Donor v. Commissioner of Internal Revenue, 102419 FEDTAX, 3300-11

Docket Nº:3300-11, 3354-11
Attorney:Matthew D. Lerner, for petitioners. Carina J. Campobasso and Derek W. Kelley, for respondent.
Case Date:October 24, 2019
Court:United States Tax Court

T.C. Memo. 2019-144







Nos. 3300-11, 3354-11

United States Tax Court

October 24, 2019

Matthew D. Lerner, for petitioners.

Carina J. Campobasso and Derek W. Kelley, for respondent.



Ps owned KT Corp., and their three sons owned CS Corp. Ps and their sons merged the two in 1995, and CS Corp. was the surviving entity. In valuing the two companies for purposes of the merger, they incorrectly assumed that CS Corp. owned intangibles that instead KT Corp. owned. Ps therefore accepted a disproportionately low number of shares in the new company, and their sons received a disproportionately high number of shares. Ps thereby made disguised gifts to their sons consisting of portions of the value of KT Corp.

R issued notices of deficiency to Ps determining for each a gift tax liability. In Cavallaro v. Commissioner, T.C. Memo. 2014-189, we held that Ps had failed to meet their burden to prove the respective values of KT Corp. and CS Corp. On the basis of that failure, and by treating R's valuation of CS Corp. as a concession (compared to the zero value in the notice of deficiency), we held that Ps made gifts to their sons in 1995 totaling $29.7 million. Ps appealed. The Court of Appeals affirmed our factual findings and our holding that Ps had the burden of proof; but the court held that we erred in our statement of the content of Ps' burden of proof and concluded that we should have considered Ps' arguments rebutting R's expert witness testimony on the subject of valuation, in order to determine whether the resulting determination was arbitrary and excessive. On remand we now consider Ps' arguments concerning R's expert's report.

Held: R's valuation expert's error caused him to overvalue the disguised gifts by $6.9 million and rendered R's valuation arbitrary and excessive.


further, after correcting for that error, we determine that Ps gave their sons gifts valued at a total of $22.8 million.

These cases are before us on remand from the Court of Appeals for the First Circuit for reconsideration on the issue of valuation.

See Cavallaro v. Commissioner ("Cavallaro III"), 842 F.3d 16 (1st Cir. 2016), aff'g in part, rev'g in part and remanding Cavallaro v. Commissioner ("Cavallaro II"), T.C. Memo. 2014-189.1 At the trial of these cases the Commissioner presented the report of an expert witness to assert, for purposes of sections 2501 and 2502, 2 the proposed value of disguised gifts that William Cavallaro and Patricia Cavallaro had made to their sons. The question before us on this remand is whether the Commissioner's expert's valuation is "arbitrary and excessive". If it is, then we are tasked with determining the proper amounts of the Cavallaros' tax liabilities.


Many of the relevant facts underlying these cases are set forth in Cavallaro II and Cavallaro III, and we assume familiarity with those opinions. We restate and summarize certain relevant facts below.

The Cavallaro family, Knight and Camelot, and the merger

In 1979 the Cavallaros incorporated Knight Tool Co., Inc. ("Knight"), a machine shop and contract manufacturer. Mrs. Cavallaro owned 51% of Knight's stock, and Mr. Cavallaro owned 49%. The Cavallaros' three sons (Ken, Paul, and James) worked in the family business at various times. Mr. Cavallaro and his son Ken worked with Knight engineers and employees to develop a liquid-adhesive dispensing machine prototype, which came to be known as the "CAM/A LOT" machine. Ken, Paul, and James incorporated Camelot Systems, Inc. ("Camelot"). Knight manufactured the CAM/A LOT machines, and Camelot sold them.

In 1994 the Cavallaros' accountants at Ernst & Young ("E&Y") reviewed the situations of the Cavallaros, Knight, and Camelot. E&Y accountant Lawrence Goodman signed a letter dated December 15, 1994, 3 recommending the merger of the two companies. He projected that in such a merger "the majority of the shares (possibly as high as 85%) [will] go[] to Bill and Patti." E&Y valued the merged company as being worth between $70 and $75 million. However, attorneys at

Hale & Dorr later advised the Cavallaros to assume (incorrectly) that Camelot, not Knight, owned the significant intangible assets. The accountants did not agree with that view, and one of them wrote Mr. Hamel a letter concerning errors he perceived in the affidavits that were prepared by Hale & Dorr; but Mr. Hamel responded: "History 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." As a result the accountants acquiesced, and E&Y eventually attributed to Mr. and Mrs. Cavallaro considerably less than 85% of the stock in the merged company. See Cavallaro II, at *28-*31.

On December 31, 1995, the Cavallaros and their sons merged Knight and Camelot. In that merger Mrs. Cavallaro received 20 shares of the new company, Mr. Cavallaro received 18 shares, and 54 shares each were distributed to Ken, Paul, and James. Thus, Mr. and Mrs. Cavallaro received 19% of the shares, not the "the majority of the shares (possibly as high as 85%)" that E&Y had foreseen. Rather, it was the Cavallaros' sons who received the majority of the shares of the new company--i.e., 81% in the aggregate--which allegedly represented the pre-merger value of Camelot.

Examination and notices of deficiency

The IRS conducted a gift tax examination relating to the Cavallaros, and on November 18, 2010, the IRS issued statutory notices of deficiency to Mr. Cavallaro and Mrs. Cavallaro for the tax year 1995, determining that, by means of the merger, each of the parents had made a taxable gift of $23, 085, 000 to their sons, resulting in gift tax liabilities. The Cavallaros timely petitioned this Court for redetermination of their gift tax deficiencies.

Valuations in Cavallaro II

During trial Mr. and Mrs. Cavallaro entered into evidence two reports on the issue of valuation--the E&Y valuation performed by Timothy Maio in 1996 (valuing the combined companies as of October 31, 1995), on which the post-merger share distribution had been based, and the valuation prepared for trial in Cavallaro II by John Murphy of Atlantic Management Co. Mr. Maio had valued the combined company at $70 to $75 million, and Mr. Murphy valued the combined company at $72.8 million. Both assumed (contrary to our factual findings in Cavallaro II) that Camelot had owned the CAM/A LOT technology and that Knight had been a contractor for Camelot.

The Commissioner retained Marc Bello of Edelstein & Co. to determine the 1995 fair market values of Knight and Camelot. His report assumed (correctly, per our findings in Cavallaro II) that Knight had owned the significant intangible assets. Mr. Bello adjusted for the non-arm's-length nature of the two companies and then valued the combined entities using a discounted cashflow ("DCF") method. Mr. Bello concluded that the total value of the merged entity was $64.5 million (i.e., less than the value as reckoned by Mr. Maio and Mr. Murphy), that Knight's value was $41.9 million (i.e., 65% of the total), and that Camelot's value was $22.6 million (i.e., 35% of the total). On the basis of Mr. Bello's analysis, the Commissioner argued that the December 31, 1995, merger of Knight and Camelot and the disproportionate distribution of shares resulted in a gift to the Cavallaros' sons totaling $29.7 million. The Cavallaros cross-examined Mr. Bello, challenged his methodology, and alleged that his valuation was flawed for a number of reasons.

Holding in Cavallaro II

In Cavallaro II we found that Mr. and Mrs. Cavallaro's corporation Knight, rather than their sons' corporation Camelot, owned the technology; that "the 1995 merger transaction was notably lacking in arm's length character"; that the merger of the two companies with the issuance of 81% of the stock of the new combined entity to the sons reflected a presumption that Camelot had owned the technology; that the 81%-19% allocation of the stock was therefore not in accord with the actual relative values of the two companies; and that the transaction therefore resulted in disguised gifts to the sons. See Cavallaro II, at *33-*34, *54-*56, *60-*61.

In Cavallaro II we held in favor of the Commissioner on the basis of the Cavallaros' failure to meet their burden of proof. (They put on no evidence as to the relative values of the two corporations under the correct assumption that Knight, not Camelot, owned the intangibles.)...

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