WILLIAM CAVALLARO AND PATRICIA CAVALLARO, Donors, Petitioners, Appellants,
COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.
FROM THE UNITED STATES TAX COURT [Hon. David Gustafson, U.S.
Tax Court Judge]
H. Good, with whom Philip G. Cormier, Good Schneider Cormier,
Edward DeFranceschi, DeFranceschi & Klemm, P.C., Jack W.
Pirozzolo, Joseph R. Guerra, Matthew Lerner, and Sidley
Austin LLP were on brief, for appellants.
Caroline D. Ciraolo, Acting Assistant Attorney General, with
whom Bruce R. Ellisen, Attorney, Tax Division, U.S.
Department of Justice, and Ivan C. Dale, Attorney, Tax
Division, U.S. Department of Justice, were on brief, for
Howard, Chief Judge, Lynch and Kayatta, Circuit Judges.
HOWARD, Chief Judge.
Cavallaro and his wife Patricia Cavallaro (together,
"the Cavallaros") appeal from a Tax Court decision
affirming a determination by the Internal Revenue Service
("IRS") Commissioner that they owed gift taxes on a
$29, 670, 000 gift to their sons. After careful
consideration, we affirm in part, reverse in part, and remand
to the Tax Court for further proceedings consistent with this
1979, the Cavallaros started Knight Tool Co.
("Knight"), a contract manufacturing company that
made custom tools and machine parts. William Cavallaro --
whose principal work was making and selling the
business's products -- owned 49% of Knight's stock,
while Patricia Cavallaro -- who acted as an administrator and
bookkeeper -- owned 51%. The Cavallaros' three sons Ken,
Paul, and James eventually joined the family business.
1982, Knight deviated from its traditional business and
developed a liquid-dispensing system for adhesives called
"CAM/ALOT." Although Knight invested substantial
resources in CAM/ALOT's development, the product had
significant flaws, and profits failed to outpace production
costs. As a result, the Cavallaros decided to refocus on
their core business.
however, continued to believe in the CAM/ALOT technology and
asked his parents if he and his brothers could organize a new
corporation, Camelot Systems, Inc. ("Camelot"), to
further develop it. The Cavallaros assented. After
Camelot's incorporation, Ken worked with William
Cavallaro and other Knight personnel to change CAM/ALOT's
design in order to meet customers' needs. Knight
manufactured the CAM/ALOT systems, while Camelot sold and
distributed them to third parties.
who worked on CAM/ALOT systems after Camelot's
incorporation, including Ken, remained on the Knight payroll
and received all their wages from Knight. Knight's and
Camelot's financial affairs overlapped in other ways as
well. For instance, Camelot did not have its own bank
accounts; with minor exceptions, Camelot's bills were
paid using Knight's funds. And, as a result of how Knight
billed Camelot, Knight effectively immunized Camelot from
risk of non-payment for CAM/ALOT systems.
1994, the Cavallaros hired both accountants and lawyers to
review their estate plan. There was significant friction
between these two groups of advisers. Essentially, the
lawyers wanted the Cavallaros to claim that the value of the
CAM/ALOT technology inhered in Camelot -- and so was already
owned by Ken, Paul, and James -- whereas the accountants
objected to this proposal because it was at odds with the
overwhelming evidence that Knight owned the technology and
always had. Attorney Louis Hamel argued in a letter to
accountant Kevin McGillivray: "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 of
Hamel's persuasive efforts, the lawyers' view
prevailed. Both the lawyers and accountants came to endorse
Hamel's suggestion that a 1987 transfer of the CAM/ALOT
technology be memorialized in affidavits and a confirmatory
bill of sale. Members of the Cavallaro family signed these
documents in May 1995.
and Camelot subsequently prepared to merge. As part of their
preparations, the Cavallaros hired accountant Timothy Maio to
determine the respective values of the two companies. Using a
market-based approach, Maio valued the proposed combined
entity at $70-$75 million and valued Knight's portion at
just $13-$15 million (or 19%). Notably, Maio assumed that
Camelot owned the CAM/ALOT technology and that Knight was a
contractor for Camelot.
December 31, 1995, Knight and Camelot merged in a tax-free
merger that left Camelot as the surviving corporation.
William Cavallaro received 18 shares of stock in the merged
company; Patricia Cavallaro received 20 shares; Ken, Paul,
and James received 54 shares each. The relative value of each
company, as determined by Maio, informed the distribution of
shares. Seven months later, Cookson America, Inc. purchased
Camelot for $57 million in cash. On the basis of stock
ownership, the Cavallaros received a total of $10, 830, 000,
and each son received $15, 390, 000.
1998, the IRS opened an examination of Knight's and
Camelot's 1994 and 1995 income tax returns. During the
income tax examination, the IRS identified a possible gift
tax issue in connection with the 1995 merger and opened a
gift tax examination as well. That examination resulted in
litigation before this court. See Cavallaro
v. United States (Cavallaro I),
284 F.3d 236 (1st Cir. 2002) (affirming denial of
taxpayers' motion to quash a third-party recordkeeper
the IRS issued notices of deficiency to the Cavallaros for
tax year 1995. The IRS determined -- without first having
obtained an appraisal -- that Camelot had a pre-merger value
of $0. Thus, when Knight merged with Camelot, William and
Patricia Cavallaro each made a taxable gift of $23, 085, 000
to their sons.As a result, each of the Cavallaros
incurred an increase in tax liability in the amount of $12,
696, 750. The notices of deficiency also imposed additions to
tax for failure to file and fraud, pursuant to Internal
Revenue Code §§ 6651(a)(1) and 6663(a),
THE TAX COURT PROCEEDINGS
Cavallaros filed a petition for review with the Tax Court.
During discovery, the Commissioner disclosed that -- after
the notices of deficiency were issued -- he directed
accountant Marc Bello to appraise the value of both Knight
and Camelot at the time of the merger. Working under the
assumption that Knight rather than Camelot owned the CAM/ALOT
technology, Bello valued the combined entities at
approximately $64.5 million. Bello concluded that Camelot was
worth $22.6 million. The deficiencies would, therefore, be
lower than those set forth in the original notices, which
assumed that Camelot had no value.
Cavallaros interpreted the Bello report to mean that the
Commissioner had changed his theory of liability. More
specifically, they surmised that the Commissioner was no
longer pursuing his original theory -- that Camelot was a
shell corporation formed to disguise a gift transfer from the
Cavallaros to their sons -- in favor of a new theory that
Knight was merely undervalued. Prior to trial, the Cavallaros
used the Bello report as the basis for their argument that
the original notices of deficiency were arbitrary and
excessive, or, in the alternative, that the
Commissioner's new theory of liability was a "new
matter" within the meaning of Tax Court Rule 142. They
moved unsuccessfully to shift the burden of proof to the
the eight-day bench trial, the Commissioner introduced the
Bello valuation into evidence to support his revised
deficiency. The Cavallaros introduced both the 1995 Maio
valuation and a valuation by John Murphy of Atlantic
Management Company, which was consistent with the Maio
valuation. Like Maio, Murphy assumed that Camelot owned the
CAM/ALOT technology. Ownership of the CAM/ALOT-related
technology was a central focus of the trial. The Tax Court
ultimately concluded that Knight owned all of it.
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
Court ultimately concluded that the Cavallaros were deficient
in paying the gift tax due for calendar year 1995: William
Cavallaro owed $7, 652, 980 and Patricia Cavallaro owed $8,
009, 020. The court also determined -- favorably to the
Cavallaros -- that no penalties for underpayment were due
under I.R.C. § 6662(a), § 6662(h), or §
6663(a), and there were no additions to tax due under I.R.C.
§ 6651(a)(1) for failure to file a gift tax return.
appeal timely followed.
STANDARD OF REVIEW
review decisions of the [T]ax [C]ourt 'in the same manner
and to the same extent as decisions of the district courts in
civil actions tried without a jury.'" Interex,
Inc. v. Comm'r, 321 F.3d 55, 58
(1st Cir. 2003) (quoting 26 U.S.C. § 7482(a)(1)). Thus,
we review the Tax Court's legal conclusions de novo and
its factual findings for clear error. Id. We have
the authority "to affirm or, if the decision of the Tax
Court is not in accordance with law, to modify or to reverse
the decision of the Tax Court, with or without remanding the
case for a rehearing, as justice may require." I.R.C.
CLAIMS ON APPEAL
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 CAM/ALOT-related technology. Second, they contend that
the Tax Court ...