So much for professional help! Hardworking taxpayers who built a successful business relied on estate planning professionals to effect a transfer of wealth that would minimize their tax liability. The resulting merger of two family businesses led to an IRS deficiency notice alleging the couple was liable for making a $46 million gift to their sons.

‘A few embarrassing facts.’ In 1979, the taxpayer husband and wife founded a company, Knight, which built custom tools and machines. Eventually, the husband and a son used Knight resources to develop a unique machine, CAM/ALOT, and formed another company, Camelot, to take the product to market. The taxpayers’ three sons owned Camelot in equal parts. No contemporaneous documents showed a transfer of the rights to the machines from Knight to Camelot. Knight built the machines and financed the operations of both businesses. The two companies worked out of the same building and shared payroll and accounting services. When the taxpayers hired a major accounting firm for tax advice, the latter prepared tax returns that claimed R&D tax credits for Knight, based on work Knight engineers had done.

In 1994, the taxpayers also retained a well-known law firm for estate planning purposes. Initially, the accountants and the lawyer had differing ideas as to which entity owned the technology and how to pass that value down to the three sons. The attorney set out to construct a narrative in which the value transfer from Knight to Camelot started at the time Camelot was incorporated. When told that real events did not bear out this story, the attorney said that in any history one had “to squeeze a few embarrassing facts into the suitcase by force.” Eventually, the accountants fell in line and the professionals structured a merger based on the premise that no gift tax was due because, on the merger date, Camelot already owned the CAM/ALOT technology. In 1995, the petitioners accepted a 19% interest in the new entity, while the three sons claimed the remaining 81% in equal measure. Effectively, Camelot was valued at four times the value of Knight. Six months later, the merged company was sold for $57 million in cash.

Fifteen years later, the IRS issued a deficiency notice claiming the premerger Camelot had zero value and the merger resulted in a roughly $23 million gift from each parent to the sons.

Faulty key assumption: The issue in Tax Court was whether the petitioners agreed to an unduly low interest in the merged company and the sons received an unduly high interest. The court considered valuation testimony from three experts. The taxpayer’s two experts arrived at similar conclusions. Both appraisers relied on the assumption that, at the time of the merger, Camelot owned the value of the technology. They both used a market approach and valued the merged entity between $70 million and $75 million and Knight’s portion of that value between $13 million and $15 million. Both said they were unable to perform a stand-alone valuation for Camelot. In contrast, the IRS’s trial expert assumed Knight owned the technology. He based his valuation on a discounted cash flow analysis and concluded the merged entity was worth $64.5 million—less than the taxpayers’ experts stated. He determined that 65% of that value belonged to Knight, that is, $41.9 million. As a result, the IRS conceded some ground and lowered the gift amount to $29.6 million.

The court found that Knight owned the technology and the merger was not an arm’s-length transaction. Because the taxpayers’ valuations were based on the wrong assumption, there was no evidence to counter the IRS valuation. The court also said the petitioners had a reasonable-cause defense and were not subject to an accuracy-related penalty. Since they had no formal legal or accounting background, they in good faith and to their detriment hired professionals. “The fault in the positions [the taxpayers] took was attributable not to them but to the professionals who advised them,” the court noted.

Takeaway: The conduct of the estate planning professionals raises serious ethical issues. The court noted there was “doctoring” of documents and filing of amended tax returns to “accommodate” the idea that Camelot was the technology’s owner. Ultimately, the IRS was able to gain access to the damaging material and the taxpayers, who played no role in formulating or executing the strategy, paid the price.

Find an extended discussion of Cavallaro v. Commissioner, 2014 Tax Ct. Memo LEXIS 189 (Sept. 17, 2014), in the January issue of Business Valuation Update; the court’s opinion will be available soon at BVLaw.