The Burden of Gifts

The Facts –Merging Companies, Giving Gifts.

So, what did the Cavallaros get their sons?  A merger, resulting in a gift worth about $29,670,000 (that is on my list, but probably not going to be under my tree).  The Cavallaros had a successful company  (“Knight”) that made custom tool and machine parts.  Husband owned 49%, and wife had 51%.  At some point, they tried to expand into a liquid dispensing system manufacturer, but it initially failed.  One of the sons asked if he could continue to try to develop the system under a new entity (“Camelot”), and the parents agreed.  That son and two other sons owned Camelot.  Ten or so years later, the Cavallaros brought in lawyers and accountants to review their estate plan.  The accountants felt the now successful other line of business (“newtech”) was part of, or owned by, Knight.  This was how it was treated by Knight and how it was kept on the books.  The lawyers, however, felt it should be treated as having already passed to Camelot, which was marketing and selling the technology, and which would have already transferred the value to the three sons.

The lawyer, in trying to convince the accountant of this, stated, “[h]istory does not formulate itself, the historian has to give it form without being discouraged by having to squeeze a few embarrassing facts into the suitcase by force.”  Facts can be the worst.  The lawyer eventually convinced the accountant and family, and then had affidavits, memos, and a confirmatory bill of sale evidencing newtech in Camelot.

The family had a valuation of the two companies post merger, which the valuation expert valued  at $70MM to $75MM, with the Knight portion worth about $13MM to $15MM (less than 20% of the total company). Camelot, with the ownership of newtech, was valued at over 80%.    After the merger, Mr. C got 18 shares of the merged company, Mrs. C got 20 shares, and each son got 54 shares.  Shortly thereafter, the company was sold, with the Cavallaros getting $10.8MM total, and each son receiving $15.4MM.

Later, the IRS examined the two companies, and disagreed about the ownership of newtech, leading it to investigate the transaction for potential gifts from the merger.  The Service eventually issued a notice of deficiency for the gifts from the Cavallaros to their sons.  The IRS’ initial position, without an appraisal, was that Camelot had no value, resulting in a roughly $46MM gift from the merger, with $12.6MM in tax due.  The service also imposed penalties for the failure to file the return and for fraud under Sections 6651(a)(1) and 6663(a).

The Cavallaros took the matter to the Tax Court, and during discovery found that the Service had a valuation done after the deficiency was issued, which had been done by an accountant named Bello, and the appraisal indicated Knight had a value of $22.6MM prior to the merger (not $0).  The Cavallaros used the valuation to make two arguments against the Service, both of which could have shifted the burden of proof to the Service.  First, the Cavallaros argued that the original deficiency was arbitrary and excessive.  Second, the Cavallaros argued the Service had initially taken the position that Camelot was a shell corporation used for a sham transaction, which was used solely for making a disguised gift.  The Cavallaros argued that the Service’s new position that the Cavallaros had grossly understated the value of Camelot was a “new matter” under Tax Court Rule 142.  Based on this, the taxpayers sought to shift the burden of proof to the Service.

The First Circuit summarized the tax court holding as follows:

The Tax Court denied the Cavallaros’ renewed motion to shift the burden of proof to the Commissioner. While noting that it was “evidently true that the Commissioner did not obtain an appraisal before issuing the notices” of deficiency, the Tax Court found that there was a sufficient basis for issuing the notices and, thus, that they were not arbitrary. Further, the court found unpersuasive the Cavallaros’ argument that the Commissioner’s litigating position was a “new matter” and stated that the Commissioner’s “partial concessions as to Camelot’s non-zero value” did not require a new theory or change the issues for trial.

And, summarized the Cavallaros’ appeal on this issue, and the question of what the burden was, as follows:

On appeal, the Cavallaros renew their claim that the Tax Court erred by failing to shift the burden of proof to the Commissioner for two independent reasons: because (1) the original notices of deficiency were arbitrary and excessive, and (2) the Commissioner relied on a new theory of liability. They make two additional arguments. First, they claim that the Tax Court improperly concluded that Knight owned all of the [newtech] related technology. Second, they contend that the Tax Court erred by misstating their burden of proof and subsequently failing to consider alleged flaws in Bello’s valuation of the two companies.

In general, there is a presumption of correctness of an IRS notice of deficiency, and the taxpayer must prove by a preponderance of the evidence that the Service erroneously assessed tax (which isn’t necessarily the same as showing the taxpayer’s correct tax liability).  It is worth noting that this examination began prior to the enactment of RRA98, which amended Section 7491 dealing with burdens of proof.  Those changes made it easier, in certain circumstances, for taxpayers to shift the burden to the Service, but those provisions were not available to the Cavallaros (although I’m not sure that would have mattered in this case).

Excessive and Arbitrary

As indicated above, the first argument the Cavallaros made was that the deficiency notice was excessive and arbitrary.  Not much text was devoted to this argument, and the First Circuit noted this was a limited doctrine.  Essentially, a taxpayer must argue that the assessment has “no factual relationship to the taxpayer’s liability…” Zuhone v. Comm’r, 883 F2d 1317 (7^th Cir 1989).  The Court said its question was “whether the [taxpayers] have carried their burden of producing evidence from which it can [conclude] that their deficiency assessments utterly lacked rational foundation.”  Although the Service initially used no formula, and had no valuation, the Court found that did not result in a conclusion that the initial assessment lacked a rational foundation.  As the Service had seen statements about “squeezing a few embarrassing facts into a suitcase,” and other information about aggressive planning, the Court found sufficient evidence to conclude the Camelot substantially less, and perhaps no, value.

The policy behind this makes sense.  The taxpayer has all the information, and may not have  been cooperating, but the Court was fairly dismissive of this argument, when there were some negative facts for the Service (obtaining a valuation shortly after assessment, which showed substantial value – hard to imagine it had none of that information when assessing).

New Matter

The Cavallaros second argument was that the Service was raising a new matter, which based on the facts from the First Circuit, seems like an aggressive characterization.  Under the Tax Court rules, a party raising a “new matter” has the burden of proof on that matter.  If the Service seeks to impose tax based on a rationale not in the notice, it is treated as having raised a “new matter”.  See Shea v. Comm’r, 112 TC 183 (1999).  Whether a new theory is a new matter is not always clear.  The Court noted, a new theory is “treated as a new matter when it either alters the original deficiency or requires presentation of different evidence.” Wayne Bolt & Nut Co. v. Comm’r, 93 TC 500 (1989).  That is not the case if the theory “clarifies or develops the original determination.”

Here, the Cavallaros believed that the original argument was that Camelot was a worthless sham, but at trial the government argued that Camelot was overvalued by the Cavallaros.  The notice, however, never indicated Camelot was a sham.  The notice stated:

[Under Section 2511,] donor’s merger of Knight Tool Co. into Camelot Systems, Inc. in return for 19% of the stock of Camelot Systems, Inc. resulted in a gift of $23,085,000.00 to the other shareholders of Camelot Systems, Inc. Accordingly, taxable gifts are increased $23,085,000.00.

The Court stated that the “clear implication was that, because Knight was undervalued, the…merger allowed for a disguised gift…”  The Court found that when the IRS subsequently changed its position on the value from $0 to around $22.7MM, it was “simply a refinement”, which it held was in line with its position that, “if a deficiency notice is broadly worded and the Commissioner later advances a theory not inconsistent with the language, the theory does not constitute a new matter…”  The Court also found that the notice clearly informed the Cavallaros that the Service was questioning their valuation.   This holding, again, makes sense, but I have conflicted feelings about incentivizing the Service to issue notices that are overly broad and vague.

What Was the Burden?

The most interesting aspect of the holding came from the application of the burden of proof in relation to challenging the IRS’s valuation of the entities.  The Cavallaros, before the Tax Court, had attempted to challenge the valuation report by Bello that was relied upon by the Service and the Court, believing it to have substantial flaws.  The Tax Court disallowed this challenge, believing it to be unnecessary.  The Tax Court stated that the Cavallaros had “the burden of proof to show the proper amount of their tax liability.”  The Tax Court had found that the Cavallaros’ valuations were incorrect, because they assumed full ownership of newtech in Camelot and the Tax Court had held the technology was owned by Knight.  The Tax Court further held that without valuations, the Cavallaros could not prove their correct tax liability, and therefore lost the case, so challenging the Bello valuation wasn’t necessary.  The Cavallaros, however, argued that their burden was not to show the proper amount of tax, but to prove that the alleged deficiencies by the Service were erroneous.  One avenue of doing this was to address the flaws in the Bello valuation.

In this instance, the First Circuit agreed with the Cavallaros, stating:

 [a]lthough the Tax Court did not misallocate the burden of proof at trial, we agree with the [taxpayers] that the Tax Court misstated the content of that burden.  The Commissioner’s deficiency notices enjoyed a presumption of correctness, and the [taxpayers] had the burden of proving by a preponderance of the evidence that they were erroneous.

The First Circuit held this was a clear error, and the Cavallaros should have had the opportunity to show the valuation was arbitrary and excessive, which could have then indicated the Service assessment was incorrect.   The First Circuit remanded the case to the Tax Court to determine the evidentiary value of the Bello valuation, stating that if it was not valid the Tax Court would be responsible for determining the correct valuation and amount of tax due.

This procedural misstep by the Tax Court was a bit of a gift for the taxpayers, allowing them another shot at reducing their tax burden.  I would note, the Tax Court did state the burden correctly in the text of the holding, which it stated in multiple places as the petitioner having to show the deficiency notice was incorrect, and indicating “where the Commissioner has made a partial concession of the determination in the notice of deficiency, the petitioner has the burden to prove the remaining determination wrong” (quoting Silverman v. Comm’r, 538 F2d 927 (2d Cir. 1976)).  However, in the discussion of the review of the valuations, it did state, “[i]t 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 [newtech]…”  This did lead to the Tax Court not reviewing the valuations.

This was a good catch by the litigating attorneys, and goes to show that you need to pay close attention to every aspect of a holding, because even though a Court may correctly state the rules, it still can drift from those rules in coming to its holding.  At least one other commentator, Dominick Schirripa at Bloomberg BNA, believes this could be a substantial holding for taxpayers.  He indicates it is fairly common  for the Court to require the taxpayer to show the correct liability in order to prove the Service’s assessment is incorrect.  Mr. Schirripa may be correct, but I think my expectation from the case is a little more tempered (which Mr. Schirripa also notes in his post).   It would seem for many income tax cases, and gift and estate, showing the correct tax is really the only way to show that the Service assessment was incorrect.  In this case, where a valuation is at question, there are various ways to attack the Service’s valuations without presenting evidence of the correct tax due.  Since it may be limited circumstances where this is the case, this holding may not broadly impact how cases are handled before the Tax Court, but it is worth keeping in mind when reviewing a potential case.