Why a Tax Attorney’s Advice is Important: Estate Planning, Gift Tax, Business Succession, and the Ability to Rely on Advice by Counsel

Case of the Week: Cavallaro

A recently published tax court opinion provides us with a fascinating case involving a rags to riches story of a tightly-knit hardworking family and the creation, merger and eventual sale of two related family companies. It hit our radar because of the impermissible tax position taken that resulted in the US Tax Court upholding an enormous gift tax assessment and the resulting tax problems for the founders (the parents).

A Rags to Riches Story

In the 1950s, William Cavallaro transferred from the 9th grade to a trade school machine shop program and then worked his way from janitor to production manager at a local tool company. His wife, Patricia, earned a high school degree, took a few college-level secretarial courses and had one year of experience doing clerical work before getting married in 1960 and raising their three sons. In 1979, the Cavallaros established Knight Tool Co. (“Knight”). William made and sold custom manufacturing tools and parts for other companies, and Patricia handled the secretarial work and the bookkeeping. Their three sons finished school and eventually they all worked for the company.

In 1982, William and his eldest son Kevin began work on the first liquid-dispensing machine prototypes to neatly and repetitively attach various parts to computer circuit boards (they called it CAM/ALOT). Knight initially lost money on CAM/ALOT and in order to acquire additional capital through third-party investors to correct flaws in the machine, the Cavallaro sons incorporated a second company in 1987. The sole purpose of the new company, Camelot Systems, Inc. (“Camelot”) was to develop a successful liquid-dispensing machine and market it. This was done with their parents’ full consent—at the new company’s first meeting William handed the minute book over to Ken, saying, “Take it; it’s yours”; however, no documentation was ever prepared transferring rights in the machine to Camelot.

Ken continued to develop the market for the machine, while his father and the Knight engineers made and improved on them. Knight in effect was acting as the manufacturer and Camelot as the contractor. On the administrative, bookkeeping, tax and legal documentation side, however, Camelot was characterized as a sales agent thus leaving only Knight at risk for nonpayment, the intellectual property registered to Knight, all Camelot wages were paid by Knight, Knight received the R&D credits for all work on the machines, and Knight paid all of Camelot’s bills. However, Camelot received a disproportionate share of the profits.

Estate Planning problem

In 1994 and 1995, the Cavallaros revised their estate plans. Recognizing the potential problem of Knight’s increasing value, their estate planning attorney decided that the 1987 handing of the minute book to Ken constituted a “symbolic transfer” of the CAM/ALOT technology to Camelot. As noted above, the respective companies’ administrative records and tax returns did not reflect any transfer.

While the court characterized as either “the deliberate benevolence of Mr. and Mrs. Cavallaro toward their sons” or “a non-arm’s-length carelessness born of the family relationships of the parties,” and as such, the sons’ company (“Camelot”) received a disproportionate share of profits that technically belonged to the father’s company (“Knight”). In essence, the estate attorney’s planning conflicted with the administrative and tax records previously maintained and filed.

In order to effectuate the estate plan, the Cavallaro’s (through their accountants) prepared sets of amended tax returns for both Camelot and Knight, disclaiming research and development credits previously taken by Knight and claiming them for Camelot.

Merger and Sale

By 1995, the value of the CAM/ALOT machine had increased significantly and the Cavallaros decided to merge the two companies to assure that Camalot could more easily comply with certification in the European market. The combined entity was valued between $70 and $75 million, with Knight’s portion between $13 and $15 million. The tax-free merger took place on December 31, 1995, with Camelot as the surviving corporation. The majority of the shares were allocated to the Cavallaro sons. The company was sold in 1996 for $57 million in cash and up to $43 million in potential deferred payments based on future profits. William and Patricia received a total of $10.8 million and each of their sons received $15.29 million.

Tax Audit as Trigger for the Disallowance

In January of 1998, the IRS conducted an audit of Knight’s and Camelot’s 1994 and 1995 income tax returns. During the income tax examination, the IRS learned that there might be a possible gift tax issue, and a gift tax examination was opened the following month. In 2005, the Cavallaros filed gift tax returns for the 1995 gifts, showing no amount due. In November 2010, the IRS issued notices of deficiency to William and Patricia, deeming the merger a constructive gift to the Cavallaro’s sons in the amount of $46.1 million, with a gift tax liability of approximately $25 million. Although the gift amounts were later reduced by IRS to $29.6 million, the Cavallaros appealed the enormous sum to Tax Court. The Tax Court concluded that as a result of the distorted allocation of the stock, William and Patricia Cavallaro, did in fact, convey gifts to their sons totaling nearly $30 million.

Additions to tax were also asserted under IRC section 6651(a)(1) for failure to file timely gift tax returns and penalties under section 6663(a) for fraud. The IRS Commissioner later substituted the fraud penalties with alternative section 6662 accuracy-related penalties.

Section 6662 Accuracy-Related Penalties and Defenses

Under IRC section 6662, an “accuracy-related penalty” may be imposed for a number of reasons, among them “a substantial estate or gift tax valuation understatement” and a “gross valuation misstatement.”

A “substantial estate or gift tax valuation understatement” is defined under section 6662(g)(1) as a valuation reported at 50% or less of the actual value and where the underpayment is more than $5,000. The tax imposed is 20% of the underpayment.

A “gross valuation misstatement” under section 6662(h) occurs when the valuation reported is less than 25% of its actual value. Where there is a gross valuation misstatement, the penalty is increased from 20% to 40%.

Reasonable Cause as a Defense to Accuracy Related Tax Penalties

The court determined that since the parents’ gift tax returns were filed 9 years late, section 6651(a)(1) applied to the case. It also held that the threshold for accuracy-related penalties under section 6662 had been met. However, the judge agreed with the Cavallaros’ assertion of “reasonable cause” as a defense to liability and did not impose the penalties—the Court was clearly impressed by the work ethic and honesty of the parents, and found that they acted in good faith, relying on the mistaken advice of their otherwise competent tax advisers. The court found that the Cavallaros met all three requirements for avoidance of liability due to reliance on a tax adviser’s guidance:

  1. Their estate planning attorney and accountants were competent professionals, well known in their areas of practice and all had sufficient expertise to justify reliance,
  2. They provided their advisors with all the necessary and accurate information required to structure their businesses and estate, and
  3. The taxpayers were not highly educated and relied in good faith on their advisers’ judgment.

The court pointed out that the Cavallaros should not be held responsible for a legal fiction concocted by their estate planning attorney. Unfortunately, the gift tax assessment was still applicable and the Cavallaros have for all intents and purposes been punished for their benevolence.

A Full Service Tax Preparation and Law Firm

The Cavallaro case demonstrates how important it is to have top-notch legal and tax planning advice, and for your attorneys and accountants to be consistently on the same page. The tax firm of Moskowitz, LLP is staffed by tax attorneys, certified public accountants, enrolled agents and a phenomenal support staff. We are known for our pursuit of excellent tax law representation.

The hard lesson learned here is that it is crucial to obtain tax law advise from a knowledgeable tax attorney before (and when) making estate and business decisions.

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