Taxpayers can rebut IRS expert valuation, appeals court says

BVWireIssue #172-3
January 25, 2017

One of the most notorious tax cases in 2014 involved hardworking family business owners who had relied on the dubious estate tax advice of lawyers and faced serious gift tax exposure as a consequence. But a recent appeals court ruling throws the taxpayers a lifeline. The crux of the matter now is whether the expert valuation on which the Internal Revenue Service built its case can hold up under close scrutiny from the Tax Court.

Tech transfer: The parents owned Knight Tool Co. (Knight), a business that developed an automated liquid-dispensing machine—CAM/ALOT. In 1987, their sons formed a separate company, Camelot, to refine and market the technology. In 1994, the taxpayers hired experienced accountants and lawyers to determine which entity owned the value of the CAM/ALOT technology and come up with a strategy of how to pass the value on to the sons in a way that minimized estate tax liability. The lawyers fashioned a merger based on the premise that no gift tax was due because, in 1995, on the merger date, Camelot already owned the CAM/ALOT technology. According to the lawyers’ narrative, the technology was transferred to Camelot years earlier. This version of events had no support in the record.

In its deficiency notices, the IRS claimed on the merger date Camelot had zero value and the merger resulted in a gift of $23 million from each parent to the sons. The taxpayers petitioned the Tax Court for review. By the time of trial, the IRS had obtained an expert valuation and reduced the taxpayers’ liability to $29.6 million. The taxpayers claimed the IRS’s expert valuation was unsound because the expert proceeded from the wrong assumption (that Knight owned the technology) and his income-based analysis had serious methodological flaws. The taxpayers offered two expert appraisals, both of which assumed that Camelot owned the technology at the time of merger.

The Tax Court found Knight, not Camelot, owned the technology. Since the taxpayers had the burden of showing the proper amount of their tax liability and their valuations were based on the wrong assumption, they had no evidence to do so. Accordingly, the Tax Court, without more evidence, adopted the IRS’s deficiency finding, while allowing the IRS’s finding was based on “an arguably flawed [valuation] analysis.”

Remanded: The Court of Appeals (1st Circuit) found the Tax Court misstated the law on the taxpayers’ burden and was wrong not to explore the taxpayers’ numerous criticisms of the IRS’s expert valuation in detail. It remanded for another hearing on the valuation issue. Stay tuned.

The case is Cavallaro v. Commissioner, 2016 U.S. App. LEXIS 20713 (Nov. 18, 2016) (Cavallero II). A digest and the court’s opinion will be available at BVLaw.

A digest of the earlier decision, Cavallaro v. Commissioner, 2014 Tax Ct. Memo LEXIS 189 (Sept. 17, 2014), and the Tax Court’s opinion are already available at BVLaw.

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