William Cavallaro and Patricia Cavallaro appealed to the U.S. Court of Appeals for the First Circuit a Tax Court decision that they owed gift taxes on a $29.67 million gift to their sons.[1] The First Circuit ruled that the Tax Court erred by not allowing the Cavallaros to present evidence challenging the valuation of the Commissioner’s expert.
Case Background
In 1979, the Cavallaros started Knight Tool Co. (Knight), a contract manufacturing company that made custom tools and machine parts. In 1982, Knight developed a liquid-dispensing system for adhesives called CAM/ALOT. The new system wasn’t an immediate success, and Knight decided to refocus its efforts on its other core business products.
In 1987, the three sons of the Cavallaros organized Camelot Systems, Inc. (Camelot) to further develop the CAM/ALOT system. After further refinements to the system, Knight began manufacturing the CAM/ALOT systems, and Camelot sold and distributed them to customers.
The tax dispute with the Internal Revenue Service arose from a 1995 merger of Knight and Camelot. The Cavallaros contended that the CAM/ALOT technology was transferred from Knight to Camelot in 1987 at the time Camelot was formed. The IRS took the position that Knight continued to own the CAM/ALOT technology at the time of the merger.
The IRS issued notices of deficiency to the Cavallaros for the tax year 1995, which were based on the assumption that Camelot had a pre-merger value of $0. Based on this assumption, the IRS contended that when Knight merged with Camelot, the Cavallaros each made a taxable gift of $23.085 million to their sons.
Prior to the Tax Court trial, the Commissioner secured an expert who concluded that Camelot had a value of $22.6 million at the time of the merger and, therefore, lowered the amounts that were set forth in the original notices, which assumed that Camelot had no value. Prior to trial, the Cavallaros used this new information to argue that the original notices of deficiency were arbitrary and excessive and that the Commissioner was introducing a new matter before the Tax Court. The Cavallaros argued that these new theories shifted the burden of proof to the Commissioner.
The Tax Court concluded that Knight owned the CAM/ALOT technology. It also denied the Cavallaros’ motion to shift the burden of proof to the Commissioner because it was unpersuaded by the Cavallaros’ argument that the Commissioner’s litigating position was a “new matter” that either introduced a new theory or changed the issues for trial. The Tax Court ultimately concluded that the Cavallaros were deficient in paying gift tax due for 1995 of $15.662 million.
The Appeal
On appeal, the Cavallaros claimed that the Tax Court erred and should have shifted the burden of proof to the Commissioner because: (1) the original notices of deficiency were arbitrary and excessive, and (2) the Commissioner relied on a new theory of liability. The Cavallaros also claimed that the Tax Court improperly concluded that Knight owned all the CAM/ALOT-related technology and the Tax Court erred by misstating their burden of proof and failing to consider the alleged flaws in the Commissioner expert’s valuation of Knight and Camelot.
Deficiency Notices
In addressing the Cavallaros’ burden-shifting argument, the First Circuit considered whether the Cavallaros carried their burden of producing evidence from which it could be concluded that their initial deficiency notices lacked rational foundation. After reviewing the evidence, the First Circuit found there was sufficient basis for the IRS to conclude that Camelot’s value was de minimis for purposes of preparing the initial notices of deficiency and, as a result, the notices weren’t arbitrary and excessive. In addressing the Cavallaros’ argument that the Commissioner relied on a new theory of liability at trial, the First Circuit stated that the Commissioner’s adoption of its expert’s valuation was simply a refinement of its original theory rather than a new theory. Consequently, the First Circuit was unpersuaded by both of the Cavallaros’ burden-shifting arguments and affirmed the Tax Court’s determination that the burden of proof was on the Cavallaros.
Ownership of Technology
Next, the First Circuit addressed the Cavallaros challenge of the Tax Court’s findings that Knight owned all of the CAM/ALOT technology. The First Circuit found that the record amply supported the Tax Court’s determination on this issue. The court noted that Knight created the first CAM/ALOT system, and, even after the formation of Camelot, the financial affairs of the companies overlapped significantly. The court also noted that Knight owned certain public registrations of intellectual property; the CAM/ALOT trademark was registered to Knight until the time of the merger; and four patent applications, which were filed by William Cavallaro, identified Knight as his assignee. The First Circuit concluded that the Cavallaros didn’t advance any argument that would warrant overturning the Tax Court’s finding that Knight owned all of the CAM/ALOT technology at the time of the merger.
Valuation
In challenging the valuation provided by the Commissioner’s expert and relied on by the Tax Court, the Cavallaros argued that the Tax Court again erred with respect to the burden of proof. The Tax Court stated that the Cavallaros had “the burden of proof to show the proper amount of their tax liability,” but the Cavallaros argued that their burden was to establish “that the alleged deficiencies were erroneous.” The Cavallaros argued that this “legal error” by the Tax Court led to another error, which was the Tax Court’s refusal to consider their evidence that the Commissioner expert’s valuation was flawed. Accordingly, the First Circuit determined whether the Tax Court misstated the burden of proof and whether the Tax Court erred in adopting the Commissioner’s valuation without considering its alleged defects.
The First Circuit agreed with the Cavallaros that the Tax Court misstated the burden of proof. The First Circuit also noted that the Cavallaros attempted to show that the Commissioner's valuation was arbitrary and excessive by challenging its methodology, but the Tax Court refused to hear those challenges because, even if the Cavallaros were correct, they couldn’t show the correct amount of their tax liability. The First Circuit held that the Cavallaros should have had the opportunity to rebut the Commissioner’s valuation and to show that the Commissioner's assessment was arbitrary and excessive. And, if they succeeded in doing so, the Tax Court should have then determined for itself the correct amount of tax liability rather than simply adopting the Commissioner's position. As a result, the First Circuit remanded so the Tax Court could evaluate the Cavallaros' arguments that the Commissioner expert’s valuation had methodological flaws that made it arbitrary and excessive.
[1] See Cavallaro v. Commissioner, T.C. Memo. 2014-189 (Sept. 17, 2014) and Cavallaro v. Commissioner, U.S. Court of Appeals for the First Circuit (Nov. 18, 2016).
