Merger is Constructive Gift in Cavallaro

In Cavallaro v. Commissioner, (TCM 2014-189), the Tax Court decided a dispute that’s been ongoing since an Internal Revenue Service examination in January 1998.  This initial examination resulted from the sale of Camelot Systems, Inc., for $57 million (plus an earn-out that was never paid) in 1996.  But the history of the case goes back even further.

 

Facts

William and Patricia Cavallaro started Knight Tool Co., Inc., in 1976 and incorporated the company in 1979, as equal 50/50 shareholders. Knight was a machine shop, primarily making tools and parts for defense, aerospace and industrial customers.

• In 1982, Knight created what would become its sole hit product: the CAM/ALOT Liquid Dispensing System for the production of computer circuit boards.  The company did well and saw growth, over the years, in both its traditional machine tooling business and with CAM/ALOT.
• In 1987, the Cavallaros’ three sons founded and incorporated Camelot Systems, Inc., as equal 1/3 owners, to market and sell the CAM/ALOT system.  However, only one of the three brothers, Ken Cavallaro, worked actively for Camelot.
• With the success of their services and products, the two companies grew significantly.  Combined pretax income for Knight and Camelot together appears to have exceeded $5.5 million in 1995.
• On Dec. 31, 1995, the family agreed to merge the two companies, as a part of the family’s estate planning, and their accountant was asked to prepare a valuation.  The accountant worked under the assumption that Camelot was the owner of the CAM/ALOT technology and valued the combined entity at a range from $70 million to $75 million, with a portion allocated to Knight of only $13 million to $15 million.  Post-merger, William and Patricia owned 19 percent and their children held 81 percent of the surviving entity.
• During the income tax examination in 1998, the IRS learned that there might be a possible gift tax issue in connection with the 1995 merger of Knight and Camelot, and opened a new examination of this additional issue.
• The IRS issued a notice of deficiency (NOD) in November 2010, after very substantial legal wrangling, including over document production.  Subpoenas for very important documents were attempted and quashed based on privilege, but the IRS prevailed on this point (see Cavallaro v United States (1^st Cir., Ct. of App. 2002)).
• The NOD determined that Camelot had zero value pre-merger and that both William and Patricia had made taxable gifts of more than $23 million to their sons as a result of the merger.

 

Taxpayers’ Claims

The subsequent Tax Court case revolves around the following question: Did Camelot own CAM/ALOT as of the merger in 1995, or had Knight always owned the technology (including trademarks and associated intangibles)?  The petitioners, essentially, argued:

1. The technology was transferred to Camelot at its founding in 1987, even though no documents evidencing or formalizing this transfer were ever executed.  The Cavallaros were unsophisticated in business and legal matters but intended to transfer CAM/ALOT for valid business reasons, so the transfer took place without formal written agreements.
2. The product was unsuccessful and unprofitable as of 1987 and had zero, or negligible, value.  The point of founding Camelot was to improve and promote the product within its target market, so, to the extent that the technology increased in value, this should accrue to the benefit of Camelot.
3. The product was in fact improved over the years, in numerous ways, and became successful as a result of these improvements and the efforts of Ken Cavallaro, in particular.

However, it also belongs to the story that:

1. Highly damning documents were produced in court (including letters to and from their trusts & estates attorney), pointing the court to the conclusion that the primary purpose of the merger was to avoid estate and gift taxes.
2. The accountants for the family and their entities had taken positions, in several prior documents and tax filings, that the technology was the property of Knight, not Camelot.  Some of the tax returns were re-filed after the family started to consider their estate planning objectives.
3. Camelot always functioned primarily as a sales organization, purchasing and re-selling products from Knight.  It was identified as such (including with SIC codes) in several public filings.
4. The two companies operated symbiotically, with all employees on Knight’s payroll.  Camelot didn’t even have its own bank accounts.  This tends to make it hard to substantiate investments made by Camelot (or on its behalf) to improve and re-design the product.
5. Almost all trademarks or patent filings for the product indicate Knight as owner or assignee of intellectual property rights.

 

Tax Court Ruling

The court found that the parents made gifts totaling $29.6 million on Dec. 31, 1995.  As could be expected in a case of this magnitude, several valuations were presented and reviewed, but the deciding factor of the case was the court’s finding that the taxpayers’ position on the ownership of CAM/ALOT wasn’t credible. The following excerpts are key:

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 party either would have offered to purchase Camelot at a much lower price or (more likely) would have walked away from the deal altogether.

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.

As to the exact valuation of Knight given up by the parents in the merger, the Court finds both valuations performed for the taxpayers to be based on an incorrect fundamental premise (Camelot’s ownership of the technology). As to the IRS’ expert:  

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.

And since the taxpayers’ expert valuations were held to be incompatible with the court’s findings of fact, the court stated “[w]e are thus left with the Commissioner’s concession, effectively unrebutted by the party with the burden of proof.”

 

Penalties

The court found that the Cavallaros had reasonable cause for both their failure to file and  the substantial tax understatement.  This requires good-faith reliance on competent professional advice from an advisor with access to all relevant facts. The court found that their lawyer “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.”  Based on this, the family was advised that Knight didn’t own the technology in 1995.  There was also no evidence suggesting that the Cavallaros ever provided false information to their legal, accounting or valuation advisors.

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.)

 

Lessons Learned

Could this have been a winnable case for the taxpayers?  Probably not the way the evidence stood at the time of trial.  However, it seems possible that better planning at an earlier stage might have altered the outcome:

• Handshake or oral agreements are far from uncommon.  The fact that the 1987 transfer took place without written documentation isn’t a fatal flaw in and of itself.
• Ken’s and Camelot’s involvement in taking a failed and poorly-designed product and transforming it to a commercial hit appears to have been quite substantial, perhaps decisive.  In other words, the purpose of Camelot, as a driver and evangelizer of the technology appears to have paid off.
• To the extent that the value of the technology was negligible in 1987 (which seems quite clear) and that Camelot played a major role in increasing that value (plausible), some of that value should logically accrue to Camelot.

The case, along with the related earlier trials in district court and the First Circuit, is also a timely reminder that attorney-client privilege is a highly limited and circumscribed right.