The long saga of couple William and Patricia Cavallaro’s gift tax fight with the IRS is not over yet but is closer to being resolved. A federal appeals court has upheld the IRS’s characterization of the merger of their company, Knight Tool Company, with their sons’ corporation, Camelot Systems, Inc., as a taxable gift from the parents to the sons. (Cavallaro v. Commr., 2016) The controversy started in 1998 when the IRS first examined the merger and uncovered what it thought was a gift transaction. The IRS assessed a gift tax deficiency against the parents in 2010, and the parties have been battling it out in the courts ever since.
The dispute is over which company owned valuable technology, the CAM/A LOT machine, that was developed first by the parent’s corporation, Knight Tool. Later, the sons formed Camelot System’s Inc. to further perfect and market the machine, in conjunction with Knight’s engineers. In 1995, the two companies decided to merge. When the companies were appraised, the value of the CAM/A LOT machine was included as Camelot’s asset. The couple argued that they had “informally” transferred the machine to their sons’ corporation.
Where the Gift Comes In
The gift tax problem arose from the valuation of the machine as Camelot’s asset. Whether a gift occurs in the merger of family corporations depends on the ownership interest each party gets in the combined entity. The ownership shares must fairly reflect the value brought into the merger by each side. The IRS included the machine in the value of Knight Tool. The numbers get complicated, but, essentially, the IRS treated the merger as a gift because including the machine in Knight Tool Company’s valuation meant that the parents had transferred substantially more value to the sons in the merger than they received in the merged corporation. The IRS’s valuation expert attributed 65 percent of the value of the merged entity to Knight, but the Cavallaros only ended up with 19% ownership of the merged corporation. The Tax Court, in a 2014 decision, Cavallaro v. Commr., agreed with the IRS.
New Valuations but No Penalties
The 1st Circuit Court of Appeals in Boston, MA found there was a gift from the parents to the sons but remanded the case for further valuation. The Court believed the Cavallaros had not been given the chance to rebut the IRS’s valuation report and that they should be allowed to do so.
Although the Appeals Court determined the merger was a gift, it did not allow penalties on the Cavallaros to stand. The taxpayers were able to demonstrate in good faith that they had relied on the advice of a Big Four accounting firm and on tax lawyers that they did not have to report a taxable gift.
So, the case will continue, but is getting closer to a final resolution. What is the lesson learned? Two corporations with owners who have family relationships need to formalize their transactions and make them as arm’s length as possible. Also, mergers involving related parties are in danger of being recharacterized as a gift if the relative values in the new company do not reflect the true contributions of each company.