equipment created the
CAM/ALOT machines. Camelot then paid for each machine a price that included
4
(...continued)
for the years ending June 30, 1990, through December 31, 1993 (Knight elected to
change its fiscal yearend in 1993), Knight reported its business activity as
“Manufacturing” of “Tools” and selected business code no. 3540 (which signifies
the “Manufacturing” of “Metalworking machinery”). On Camelot’s original
Forms 1120 for the tax years 1988 through 1992, Camelot reported its business
activity as “Sales” of “Machinery & Equip”, and selected the business code no.
5008 (which signifies the “Wholesale Trade” of “Machinery, equipment, and
supplies”). For tax year 1993, when Camelot claimed S corporation status and
filed its return on Form 1120S, “U.S. Income Tax Return for an S Corporation” (a
form that required a business code but not a verbal statement of business activity),
Camelot continued to use the same business code, 5008, that it had used in prior
years.
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[*18] Knight’s direct costs plus an “overhead burden rate”. (Mr. and Mrs.
Cavallaro claim that this rate was set so that Camelot would purchase the
CAM/ALOT technology incrementally over time, but the evidence does not
support this claim.)
Some of Camelot’s purchase orders were for batches of machines, as to
which Ken Cavallaro expected eventual but not-yet-received orders from
customers. Knight did not bill Camelot until the machines were completed and
ready for delivery, and Camelot did not pay for the machines until the ultimate
customer had paid Camelot. Thus, Knight was at risk for non-payment, and
Camelot was effectively immune from such risk.
As reflected by the documentary evidence, Camelot had no employees from
1987 to 1995. All the persons who worked on CAM/ALOT machines after
Camelot’s incorporation--including Ken Cavallaro--were on the Knight payroll
and received all their wages from Knight.5
In addition to a shared payroll system, Camelot’s and Knight’s financial
affairs overlapped in other ways. In 1989 Camelot and Knight entered into a joint
5
For example, for 1992 and 1993 Knight reported spending $457,072 and
$748,864 for salaries and wages as a part of its selling and administration
expenses, whereas for the same years Camelot reported spending only $61,032 and
$86,205 for salaries and wages, all of which was for its international affiliate,
Camelot S.A.
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[*19] financing agreement for an $850,000 line of credit and a $150,000 term
loan, for which Knight and Camelot executed cross-corporate guaranties of their
respective obligations; but the risk was allocated not to Camelot (or the Cavallaro
sons) but to Knight (and Mr. and Mrs. Cavallaro): The agreement was
collateralized by all of Knight’s business assets and an agreement by Mr. and Mrs.
Cavallaro not to sell or encumber the 216 River Street property, Knight’s place of
business. Mr. and Mrs. Cavallaro also executed personal unlimited guaranties of
Knight’s and Camelot’s financial obligations.6 In 1992 the parties executed two
subsequent financing agreements with the same lender and identical guaranties as
for the 1989 loan.
Camelot did not have its own bank accounts or books of account. Rather,
intercompany accounts were created on Knight’s books so that Camelot could be
billed for certain expenses, and this accounting device was used to charge Camelot
for overhead expenses. With minor exceptions,7 Camelot’s bills were paid using
Knight’s funds.
6
Before and after the incorporation of Camelot in 1987, Mr. and
Mrs. Cavallaro mortgaged their house to support Knight’s operations.
7
Mr. McGillivray explained that Camelot did make some direct payments
for its own expenses, such as for those costs associated with trade shows,
advertising, marketing, the west coast and foreign offices, and warranty costs.
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[*20] Allocation of income and expenses
Apart from those minor exceptions, the record does not reflect a consistent
or systematic approach to the overall allocations of income and expenses between
the two companies, and Knight received less income than it should have as the
manufacturer of the machines, while Camelot received more than it should have as
the mere seller.8 Knight provided the equipment and personnel for making the
machines, paid the bills, and bore the risk; but profits were disproportionately
allocated to Camelot. We attribute this disproportion not to the objective values of
the companies but either to the deliberate benevolence of Mr. and Mrs. Cavallaro
toward their sons or else to a non-arm’s-length carelessness born of the family
relationships of the parties.
Camelot and Knight’s outside accountant, Mr. McGillivray, testified at trial
that sums of money were allocated between the companies as needed to cover
expenses incurred by one or the other. However, Mr. McGillivray’s credibility at
trial was damaged when he confessed to having given false testimony to the Court
8
Although 90% of Knight’s business was for CAM/ALOT machines, Knight
did not enjoy a profit margin similar to Camelot’s on the sales of the dispensing
machines. As illustrated by one seven-month representative snapshot, from
October 1991 to April 1992, Camelot reported an average gross profit percentage
of 24%, whereas Knight’s average gross profit was a mere 6%.
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[*21] during his first day of testimony,9 and we therefore discredit his explanation
of the financial allocations between the companies. Mr. McGillivray prepared a
spreadsheet comparing the balance sheets of the two companies and (at a point
before the current controversy arose) handwrote a note in the margin (presumably
to management) that he would “‘run the numbers to shift more of [the] burden to
[Camelot].’”
Until at least as late as 1994, no allocation of expense to Camelot was made
for Knight workers who built the CAM/ALOT liquid-dispensing machines.
Rather, their time was accounted for as Knight time, and Camelot paid for it
indirectly only as it paid for a machine to which Knight’s employee expense had
been allocated as a cost of sales. This was deemed the “overhead burden rate”.
The fact that Knight was the manufacturer of the CAM/ALOT machines
(rather than Camelot’s contractor) and Camelot was its sales agent (rather than the
manufacturer) is itself evidence tending to show that Knight, not Camelot, owned
the technology, the subject to which we now explicitly turn.
9
Mr. McGillivray admitted that he had lied when he initially testified that he
did not know who altered the companies’ previously prepared financial
statements, tending to make Camelot look like the “owner” and not just the
“seller” of the CAM/ALOT technology. In fact, it was Mr. McGillivray himself
who altered the original statements, many years after he had first created them.
- 22 -
[*22] Ownership of CAM/ALOT technology
It is undisputed that Knight originally owned the CAM/ALOT technology.
We find that Knight never transferred it to Camelot and that Knight, not Camelot,
owned the incremental improvements in that technology over the succeeding
years. The record contains no document of any sort memorializing any transfer of
CAM/ALOT technology from Knight to Camelot,10 and no document granted
Camelot any rights (exclusive or otherwise) to any CAM/ALOT technology. No
document restricted Knight from licensing any aspect of the technology to another
manufacturer or user, nor from using any CAM/ALOT-related technology on
machines it might sell itself on its own account. On the contrary, with two
exceptions, the documents in the record all tend to show affirmatively that Knight
continued to own the technology and intangibles associated with the CAM/ALOT
machines.
The two exceptions are: (1) mechanical drawings of assorted parts for
machines produced for various customers, which state that Camelot owns the
drawings--the earliest of which is dated November 3, 1992; and (2) copyright
notices on the software, which state that the copyright holder is Camelot. The
software copyright notices appeared on the computer screens used with
10
We discuss below a belated and fictitious 1995 “confirmatory” agreement.
- 23 -
[*23] CAM/ALOT machines and were visible to a user upon startup of the
machine. Any probative value of the drawings and copyright notices is
outweighed by the other evidence of Knight’s ownership:
The few public registrations of intellectual property were all owned by
Knight: The CAM/ALOT trademark was registered to Knight on August 27,
1985, and it remained registered to Knight until December 31, 1995, when Knight
assigned it to Camelot in connection with the merger on that date. As for patent
registrations, the dispensing machine as a whole had never been patented (and was
presumably not patentable as such). Rather, as of 1987, the CAM/ALOT
technology subsisted in Knight’s know-how, trade secrets, assembled work force,
and other similar intangible assets. Various improvements or features of the
machine might have been patentable; and before the 1995 merger of Knight and
Camelot Mr. Cavallaro filed four patent applications related to pumps he had
designed. In his patent applications he identified not Camelot but Knight as his
assignee.11
11
The evidence does not show that these particular pumps turned out to have
great value or utility in the CAM/ALOT process, but we consider them significant,
since we think that, between parties dealing at arm’s length, the supposed acquirer
of the CAM/ALOT technology would have assured ownership of all the related
patents. Knight owned a few patents; Camelot owned none.
- 24 -
[*24] In 1992--before the current controversy arose--Knight and Camelot had an
occasion to determine who was the owner of the technology, and they determined
it was Knight, not Camelot. The companies engaged the accounting firm of Ernst
& Young (“E&Y”) for advice on various tax issues, including the availability of
research and development (“R&D”) tax credits pursuant to section 41. E&Y
accountants studied Camelot’s and Knight’s financial statements and past
expenditures and determined that a portion of the work that had been done in prior
years by Knight’s engineers could be characterized as R&D costs eligible for the
tax credit.
When that study was concluded, the accountants prepared and signed
amended tax returns for Knight for the years 1990 to 1993, claiming the R&D
credits for Knight.12 Only after the involvement of Mr. and Mrs. Cavallaro’s
estate-planning attorneys in 1994 and 1995 (discussed below) did the accountants
prepare another set of amended returns for both Camelot and Knight, this time
12
Petitioners have challenged the significance of Knight’s claiming the R&D
credit by arguing that Knight might have been entitled to claim the credit even if
Camelot was the owner of the technology. This argument can be assumed valid,
but it misses the point: There is no suggestion that, at the relevant time, Knight
entertained this late-arising thought that a non-owner could claim the credit.
Rather, when the idea first arose that Camelot might be treated as the owner of the
technology, Knight’s personnel immediately saw a dissonance between that idea
and Knight’s original claim of the credits; hence, they filed amended returns to try
to fix the problem and accommodate the new idea. See infra note 15.
- 25 -
[*25] disclaiming the R&D credits previously taken by Knight and claiming the
R&D credits for Camelot.
The accountants’ early consideration of merger
Mr. and Mrs. Cavallaro had prepared wills in the past, but as the combined
fortunes of Knight and Camelot improved, they believed that their estate plan
should be reviewed. At their request, E&Y accountants began to consider the
Cavallaros’ estate plan. They observed that the elder Cavallaros’ generation
possessed value that would eventually be passed down to the three sons
(generating estate tax liability), and they considered various strategies to minimize
the estate tax, including a “Grantor Retained Annuity Trust”, or “GRAT”. The
E&Y professionals concluded that merging the two companies was a necessary
first step to transfer some of Knight’s value to the sons through Camelot (and
therefore achieve the Cavallaros’ estate planning objectives) and to eventually sell
the combined entities.
Different advice from the lawyers
Unbeknownst to their E&Y accountants, the Cavallaros had also retained
attorneys at the Boston law firm of Hale & Dorr to give them estate planning
advice. Mr. and Mrs. Cavallaro had seen a brochure from that firm that included
the name of a long-time acquaintance of Mrs. Cavallaro--Louis Hamel--and they
- 26 -
[*26] contacted him. At a meeting in October 1994, Mr. Hamel reviewed the
Cavallaros’ estates and businesses, and observed the same issue that the
accountants had seen--i.e., that passing to the next generation the value held in the
parents’ generation (i.e., in Knight) would result in estate tax liability for the
estates of Mr. and Mrs. Cavallaro. Accordingly, Mr. Hamel determined that the
Cavallaros should claim instead that the value of the CAM/ALOT technology
inhered in Camelot, and was thus already owned by the three sons. He based this
determination on his conclusion that a one-time transfer of some of the
CAM/ALOT technology had occurred in 1987 (when Camelot was created) and
that there had also been ongoing transfers from time to time since then. This
conclusion was based not on documentation of transfers (there was none) but on a
supposed significance that Mr. Hamel contrived from the November 1987 incident
in which Mr. Cavallaro had handed the Camelot minute book to Ken Cavallaro at
the meeting in Mr. Cirome’s office. Mr. Hamel testified at trial that he construed
this as a ceremonial or symbolic act for the transfer of the CAM/ALOT
technology13--a construction that the evidence does not support.
13
At trial Mr. Hamel explained that the events of the November 1987
meeting “reminded me of the ancient way of transferring land. You own the land,
hand some twigs to the buyer or donoree and say, ‘Take it; it’s yours.’”
- 27 -
[*27] Given the lack of documentation for the transfer, Mr. Hamel suggested in
1994 that the Cavallaros should prepare affidavits and a “confirmatory” bill of sale
attesting to a 1987 transfer, so that when they died and their estate matters were
being addressed (by the IRS in particular), there would be evidence that not their
company, Knight, but rather Camelot (and through it their sons) had owned the
valuable technology underlying the CAM/ALOT machine. An associate of
Mr. Hamel interviewed Mr. Cavallaro and Ken Cavallaro; and as to the ownership
of the technology, Mr. Cavallaro said nothing to support a 1987 transfer. On the
contrary, when Mr. Cavallaro was asked whether there were “ever any agreements
either written or oral transferring the technology that Knight Tool developed” he
said that he “[n]ever gave it any thought”.
At trial, Mrs. Cavallaro confirmed Mr. Cavallaro’s recitation of the facts.
She was asked: “[H]ow did the transfer of the technology from Knight to Camelot
occur? Was there a document signed between you and your husband as the
owners of Knight transferring the technology [in 1987]?” In response,
Mrs. Cavallaro stated: “Why would there be a document? Nobody told us there
should be a document.” Nonetheless, Hale & Dorr prepared affidavits and a
- 28 -
[*28] “Confirmatory Bill of Sale” that asserted a 1987 technology transfer from
Knight to Camelot.14
Falling into line
Before the affidavits and confirmatory bill of sale were executed by
Mr. Cavallaro and Ken Cavallaro on May 23, 1995, David Frac (then chief
financial officer of both Camelot and Knight) transmitted them to E&Y for review.
Then Mr. Hamel began a correspondence campaign to convince the E&Y
accountants, as well as Mr. McGillivray, to adopt his view of the CAM/ALOT
technology ownership, as outlined in the affidavits. In one letter to E&Y
describing the transfer of CAM/ALOT technology, Mr. Hamel highlights his
estate planning concerns:
From an estate planning perspective, the present two-
corporation arrangement is advantageous. I see no advantage to
merging them, and I think we both agree that a merger of any kind
would leave us with the problem of getting the product of the merger
out of the estates of the older generation * * *.
14
Ken Cavallaro’s affidavit, as prepared by Hale & Dorr, reads: “Knight
Tool transferred the original dispensing product to Camelot when the latter was
formed in 1987 and Knight Tool received no compensation for this transfer, which
was a gift by the shareholders of Knight Tool to the shareholders of Camelot.”
- 29 -
[*29] In turn, Mr. McGillivray wrote a letter to Hale & Dorr, asserting various
errors he saw present in the affidavits. Responding to Mr. McGillivray’s letter,
Mr. Hamel wrote:
With regard to the ownership of the “technology,” I am going to be
guided by the history which comes out of [the] interviews with the
key players. In any history there are a few events which do not fit the
picture which the historian sees as “what happened.” History 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.
Of course, the “embarrassing facts” were those facts that showed that Knight
owned the technology and always had, and Mr. Hamel advocated “squeez[ing
those facts] * * * into the suitcase by force”--i.e., disregarding or suppressing
those facts in order to take the more advantageous position.
The accountants initially objected to Mr. Hamel’s proposal that the
CAM/ALOT technology had been transferred in 1987. They explained that
Mr. Hamel’s idea was at odds with all the evidence and that it was at odds with
Knight’s recent amended returns claiming R&D credits for the engineering work
on the CAM/ALOT machine.15
15
Eric Wolf, E&Y partner, wrote in his letter to Mr. Hamel:
We understand the affidavits and the fax [sic] that they present.
There are other documents in the public domain that may not
(continued...)
- 30 -
[*30] As a result of Mr. Hamel’s correspondence campaign, however, the
previously separate tracks of advice--one from the accountants at E&Y and
Mr. McGillivray, and the other from the attorneys at Hale & Dorr--now came
together for the first time. The contradiction was evident to all the professionals:
The accountants had assumed no 1987 transfer (and thus believed there was a need
for a means to transmit value to the next generation), but the attorneys postulated a
1987 transfer (and subsequent transfers) pursuant to which that value had already
been placed in the hands of the next generation. The attorneys eventually
prevailed, however, and the accountants acquiesced. Eventually all of the advisers
lined up behind Mr. Hamel’s suggestion that a 1987 transfer be memorialized in
the affidavits and the confirmatory bill of sale. They provided a draft of the
documents, which Mrs. Cavallaro read aloud to Mr. Cavallaro. After they
reported a few typographical errors, the attorneys prepared final versions, which
Mr. Cavallaro and Ken Cavallaro executed on May 23, 1995.
15
(...continued)
necessarily reflect the facts as stated in the affidavits. Specifically,
there have been tax returns filed for 1993 which do not coincide with
the ownership of technology issue relative to the way in which R&D
credits have been claimed, and there may be certain financial
statements which have been issued which also do not appropriately
reflect that which is stated in the affidavits. We should discuss
whether or not any steps should be taken to address these
inconsistencies.
- 31 -
[*31] Mr. and Mrs. Cavallaro had been oblivious to the disagreement between the
accountants and the lawyers about the transfer of CAM/ALOT technology. All
they knew was that their acquaintance and lawyer, Mr. Hamel, advised them that
Mr. Cavallaro’s act of passing the corporate minute book to Ken Cavallaro in
November 1987 warranted their asserting that a technology transfer had occurred.
Mr. Cavallaro followed Mr. Hamel’s advice and signed the affidavit and
confirmatory bill of sale.
Later consideration of merger
In the early 1990s Ken Cavallaro and Camelot began distributing the
CAM/ALOT machines internationally and established a customer base in Europe.
In order to keep pace with changing European Union manufacturing regulations,
however, Camelot had to become CE certified16--an expensive and
time-consuming process--and it did so. Unbeknownst to them at the time, in order
for Camelot and the CAM/ALOT products to be in compliance with CE marking,
Camelot had to certify that all the liquid-dispensing machine components
complied with European Union manufacturing Directives. This meant that the
16
Since 1993, products sold in the European Economic Area must display a
symbol called the “CE Marking”. CE stands for the French phrase “Conformité
Européenne”, which means “European Conformity”. This symbol is affixed to a
product as testimony that it meets all relevant Directives, i.e., regulations.
- 32 -
[*32] manufacturer of CAM/ALOT products, Knight, also had to achieve the CE
marking; but Mr. Cavallaro made it clear to Ken Cavallaro that he was unwilling
to spend the time and money necessary for Knight to do so.
Camelot wanted to continue expanding its presence in the European liquid-
dispensing machine market, and the two companies began discussing the
possibility of a merger, which the Cavallaros stated would circumvent the need for
Knight to undergo CE certification independently. That is, they believed that a
merged company would inherit Camelot’s CE marking without further
certification.
Merger on December 31, 1995
After all the discussion of estate planning issues and of continued
CAM/ALOT production for distribution in Europe, in late 1995 Camelot and
Knight decided to begin preparations for a merger of the two companies.
Accordingly, the Cavallaros engaged E&Y to determine the respective values of
the two companies. Timothy Maio of E&Y, using a market-based approach,
identified company comparables for Knight and the newly formed merged entity.
He explained that he found no suitable comparables for the pre-merger Camelot,
and so he did not value it as a stand-alone company. He valued the proposed
- 33 -
[*33] combined entity as being worth between $70 and $75 million, with Knight’s
portion of that value being between $13 and $15 million.
On December 31, 1995, Knight and Camelot merged in a tax-free merger
with Camelot as the surviving corporation. The stock of the merged company was
distributed as follows: Mrs. Cavallaro received 20 shares, Mr. Cavallaro received
18 shares, and 54 shares each were distributed to Ken, Paul and James Cavallaro.17
Mr. and Mrs. Cavallaro explained that they distributed the shares according to the
relative value of each company, as determined by Mr. Maio (that is, 19% of the
combined entity to the former shareholders of Knight--Mr. and Mrs. Cavallaro;
and 81% of the combined entity to the founding shareholders of Camelot--Ken,
Paul, and James Cavallaro). However, in determining these relative values,
17
The Commissioner seems to argue that, because Ken Cavallaro’s
contribution to the ongoing success of Camelot was more significant than those of
his brothers, he should have received more shares in the final sale of the Camelot
entity--an argument that may conflate an ownership interest in a company with
compensation for services rendered for that company. From Camelot’s
incorporation, Ken Cavallaro’s ownership interest in Camelot was the same as his
brothers’--that is, each brother owned 50 shares. For Ken Cavallaro’s substantial
ongoing services for the company he received a commensurate annual salary
(larger than those of his brothers). However, while the brothers’ capital
contributions to Camelot were trivial (totaling $1,000), their ownership of equal
shares assured that they would benefit equally from Knight’s beneficial treatment
of Camelot, and this fact made the merger of the two companies a useful means for
Mr. and Mrs. Cavallaro to confer their wealth to the next generation with an equal
share going to each son.
- 34 -
[*34] Mr. Maio had assumed--contrary to fact--that pre-merger Camelot had
owned the CAM/ALOT technology. It had not. Consequently, Mr. Maio
overstated the relative value of Camelot and understated the relative value of
Knight. We find that as a result, by means of this distorted allocation of the stock,
Mr. and Mrs. Cavallaro conveyed disproportionate value to their sons in amounts
totaling $29.6 million.18
Sale to Cookson America, Inc.
On July 1, 1996, Cookson America, Inc. (“Cookson Group”) purchased
Camelot (i.e., the merged companies). The sale price was $57 million in cash with
a contingent additional amount--i.e., up to $43 million in potential deferred
18
The determination of the total amount of those gifts should be made by
determining the value of the post-merger company and the extent to which that
value is allocable to the two pre-merger companies and then comparing that
allocation of value to the allocation of the post-merger stock. For the first step of
that process, petitioners contend that the post-merger value is $72.8 million and
the Commissioner contends it is $64.5 million. Somewhat surprisingly, we
determine that we do not need to make a specific finding of the value of the
merged company nor even of the relative values of Knight and Camelot. Rather,
as we explain below, the persistent assumption by the Cavallaros and their experts
that Camelot and not Knight owned the technology makes their valuation invalid
and causes them to fail to carry their burden of proof, leaving us to accept the
amount of gift that the Commissioner determined, reduced to the extent of his
partial concession.
- 35 -
[*35] payments based on future profits.19 After the July 1996 sale no further
payments were made from Cookson Group to the Camelot shareholders. On the
basis of stock ownership, Mr. and Mrs. Cavallaro received a total of $10,830,000
(i.e., 19% of $57 million) while Ken, Paul, and James each received $15,390,000
(i.e., 27% of $57 million).
The IRS’s examination and notices of deficiency
In January 1998 the IRS opened an examination of Knight’s and Camelot’s
1994 and 1995 income tax returns. During the income tax examination the IRS
learned that there might be a possible gift tax issue in connection with the 1995
19
Neither petitioners nor the Commissioner look to the post-merger
July 1996 sale price ($57 million plus possible contingent payments of up to
$43 million) as the measure of the merged company’s value at the time of the
merger in December 1995. However, the Cavallaros argue in the alternative, that,
if we determine that gift tax is due, the best evidence of the value of the merged
company as of the valuation date is $57 million, the amount paid by Cookson
Group six months after the merger (and the amount assumed in the notice of
deficiency). The Commissioner counters that, if we were to value the merged
company according to the purchase price set forth in the contract with Cookson
Group, we would have to include at least some discounted portion of the $43
million contingent payment as well. The Commissioner’s point is well taken; and
since all the experts agree that the value is greater than $57 million, we do not
adopt that figure. Moreover, since neither party has provided us with a means for
projecting what portion of the contingent payments could have been expected
(though none were eventually paid) and should be included, and neither has
explained how we could take into account a post-valuation-date event, when we
generally do not do so, see Estate of Gilford v. Commissioner, 88 T.C. 38, 52
(1987), we lack the predicate for using the July 1996 sale price for this
December 1995 valuation.
- 36 -
[*36] merger of the two companies and thus also opened a gift tax examination in
February 1998. The IRS issued third-party summonses to E&Y seeking
documents that the accounting firm created or received in the fall of 1994 and in
1995 while working on estate tax and corporate merger issues with Mr. Hamel.
Petitioners filed petitions to quash these summonses and fought this issue to the
Court of Appeals for the First Circuit, which ultimately affirmed the District
Court’s order denying petitioners’ motion to quash and enforcing the summonses.
See Cavallaro v. United States, 284 F.3d 236 (1st Cir. 2002), aff’g 153 F. Supp. 2d
52 (D. Mass. 2001).
On July 7, 2005, Mr. and Mrs. Cavallaro each filed a Form 709, “United
States Gift (and Generation Skipping Transfer) Tax Return”, for the 1995 tax year,
reporting no taxable gifts and no gift tax liability.
On November 18, 2010, the IRS issued statutory notices of deficiency to
Mr. Cavallaro and Mrs. Cavallaro for the tax year 1995, determining (without
having obtained an appraisal) that pre-merger Camelot had zero value and that
each of the parents had made a taxable gift of $23,085,000 to their sons when
Knight merged with Camelot, resulting in a gift tax liability of $12,889,550 for
- 37 -
[*37] each petitioner.20 In addition, the notices of deficiency determined additions
to tax pursuant to section 6651(a)(1) for failure to file timely gift tax returns, as
well as section 6663(a) penalties for fraud. In his answers the Commissioner
asserted, for the first time, alternative section 6662 accuracy-related penalties.
Petitioners’ experts
Mr. and Mrs. Cavallaro offered into evidence two expert reports with
different but reconcilable valuations of the merged company. The first was the
report completed by Mr. Maio in January 1996--contemporaneously with the
merger--which had concluded that the merged company was worth between $70
and $75 million and that only $13 to $15 million of that value was attributable to
Knight. The Cavallaros offered the January 1996 report as evidence of the fact
that they had obtained a contemporaneous valuation.
The Cavallaros’ second expert report was composed in preparation for trial
by John Murphy of Atlantic Management Co., who used a market-based approach
similar to that used by Mr. Maio. Accordingly, Mr. Murphy’s report also
20
The Commissioner initially determined the same gift amounts for both
petitioners, despite the fact that Mrs. Cavallaro owned 51% of Knight before the
merger and Mr. Cavallaro owned 49%. The Commissioner later reduced the
determined deficiency amounts and gift tax liabilities and reflected the actual
division of ownership, claiming that Mr. Cavallaro made gifts totaling
$14,538,300 and Mrs. Cavallaro made gifts totaling $15,131,700.
- 38 -
[*38] identified company comparables for Knight21 and the newly formed merged
company. (Mr. Murphy explained in his report that he did not find suitable
comparables for Camelot and so he, too, did not value it as a stand-alone company.
Rather, he reckoned (reasonably, we find) that the value of post-merger Camelot
minus the value of pre-merger Knight equals the value of pre-merger Camelot and
allows a comparison of the relative values of the two pre-merger companies.)
Mr. Murphy’s report differed from Mr. Maio’s in only one respect, which
modestly increased Knight’s relative value: he added a royalty adjustment which
allocated 2% of Camelot’s income to Knight for the use of the CAM/ALOT
trademark and the limited use of Mr. Cavallaro’s patented pump technology in a
few of the CAM/ALOT models. Notwithstanding the fact that he made the 2%
adjustment, he stated:
Atlantic Management does not agree that a transfer pricing
adjustment is necessary or that royalty payments are warranted in
light of the respective roles of the two companies, the pricing
structure between the two pre-merger entities, and payments made
21
Mr. Murphy chose “companies that are similar in nature to Knight”, but
Mr. Murphy considered Knight’s nature to be not that of a manufacturer of the
CAM/ALOT machines and the owner of the technology but rather, in effect, to be
that of a machine shop to which Camelot “outsourced the assembly of the product
line”. In addition, Mr. Murphy’s chosen comparables were intended to be similar
to Knight in (among other things) “net profit”; but as we have shown, Knight’s
profits had been understated for years. Thus, Mr. Murphy’s comparables were not
in fact similar to Knight.
- 39 -
[*39] directly to William Cavallaro by Camelot for his technological
contributions.
Mr. Murphy valued the combined entity at $72,800,000 (i.e., within the range of
Mr. Maio’s $70 to $75 million), of which he concluded that 18.8%--i.e.,
$13,700,000--was Knight’s portion.
In discerning the relative values of Knight and Camelot, both of petitioners’
experts assumed (contrary to our findings) that Camelot owned the CAM/ALOT
technology and that Knight was a contractor for Camelot. As Mr. Murphy
explained his assumptions--
the liquid dispensing machines basically became * * * Ken and
Camelot’s product [in 1987]. And so from that point, it was our
understanding that as ideas flourished, as concepts were nurtured
through Camelot, they would be brought to Knight, Knight in the
capacity of a contract manufacturer.
Neither Mr. Maio nor Mr. Murphy opined about the values of the companies if one
assumes that Knight was not a mere contract manufacturer but instead owned the
technology and manufactured the machines, with Camelot as its sales agent.
The Commissioner’s expert
In preparation for trial, the Commissioner retained Marc Bello of Edelstein
& Co. to determine the 1995 fair market values of Knight and Camelot. Mr. Bello
assumed (as we have found) that Knight owned the CAM/ALOT
- 40 -
[*40] dispensing-machine technology. Mr. Bello valued the combined entities at
approximately $64.5 million (i.e., a lower aggregate value than Mr. Maio and
Mr. Murphy determined), and Mr. Bello determined that 65% of that value--i.e.,
$41.9 million--was Knight’s portion. To make this valuation, Mr. Bello used not
the comparable sales approach that petitioners’ experts had used but rather a
discounted cashflow method.22
We summarize here Mr. Bello’s methods and conclusion, though, as we will
explain, we decide in favor of the Commissioner but do not base the outcome of
these cases on his expert’s opinion. Mr. Bello started with the companies’ 1995
annualized pre-tax earnings (operating profits) and adjusted for cashflow items,
such as working capital, capital expenditures, and depreciation, in order to
determine the adjusted net income amounts. Then, using Robert Morris
22
The discounted cashflow method is an income-based valuation method
which analyzes future cashflow projections of a given company and discounts
them (typically using a discount rate such as the weighted average cost of capital)
to present values as of the valuation date. The discount rate is calculated by
projecting economic income for a fixed number of years (usually between 3 and
10 years), and then assuming a terminal value at the end of that period. In theory,
the amount a willing buyer would pay for the valued entity is equal to the present
value of the projected economic income, plus the discounted terminal value. See,
e.g., Estate of Jung v. Commissioner, 101 T.C. 412, 424 n.6 (1993).
- 41 -
[*41] Associates (“RMA”) industry data23 as well as data from the Almanac of
Business and Financial Ratios as benchmarks, he made normalizing adjustments to
the ongoing after-tax cashflows of both companies to better reflect his belief that a
significant amount of revenue had been improperly allocated to Camelot, given
Knight’s ownership of the technology.24
On its income tax returns, Camelot had self-reported its business activity as
“Sales” and had used the code 5008 (“Machinery, Equipment, and Supplies” in the
“Wholesale Trade” category).25 However, when Mr. Bello was evaluating
Camelot’s performance against industry norms to determine whether any of
Camelot’s numbers could have been artificially inflated, Mr. Bello chose to use
data corresponding to the Standard Industrial Classification (“SIC”) code 5084
(“Wholesaling Industries”). The RMA Annual Statement Studies describe the
companies in SIC 5084 as follows: “‘INDUSTRIAL MACHINERY AND
23
RMA is a professional association that, through the inputs from its
members, serves the financial services industry by providing resources and
information on risk. In 2000 Robert Morris Associates changed its name to the
Risk Management Association.
24
Mr. Bello determined that in 1995 Knight’s net income after tax, net of
debt, should have been $3,657,974 and Camelot’s should have been $1,959,206.
25
The 1993 instructions to Form 1120 advised that the reporting codes,
“[t]hough similar in format and structure to the Standard Industrial Classification
(SIC) codes, * * * should not be used as SIC codes.”
- 42 -
[*42] EQUIPMENT. Distribution of industrial machinery, equipment, and
supplies. This industry does not include office, restaurant, or hotel fixtures, or air
conditioning and refrigeration equipment. (SIC No. 5084).’”
Camelot’s unadjusted annualized 1995 profit percentage before taxes was
15.1%. The RMA combined industry data (sorted by sales) for profit percentage
before taxes for 1995 for SIC code 5084 was 4.1%. Mr. Bello used this 4.1% as a
starting point and then accounted for Camelot’s success by putting it in the top
90% of the RMA data distributors by applying a 3.65% premium.26 He then
determined that Camelot’s adjusted net income before tax should have been
$3,186,608, i.e., only 7.5% of Camelot’s 1995 annualized adjusted revenue of
$42,488,102. Mr. Bello then redistributed the remaining profit to Knight,
resulting in a profit split between the two companies of 36.03% of the combined
value to Camelot, and 63.97% to Knight. (The unadjusted values had allocated
72.56% to Camelot and 27.44% to Knight.) After making this normalizing
adjustment to the net cashflows, Mr. Bello calculated the projected cashflows for
the four years following the merger (1996 - 99), assumed a terminal value, and
applied the discount rate.
26
Mr. Bello stated he made the adjustment to “reflect the [Camelot] strategy
of premium pricing and higher profitability as of the valuation date”; however, he
did not explain how he came up with the number 3.65.
- 43 -
[*43] Petitioners’ critiques of the Commissioner’s expert
In addition to disagreeing with Mr. Bello’s (correct) assumption that Knight
owned the CAM/ALOT technology and was itself the manufacturer, Mr. and
Mrs. Cavallaro advance two main arguments against Mr. Bello’s valuation
methodology. First, they contend that Mr. Bello improperly used RMA data in his
analysis, particularly when he selected SIC industry codes for analyzing the
financial statements of Knight and Camelot; and they claim his normalizing
adjustments to each company’s revenue streams were thus improper. (They do not
suggest the proper SIC codes that Mr. Bello should have used in his report.)
Second, Mr. and Mrs. Cavallaro assert that Mr. Bello’s valuation report was
not independent because it was improperly influenced by respondent’s counsel.
The Cavallaros allege that before Mr. Bello conducted his analysis, respondent’s
counsel informed Mr. Bello (1) that the 1995 affidavits were false and Knight, not
Camelot, owned the CAM/ALOT technology,27 (2) that he should not interview
executives at either company,28 and (3) that he should rely only on company
27
Since we find that Knight, not Camelot, owned the technology in 1995, we
do not consider Mr. Bello’s opinion to be undermined by his so assuming.
28
The Cavallaros argue: “Mr. Bello stated in his report that had he
conducted a site visit or interviews, ‘the results of [his] analysis might have been
different.’” At trial, Mr. Bello countered that conducting a site visit for a company
(continued...)
- 44 -
[*44] financial documents prepared before 1994 in his valuation.29 The
Commissioner points to Mr. Bello’s testimony that he nonetheless performed an
independent analysis and that, if a contrary finding regarding the technology had
been warranted, he would have stated it in his report. The Commissioner also
points to Mr. Bello’s conclusions as an indicator of his independence; Mr. Bello
valued the combined entity at $64,500,000, which is far less than the values found
by both Mr. Maio (valuing the combined entity at $70-$75 million) and Mr.
Murphy ($72.8 million).
28
(...continued)
that had been sold to a third party 16 years earlier would seem to add negligible
value. Mr. Bello testified that, “considering that there were representations from
the owners and a lot of company background information, * * * under my
professional standards there was enough information to gain an understanding of
the companies that I didn’t foresee it to go back and interview the owners of the
business.”
29
Mr. Bello seems not to have followed this instruction. In his report he
cites company documents, financial and otherwise, prepared after 1994.
- 45 -
[*45] OPINION
I. Introduction
We must determine the extent to which Mr. and Mrs. Cavallaro made gifts
to their sons by merging the parents’ company (Knight) with the sons’ company
(Camelot) and allowing the sons an 81% interest in the merged entity. The parties
agree that this issue calls for a determination of the fair market value of the
merged entity and of the relative fair market values of Knight and Camelot on the
eve of that merger. In his notices of deficiency, the Commissioner determined
identical taxable gifts made by Mr. and Mrs. Cavallaro each in the amount of
$23,085,000, for a total gift of $46,170,000, but the Commissioner’s position has
evolved during the course of this litigation, and he has conceded that the value of
the gifts is less than determined in the notices of deficiency. For ease of
comparison, the positions of the notices of deficiency, the Cavallaros’ expert
(Mr. Murphy), and the Commissioner’s expert (Mr. Bello) are summarized here:
- 46 -
[*46] Competing values (rounded, in millions) and allocations
Notices of Cavallaros’ Commissioner’s
deficiency expert expert
Total value of $57.0 $72.8 $64.5
merged company
Knight Value:
Percent 100 18.8 65
Dollar $57.0 $13.7 $41.9
Camelot value:
Percent -0- 81.2 35
Dollar -0- $59.1 $22.6
81% of total value $46.1 $59.0 $52.2
Gift amount $46.1 <$0.1> $29.6
II. Burden of proof
In general, the IRS’s notice of deficiency is presumed correct, “and the
petitioner has the burden of proving it to be wrong”. Welch v. Helvering, 290
U.S. 111, 115 (1933); see also Rule 142(a). The Commissioner has conceded that
the taxable gifts totaled not $46.1 million (as in the notices of deficiency) but
instead $29.6 million (as yielded by Mr. Bello’s analysis). Where the
Commissioner has made a partial concession of the determination in the notice of
deficiency, the petitioner has the burden to prove that remaining determination
wrong. See Silverman v. Commissioner, 538 F.2d 927, 930 (2d Cir. 1976)
- 47 -
[*47] (holding that the burden of proof does not shift where the Commissioner’s
change of position operates in favor of the taxpayer), aff’g T.C. Memo. 1974-285;
cf. Rule 142 (shifting the burden “in respect of * * * increases in deficiency”).
However, the Cavallaros argue that, for two reasons,30 the burden of proof shifted
to the Commissioner. Because the burden of proof is important to the outcome in
these cases, we address those two arguments:
A. “New matter”
1. New matter relating to liability for tax
Rule 142(a)(1) provides: “ The burden of proof shall be upon the petitioner,
* * * except that, in respect of any new matter, * * * it shall be upon the
respondent.” Petitioners point out that the notices of deficiency presume that
Camelot was a shell company with zero value, whereas at trial the Commissioner
30
Before trial the Cavallaros had argued that the burden of proof shifted
pursuant to section 7491(a)(1), which provides that the burden of proof will shift
to the Commissioner on a factual issue “[i]f * * * a taxpayer introduces credible
evidence with respect to any factual issue relevant to ascertaining the liability of
the taxpayer”. However, section 7491(a)(1) is applicable to cases arising in
connection with examinations commenced after July 22, 1998, Internal Revenue
Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, sec.
3001(c)(1), 112 Stat. at 727, whereas it was before that date--i.e., on February 10,
1998--that the IRS commenced the examination at issue here by sending
petitioners a Substitute Form 4564, “Information Document Request”, requesting
information regarding the values of Knight and Camelot in 1995 and 1996.
Therefore, section 7491(a)(1) is not applicable, and it appears the Cavallaros have
abandoned this contention.
- 48 -
[*48] acknowledged that Camelot accounted for 35% of the value of the merged
entity. Petitioners argue that the Commissioner’s litigating position is a new
theory which constitutes “new matter” as to which the Commissioner has the
burden of proof. However, the Court of Appeals for the First Circuit (to which an
appeal would presumably be made in these cases) has articulated the meaning of
“new matter” in the opinion that petitioners cite and rely on, Estate of Abraham v.
Commissioner, 408 F.3d 26, 35-36 (1st Cir. 2005), aff’g T.C. Memo. 2004-39:
[W]here the Notice of Deficiency fails to adequately “describe the
basis on which the Commissioner relies to support a deficiency
determination” and the Commissioner seeks to establish the
deficiency on a basis not described in the Notice, the burden shifts to
the Commissioner on that new basis. Shea v. Comm’r of Internal
Revenue, 112 T.C. 183, 197, 1999 WL 177471 (1999); see T.C.R.
142(a)(1). “A new theory that is presented to sustain a deficiency is
treated as a new matter when it either alters the original deficiency or
requires the presentation of different evidence.” Wayne Bolt & Nut
Co. v. Comm’r, 93 T.C. 500, 507, 1989 WL 124141 (1989). But if
the theory “merely clarifies or develops the original determination[,
it] is not a new matter in respect of which [the Commissioner] bears
the burden of proof.” Id.
The Estate’s main argument is that the Notice was “latently
ambiguous, overly broad and confusing” and failed to specify all the
elements of the Commissioner’s argument * * *
Acceptance of the Estate’s arguments would amount to a
requirement that the Notice of Deficiency be as detailed as trial briefs.
There is no such requirement. The standard of specificity for notices
of deficiency is much lower. “In fact, if a deficiency notice is broadly
worded and the Commissioner later advances a theory not
- 49 -
[*49] inconsistent with that language, the theory does not constitute
new matter, and the burden of proof remains with the taxpayer.”
Abatti v. Comm’r, 644 F.2d 1385, 1390 (9th Cir.1981); see also Shea,
112 T.C. at 191. * * *
The IRS’s notice of deficiency states: “It is determined that under IRC Section
2511 donor’s merger of Knight Tool Co. into Camelot Systems, Inc. in return for
19% of the stock in Camelot Systems, Inc. resulted in a gift of $23,085,000.00 to
the other shareholders of Camelot Systems, Inc.”31 The Commissioner’s position
at trial was “not inconsistent with that language”. The Commissioner has never
abandoned that theory nor contended otherwise. His partial concessions as to
Camelot’s non-zero value did not require a new theory or change the issues for
trial. The Commissioner’s trial position was therefore not “new matter”.
2. New matter relating to liability for penalty
The Commissioner acknowledges that, unlike the additions to tax for failure
to file timely under section 6651(a)(1),32 the section 6662(a) accuracy-related
31
The language quoted above from the notice of deficiency issued to
Mrs. Cavallaro does not appear in the notice of deficiency issued to Mr. Cavallaro;
but the Commissioner explains: “It appears that this Explanation of Adjustments
sheet was inadvertently omitted from the statutory notice of deficiency issued to
petitioner William Cavallaro. However, this inadvertent omission clearly did not
prejudice Mr. Cavallaro, as shown by his petition, which is virtually identical to
the petition filed by Mrs. Cavallaro.”
32
The section 6651(a)(1) additions to tax arose in connection with an
(continued...)
- 50 -
[*50] penalties were not determined in the notice of deficiency, that they therefore
do constitute “new matter”, and that he has the burden of proof33 as to the
applicability of these penalties. However, the Commissioner contends that--
petitioners nevertheless bear the burden of showing reasonable cause
to escape the application of these penalties. * * * The statutory
notices of deficiency issued to petitioners included the civil fraud
penalty under I.R.C. § 6663 [which was conceded after trial] and
consequently raised the issue of reasonable cause. Therefore, the
defense of reasonable cause under I.R.C. § 6664 (c) is not a new
matter in the case and petitioners bear the burden of proof in showing
reasonable cause under I.R.C. § 6664(c).
We have previously held that, when a penalty is asserted as “new matter”, the
Commissioner has the burden to prove that the taxpayer’s failure “was not due to
reasonable cause or was due to willful neglect”, Arnold v. Commissioner,
T.C. Memo. 2003-259, slip op. at 10-11 (citing cases); see also Schmidt v.
32
(...continued)
examination that began before July 22, 1998 (so that the Commissioner does not
have the burden of production; see supra note 30) and was determined in the
notice of deficiency (so that it is not new matter). Consequently, the Cavallaros
have the burden of proof as to the additions to tax. As we explain below, they
succeed in a defense of reasonable cause.
33
Where section 7491(c) applies, the Commissioner bears the burden of
production and must produce sufficient evidence that the imposition of the penalty
is appropriate in a given case; but that provision is not applicable here because
these cases arose in connection with an examination that began before July 22,
1998. Ochsner v. Commissioner, T.C. Memo. 2010-122, slip op. at 18 n.11; see
supra note 30.
- 51 -
[*51] Commissioner, T.C. Memo. 2014-159, at *57-*58; and the Commissioner
points us to no authority supporting his contention that a taxpayer’s “reasonable
cause” defense against one penalty is necessarily implicated in the IRS’s assertion
of an alternative penalty, so that the taxpayer therefore has the burden to prove
reasonable cause as an equivalent defense to the alternative penalty. Moreover,
we are able to resolve the reasonable defense issue (in the Cavallaros’ favor)
however the burden is allocated, so we need not address further the issue of
burden of proof on reasonable cause. See Martin Ice Cream Co. v. Commissioner,
110 T.C. 189, 210 n.16 (1998) (“we decide the issue on a preponderance of the
evidence; therefore, the allocation of the burden of proof does not determine the
outcome”).
B. “[E]xcessive and arbitrary”
As a second basis for shifting the burden of proof, petitioners assert:
Alternatively, the controlling law also states that, where the
assessment is shown to be excessive, naked, arbitrary or without any
foundation, the burden shifts to the Respondent. * * * The gift
amount allegations and gift tax deficiencies asserted in the
now-abandoned Notices of Deficiency were not based on any
appraisal, and were excessive and arbitrary.
As we have already shown, the notices of deficiency were not “abandoned”. It is
evidently true that the Commissioner did not obtain an appraisal before issuing the
- 52 -
[*52] notices, but this did not render the notices “arbitrary”. Rather, the
Commissioner had discovered that, in merging the companies and granting stock
to their sons, petitioners had followed advice to contrive technology transfers that
had never occurred and to “squeeze a few embarrassing facts into the suitcase by
force”. This was a sufficient basis for issuing the notices, and to require more
would violate the general rule that we do not “look behind” the notice of
deficiency. Graham v. Commissioner, 82 T.C. 299, 308 (1984), aff’d, 770 F.2d
381 (3d Cir. 1985).
III. Gift tax liability
A. General gift tax principles
Section 2501(a) imposes a tax on the transfer of property by gift. The donor
is primarily responsible for paying the gift tax. Sec. 2502(c); see also 26 C.F.R.
sec. 25.2502-2, Gift Tax Regs. The gift tax is imposed upon the donor’s act of
making the transfer, rather than upon receipt by the donee, and it is measured by
the value of the property passing from the donor, rather than the value of
enrichment resulting to the donee. 26 C.F.R. sec. 25.2511-2(a). Donative intent
on the part of the donor is not an essential element for gift tax purposes; the
application of gift tax is based on the objective facts and circumstances of the
- 53 -
[*53] transfer rather than the subjective motives of the donor. 26 C.F.R. sec.
25.2511-1(g)(1), Gift Tax Regs.
Section 2512(b) provides: “Where property is transferred for less than an
adequate and full consideration in money or money’s worth, then the amount by
which the value of the property exceeded the value of the consideration shall be
deemed a gift”. Such taxable transfers include not only those transfers for which
no valuable consideration is received, as in the case of a typical gift, but “embrace
as well sales, exchanges, and other dispositions of property for a consideration to
the extent that the value of the property transferred by the donor exceeds the value
in money or money’s worth of the consideration given therefor.” 26 C.F.R. sec.
25.2512-8, Gift Tax Regs.
Where, as here, the transaction was made between family members, the
transaction is “subject to special scrutiny, and the presumption is that a transfer
between family members is a gift.” Harwood v. Commissioner, 82 T.C. 239, 258
(1984) (citing Estate of Reynolds v. Commissioner, 55 T.C. 172, 201 (1970)),
aff’d without published opinion, 786 F.2d 1174 (9th Cir. 1986).
The parties dispute whether the merger transaction was made in the
“ordinary course of business”, that is, “a transaction which is bona fide, at arm’s
- 54 -
[*54] length,[34] and free from any donative intent”, which is “considered as made
for an adequate and full consideration in money or money’s worth.” 26 C.F.R.
sec. 25.2512-8.
B. Lack of arm’s-length character
We find that the 1995 merger transaction was notably lacking in arm’s-
length character. If Camelot had offered itself to the market for acquisition
claiming ownership of the CAM/ALOT technology, it is inconceivable that a
hypothetical acquirer would do anything other than demand to see documentation
of Camelot’s ownership interest--documentation that we have found does not
exist. An unrelated hypothetical acquirer would never have been be satisfied with
Camelot’s mere assertions of ownership, or its statements that an oral agreement
effecting the transfer occurred at some point after Camelot’s incorporation.
Instead, upon realizing no such documentation was available, an unrelated party
either would have offered to purchase Camelot at a much lower price or (more
likely) would have walked away from the deal altogether.
34
See Estate of Bongard v. Commissioner, 124 T.C. 95, 122-123 (2005)
(“An arm’s-length transaction has been defined as ‘A transaction between two
unrelated and unaffiliated parties’, or alternatively, a transaction ‘between two
parties, however closely related they may be, conducted as if the parties were
strangers, so that no conflict of interest arises.’ Black’s Law Dictionary 1535 (8th
ed. 2004)”).
- 55 -
[*55] Likewise, if Knight were dealing with an unrelated party which sold
machines that had been manufactured at Knight’s risk by Knight employees on
Knight premises using technology developed by Knight personnel, where Knight
had owned the only public registrations of intellectual property and had claimed
ownership of the technology in prior tax filings, it defies belief to suggest that
Knight would have simply disclaimed the technology and allowed the unrelated
party to take it. If an unrelated party had purchased Camelot before the merger
and had then sued Knight to confirm its supposed acquisition of the CAM/ALOT
technology, without doubt that suit would fail. Camelot did not even own the
CAM/ALOT trademark registration.
But these cases, unlike those hypothetical scenarios, involve parents who
were benevolent to their sons and involve sons who could therefore proceed
without the caution that normally attends arm’s-length commercial dealings
between unrelated parties. The Cavallaros manifestly gave no thought in 1987 to
the question of which entity would own what intangibles. They gave no thought
thereafter to who was paying for the further development of the technology.
When the question of technology ownership came up in the context of claims for
R&D credits, the professionals comfortably assumed--without challenge--that of
course Knight owned the technology. And when the question finally arose
- 56 -
[*56] explicitly, it arose in an estate-planning context, when the question was
“How can we best convey wealth to our sons?” and donative intent was front and
center. In that context, the “confirmatory” bill of sale confirmed a fiction.
There is no evidence of any arm’s-length negotiations occurring between
the representatives or executives of the two companies. Instead (and despite a
wholesale lack of evidence as to Camelot’s ownership of the technology), Knight
agreed to take a less than 20% interest in the merged company, effectively valuing
Camelot at four times the value of Knight. As we stated in Dauth v.
Commissioner, 42 B.T.A. 1181, 1189 (1940):
Where the facts show that the parties to a sale demonstrate such a
lack of interest as to the price at which one sells to another that the
buyer purportedly gives a sum greatly in excess of the worth of the
property, such facts indicate that what was done was not a real
business transaction and “was not intended to have the usual results
and significance of a bona fide business deal.” Pierre S. du Pont [v.
Commissioner], * * * [37 B.T.A. 1198] p. 1242 [(1938)]. * * *
Accordingly, we find that the merger transaction between Knight and Camelot was
not engaged in at arm’s length and was not in the ordinary course of business.
C. Company valuations
Valuation is ultimately a question of fact. Estate of Newhouse v.
Commissioner, 94 T.C. 193, 217 (1990). The value of the gift depends on the fair
market value of the property, which is “the price at which such property would
- 57 -
[*57] change hands between a willing buyer and a willing seller, neither being
under any compulsion to buy or to sell, and both having reasonable knowledge of
relevant facts.” 26 C.F.R. sec. 25.2512-1. When an interest in a business is being
valued for the determination of a gift of transferred property (pursuant to section
2512), 26 C.F.R. section 25.2512-3(a), Gift Tax Regs., provides:
Care should be taken to arrive at an accurate valuation of any interest
in a business which the donor transfers without an adequate and full
consideration in money or money’s worth. The fair market value of
any interest in a business, whether a partnership or a proprietorship, is
the net amount which a willing purchaser, whether an individual or a
corporation, would pay for the interest to a willing seller, neither
being under any compulsion to buy or to sell and both having
reasonable knowledge of the relevant facts. The net value is
determined on the basis of all relevant factors including--
(1) A fair appraisal as of the date of the gift of all the assets of
the business, tangible and intangible, including good will;
(2) The demonstrated earning capacity of the business; and
(3) The other factors set forth in paragraph (f) of § 25.2512-2
relating to the valuation of corporate stock, to the extent applicable.[35]
35
Generally, the value of stock in a company is the “fair market value per
share * * * on the date of the gift.” 26 C.F.R. sec. 25.2512-2(a), Gift Tax Regs.
However, where actual selling prices are unavailable, then, in the case of shares of
stock, the factors to be considered are “the company’s net worth, prospective
earning power and dividend-paying capacity, and other relevant factors.” Id. para.
(f)(2). “Other relevant factors” include--
the goodwill of the business; the economic outlook in the particular
(continued...)
- 58 -
[*58] To assist the Court in properly valuing Knight and Camelot, both parties
retained experts in business valuation to determine the respective values of the
closely held S corporations in these cases. The Court evaluates expert opinions in
the light of each expert’s demonstrated qualifications and all other evidence in the
record. Parker v. Commissioner, 86 T.C. 547, 561 (1986). The appraiser must
use common sense and informed judgment to analyze all the facts and
circumstances of each case, maintaining “a reasonable attitude in recognition of
the fact that valuation is not an exact science.” Rev. Rul. 59-60, sec. 3.01, 1959-1
C.B. 237, 238. We are not bound by an expert’s opinions and may accept or reject
an expert opinion in full or in part in the exercise of sound judgment. Helvering v.
Nat’l Grocery Co., 304 U.S. 282, 295 (1938); Parker v. Commissioner, 86 T.C. at
561-562.
35
(...continued)
industry; the company’s position in the industry and its management;
the degree of control of the business represented by the block of stock
to be valued; and the values of securities of corporations engaged in
the same or similar lines of business which are listed on a stock
exchange. However, the weight to be accorded such comparisons or
any other evidentiary factors considered in the determination of a
value depends upon the facts of each case. * * *
Id. para. (f) (flush language).
- 59 -
[*59] Both of Mr. and Mrs. Cavallaros’ experts (i.e., Mr. Maio hired in 1995 in
anticipation of the merger and Mr. Murphy hired to testify at trial) valued the
companies using market-based approaches. They compared Knight and post-
merger Camelot to public companies that are arguably similar, if one assumes that
Camelot owned the technology (and had been entitled to the income that had been
allocated to it). But that assumption is contrary to fact. Mr. and Mrs. Cavallaro
did not meet their burden to prove that Camelot actually owned the technology,
yet they proposed no alternative valuation on the (accurate) assumption that it was
Knight, instead, that owned the technology and had been entitled to most of the
income that the CAM/ALOT product line had generated. Because we find
incorrect the Cavallaros’ fundamental premise, on which their valuations are based
(that is, we find that Knight owned the CAM/ALOT technology), Mr. Maio’s and
Mr. Murphy’s market-based comparison valuations must be disregarded entirely--
leaving petitioners with no evidence on this critical issue as to which they have the
burden of proof.
The Commissioner’s expert concluded that the total value of the combined
entities at the date of the merger was $64.5 million, that 65% of that was
attributable to Knight, and that 35% of the total was what Camelot’s shareholders
should have received in the merger. Mr. and Mrs. Cavallaro’s experts posited a
- 60 -
[*60] higher value of the combined entities, $72.8 million, though asserting that
no gift was made because the portion received by the Cavallaros accurately
reflected the value of Knight relative to Camelot at that time.
In putting forth Mr. Bello’s conclusions of value, the Commissioner has
thus conceded that the value of the combined entities is not greater than $64.5
million, and that the value of the gift made in the merger transaction is not greater
than $29.6 million. Although petitioners make several serious criticisms of his
method, their own higher valuation of $72.8 million moots those criticisms insofar
as the value of the entire merged entity is at issue.
Petitioners’ criticisms might have greater significance on the next
sub-issue--i.e., determining what portion of that value is properly attributable to
each of the two companies--but we need not resolve those criticisms or attempt to
correct the Commissioner’s figures. It is the Cavallaros who have the burden of
proof to show the proper amount of their tax liability, and neither of the expert
valuations they provided comports with our fundamental finding that Knight
owned the valuable CAM/ALOT technology before its merger with Camelot. We
are thus left with the Commissioner’s concession, effectively unrebutted by the
party with the burden of proof. The Cavallaros risked their cases on the
proposition that Camelot had owned the CAM/ALOT technology (and on a
- 61 -
[*61] valuation that assumed that proposition), but they failed to prove that
proposition (and the evidence showed it to be false). That being so, “[i]t would
serve no useful purpose to review our agreement or disagreement with each and
every aspect of the experts’ opinions.” CTUW Georgia Ketteman Hollingsworth
v. Commissioner, 86 T.C. 91, 98 (1986). We conclude that Mr. and
Mrs. Cavallaro made gifts totaling $29.6 million on December 31, 1995.36
IV. Failure-to-file additions to tax under section 6651(a)(1) and
accuracy-related penalties under section 6662
In the notices of deficiency for 1995, the IRS determined that Mr. and
Mrs. Cavallaro are both liable for the addition to tax imposed by section
6651(a)(1) for failure to timely file gift tax returns. In his answers, the
Commissioner asserted the section 6662 accuracy-related penalties (in the
alternative to the fraud penalties that the Commissioner no longer asserts). We
36
Since we base this conclusion on petitioners’ failure of proof, it is all but
immaterial that the Commissioner’s expert reached this $29.6 million gift number
by an arguably flawed analysis under which the total value of the merged entity
was $64.5 million, Knight’s value was $41.9 million (i.e., 65% of the total), and
Camelot’s value was $22.6 million (i.e., 35% of the total). Given petitioners’
failure of proof and our consequent finding of a $29.6 million gift, if we assume
instead the total value that petitioners’ expert determined--$72.8 million--then
arithmetic shows us that Knight’s value must have been $43.4 million (i.e., 59.6%
of the total) and Camelot’s value must have been $29.4 million (i.e., 40.4% of the
total). We do not choose between these two possibilities.
- 62 -
[*62] hold that the Commissioner has shown that the additions and the penalties
are applicable, but we sustain the Cavallaros’ defenses of “reasonable cause”.
A. Applicability of failure-to-file additions to tax
Section 6651(a)(1) authorizes the imposition of an addition to tax for failure
to file a timely return (unless the taxpayer proves that such failure is due to
reasonable cause and is not due to willful neglect, as discussed below). We have
found that Mr. and Mrs. Cavallaro did make gifts totaling $29.6 million, and it is
undisputed that Mr. and Mrs. Cavallaro did not file Forms 709 for the 1995 gifts
until July 7, 2005, approximately nine years late. Therefore, as a threshold matter,
the addition to tax imposed by section 6651(a)(1) is applicable in each case here
(subject to the defense described below).
B. Applicability of accuracy-related penalties
Section 6662 imposes an “accuracy-related penalty” of 20% of the portion
of the underpayment of tax where the taxpayer’s return reflects either a
“substantial estate or gift tax valuation understatement” or a “gross valuation
misstatement”. Section 6662(a), (b)(5), (h).37 Pursuant to section 6662(g)(1),
37
The accuracy-related penalty is also imposed where the tax underpayment
is attributable to the taxpayer’s negligence or disregard of rules or regulations, and
the Commissioner here alleges such negligence. However, we need not reach the
issue of negligence, since the mathematical bases for a “substantial estate or gift
(continued...)
- 63 -
[*63] there is a substantial estate or gift tax valuation understatement where the
value of property reported on an estate or gift tax return is 50% or less of its
correct value and the underpayment exceeds $5,000. Where such property is
reported at a value less than 25% of its correct value, there is a “gross valuation
misstatement” and the penalty imposed under section 6662 is increased from 20%
to 40% of the tax imposed. Sec. 6662(h).
Because we have found that Mr. and Mrs. Cavallaro made gifts totaling
$29.6 million but (as they admit) reported gifts of zero on their gift tax returns, the
gross valuation misstatement penalty imposed by section 6662(h) is applicable
here (subject to the defense discussed below).
C. Reasonable cause defenses
Both the section 6651(a)(1) addition to tax and the section 6662(a)
accuracy-related penalty are subject to a “reasonable cause” defense. The defenses
arise from distinct statutory sources, but where a taxpayer asserts reasonable cause
as a defense from liability for both because he relied on the advice of a competent
adviser, the two overlap significantly. We therefore discuss them in tandem
below.
37
(...continued)
tax valuation understatement” or a “gross valuation misstatement” are met here.
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[*64] 1. Reasonable cause for failure to file
The failure-to-file addition to tax is applied “unless it is shown that such
failure is due to reasonable cause and not due to willful neglect”. Sec. 6651(a)(1).
26 C.F.R. section 301.6651-1(c), Proced. & Admin. Regs., provides: “If the
taxpayer exercised ordinary business care and prudence and was nevertheless
unable to file the return within the prescribed time, then the delay is due to a
reasonable cause.” “Whether the elements that constitute ‘reasonable cause’ are
present in a given situation is a question of fact”, based on the circumstances of
the individual case. United States v. Boyle, 469 U.S. 241, 249 n.8 (1985).
“[W]illful neglect” is defined as “a conscious, intentional failure or reckless
indifference”. Id. at 245.
Circumstances that constitute reasonable cause include good faith reliance
on a mistaken legal opinion of a competent tax adviser that no liability was due
and it was unnecessary to file a return may also constitute reasonable cause. Id. at
250-251; McMahan v. Commissioner, 114 F.3d 366, 369 (2d Cir. 1997) (“reliance
on a mistaken legal opinion of a competent tax adviser--a lawyer or accountant--
that it was unnecessary to file a return constitutes reasonable cause”), aff’g T.C.
Memo. 1995-547. As the Supreme Court articulated in Boyle, 469 U.S. at 251:
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[*65] When an accountant or attorney advises a taxpayer on a matter
of tax law, such as whether a liability exists, it is reasonable for the
taxpayer to rely on that advice. Most taxpayers are not competent to
discern error in the substantive advice of an accountant or attorney.
To require the taxpayer to challenge the attorney, to seek a “second
opinion,” or to try to monitor counsel on the provisions of the Code
himself would nullify the very purpose of seeking the advice of a
presumed expert in the first place. * * * “Ordinary business care and
prudence” do not demand such actions.
2. Reasonable cause for the underpayment
Similarly, under section 6664(c)(1), a taxpayer who is otherwise liable for
the accuracy-related penalty may avoid the liability if he can show, first, “that
there was a reasonable cause” for the underpayment and, second, that he “acted in
good faith with respect to” the underpayment, then no accuracy-related penalty
“shall be imposed”. Whether the taxpayer acted with reasonable cause and in
good faith depends on the pertinent facts and circumstances, including his efforts
to assess his proper tax liability, his knowledge and experience, and the extent to
which he relied on the advice of a tax professional. 26 C.F.R. sec. 1.6664-4(b)(1),
Income Tax Regs. “Reliance on * * * professional advice or other facts, however,
constitutes reasonable cause and good faith if, under all the circumstances, such
reliance was reasonable and the taxpayer acted in good faith.” Id.
The Court’s caselaw sets forth the following three requirements in order for
a taxpayer to use reliance on a tax professional to avoid liability for a
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[*66] section 6662(a) penalty: “(1) The adviser was a competent professional who
had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and
accurate information to the adviser, and (3) the taxpayer actually relied in good
faith on the adviser’s judgment.” Neonatology Assocs., P.A. v. Commissioner,
115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
3. The Cavallaros’ reliance on professional advice
Mr. and Mrs. Cavallaro made the requisite showing of reasonable cause.
They had little to no advanced education, including no formal accounting, legal, or
business education. Mr. and Mrs. Cavallaro hired advisers who were competent
professionals with sufficient expertise to justify reliance. They engaged
professionals from a well-known accounting firm and a well-known law firm to
structure the tax-free merger of their S corporation, Knight Tool, with their sons’
S corporation, Camelot Systems. As discussed above, the professionals initially
had differing opinions regarding the ownership of the CAM/ALOT technology,
and the issue was explicitly considered by those professionals. The team of
advisers eventually structured the merger transaction according to the idea
proposed by the Cavallaros’ attorney Mr. Hamel at Hale & Dorr--that is, that on
the date of the merger, the CAM/ALOT technology belonged to Camelot and not
to Knight (and therefore that no gift occurred) because of a prior transfer. They
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[*67] obtained the valuation report by Mr. Maio based on this assumption and
allocated the post-merger stock accordingly.
Mr. Hamel was the author of this fiction of a 1987 transfer, which he
concocted from facts recounted to him by the Cavallaros about the 1987 meeting.
Using those facts, Mr. Hamel advised the Cavallaros that they had transferred the
CAM/ALOT technology in 1987 and that Knight therefore did not still own it in
1995. Thus, on the basis of professional advice from someone they perceived to
be competent and reliable--a friend from many years prior who had become a
partner at a well-known and successful law firm--the Cavallaros believed that their
company no longer owned the technology in 1995. Since they believed that
Camelot owned it instead, they reasonably and in good faith thought that the post-
merger division of stock that was based on Mr. Maio’s valuation was reasonable.
Mr. and Mrs. Cavallaro also assert that they provided necessary and
accurate information to their advisers. The Commissioner disputes this assertion,
arguing that Mr. and Mrs. Cavallaro do not have the defense of reasonable cause
for failing to file gift tax returns because Mr. and Mrs. Cavallaro “provided [their
attorney] with incorrect information and worked with him in developing the [false]
‘picture’ depicted in the affidavits.” As we stated above, however, it was Mr.
Hamel’s idea to create the affidavits when he realized that, if the value of the
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[*68] CAM/ALOT liquid-dispensing machine technology remained in Knight, the
corporation wholly owned by Mr. and Mrs. Cavallaro, then their eventual estate
tax liability would be greater. Mr. Hamel sought to establish a basis for arguing
that the valuable CAM/ALOT technology was already owned by the younger
generation (i.e., in their Camelot corporation), yet he was faced with the problem
that there was no documented transfer of the technology--in 1987, when Camelot
was incorporated, or later. Mr. Cavallaro could hardly be said to have contributed
to creating a false picture of that alleged transfer when he stated in the interview
preceding the affidavit’s creation that he had not even given the transfer of
technology a thought. It was Mr. Hamel who concocted the idea that the
technology transfer happened when Mr. Cirome handed the newly formed Camelot
minute book to Ken Cavallaro. Mr. and Mrs. Cavallaro were later convinced by
Mr. Hamel to adopt the idea but cannot be fairly accused of providing false
information.
There is also no evidence in the record that Mr. and Mrs. Cavallaro
provided any false or incomplete information to Mr. Maio when he was hired to
perform an independent valuation of the two companies before their merger. At
trial, Mr. Maio explained that he followed his normal practice in gathering
information from which to value a company: he conducted on-site visits of the
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[*69] two companies, he reviewed relevant company materials, and he interviewed
key principals of both. He explained that he also used the relevant financial
information of Camelot and Knight, as provided to him by the companies’
accountants. And not only did Mr. Maio state that he was given complete access
to the necessary records of both companies, but he also testified that at the time he
did his initial valuation he did not see either the affidavits prepared by Mr.
Cavallaro and Ken Cavallaro or the “Confirmatory Bill of Sale”. We find that Mr.
and Mrs. Cavallaro have established that they provided necessary and accurate
information to their advisers.
Finally, Mr. and Mrs. Cavallaro persuasively testified that they actually
relied in good faith on the advisers’ judgment when they structured the merger of
Knight and Camelot and when they received inadequate compensation (in the form
of shares of the new, merged entity) for their shares of Knight. Neither of the
Cavallaros received advanced formal education, and neither was familiar with
sophisticated legal matters; and though both had participated in the process of
forming a company, neither had previously been a part of a corporate merger.
Exercising their best judgment, they sought out professionals with the relevant
experience in structuring this type of transaction, and then they acted according to
the professionals’ recommendations. The value in dispute inhered in invisible,
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[*70] intangible assets, consisting of intellectual property that was mostly not even
susceptible of public registration. When their lawyer advised them that it had been
transferred, they were hardly in a position to contradict him. In ways that
sometimes surprise laymen, the law sometimes deems transfers to have taken
place; in fact, the very gifts that we find here are indirect, deemed transfers. If the
lawyers and accountants said that a transfer had taken place when Camelot was
created in 1987, then from the Cavallaros’ point of view, why not? The fault in
the positions the Cavallaros took was attributable not to them but to the
professionals who advised them. (Since those professionals are not parties here
and have not had a full opportunity to explain or defend themselves, we refrain
from further comment on them.)
The value of the consideration that Mr. and Mrs. Cavallaro received in the
merged Camelot and Knight entity was based on the valuation figures arrived at by
Mr. Maio of E&Y; and at the time, none of their advisers questioned the numbers
or suggested to the Cavallaros that there might be gift tax implications. We find
that Mr. and Mrs. Cavallaro did in fact rely on the judgment and advice of their
professional advisers that the technology at issue had already been owned by their
sons’ company since 1987 (and thus was not being transferred in 1995). The
Cavallaros therefore had reasonable cause not to file gift tax returns in connection
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[*71] with the 1995 merger and, when they later did file returns, had reasonable
cause to report that their gift tax liability was zero.
Because both Mr. and Mrs. Cavallaro disclosed all the relevant facts
regarding Knight and Camelot to their experienced accounts and estate-planning
attorneys and followed their advice in good faith, both Mr. and Mrs. Cavallaro
have a successful defense of reasonable cause to the section 6651(a)(1) addition to
tax and the section 6662 accuracy-related penalty.
So that the gift tax liabilities can be computed,
Decisions will be entered under
Rule 155.