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Cavallaro v. Commissioner of Internal Revenue

United States Court of Appeals, First Circuit

November 18, 2016


         APPEALS FROM THE UNITED STATES TAX COURT [Hon. David Gustafson, U.S. Tax Court Judge]

          Andrew 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 appellee.

          Before Howard, Chief Judge, Lynch and Kayatta, Circuit Judges.

          HOWARD, Chief Judge.

         William 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 opinion.

         I. BACKGROUND

         In 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.

         In 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.

         Ken, 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.

         Everyone 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.

         In 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."[1] 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.[2]

         Knight 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.

         On 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.

         In 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 summons).

         Ultimately, 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.[3]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), respectively.


         The 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.

         The 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 Commissioner.

         During 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.

         The Tax 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 for trial.

         The Tax 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.

         This appeal timely followed.


         "We 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. § 7482(c)(1).


         On 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 ...

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