Failing to Consider Flaws in Expert Valuation a $6.9 Million Error
The U.S. Tax Court erred in finding that defendants have the burden of proof to show the proper amount of their tax liability, the U.S. Court of Appeals has ruled, remanding the case back to the Tax Court which ultimately found a $6.9 million error in the IRS expert witness' valuation report that assumed little difference between mean and median averages.
In Cavallaro v. Commissioner of Internal Revenue, (T.C. Memo 2019-144 2019), William and Patricia Cavallaro had filed a petition for review with the Tax Court after the IRS determined that they each had made a $23 million disguised gift to their sons in the merger of a company owned by themselves, Knight Tool Co., and a company owned by their sons, Camelot Systems, Inc.
Central to the valuation of the companies was the technology for a liquid-dispensing system for adhesives called “CAM/ALOT” that Knight began developing in 1982. The product had significant flaws and the Cavallaros decided to refocus on their core business.
One son who believed in the product asked his parents if he and his brothers could organize a new corporation and further develop CAM/ALOT, to which the parents agree. The sons then formed Camelot Systems, Inc. (“Camelot”), to further develop it.
King's and Camelot's financial affairs overlapped significantly, with everyone remaining on the payroll of King, and King paying Camelot's bills — Camelot did not even have its own bank accounts. Knight manufactured the CAM/ALOT systems; Camelot sold and distributed them.
In 1994, the Cavallaros hired accountants and lawyers to review their estate plan. The lawyers wanted to claim that the value of the CAM/ALOT technology inhered in Camelot; the accountants objected, finding the plan at odds with the “overwhelming evidence” that Knight owned the technology and always had.
The lawyers won the argument and in 1995 members of the Cavallaro family signed affidavits and a confirmatory bill of sale for a 1987 transfer of the CAM/ALOT technology to Camelot. They then merged the two companies, tax-free, leaving Camelot as the surviving corporation.
In 1998, the IRS opened an examination of Knight's and Camelot's income tax returns, opening a gift tax examination as well. In the end, the IRS issued notices of deficiency, determining that each of the parents had made a $23 million disguised taxable gift to their sons, imposing additions to the tax for failure to file and fraud.
The Cavallaros filed for review with the Tax Court.
The IRS retained Marc Bello, a business valuation and forensic accounting expert witness to appraise the value of both Knight and Camelot at the time of the merger. While the IRS had assumed that Camelo had no value, Bello concluded that it was worth $22.6 million and the combined businesses, $64.5 million, at that time.
The Cavallaros challenged Bello's valuation on numerous grounds, but the Tax Court ultimately found that the Cavallaros were deficient, although it found that there were no penalties or other taxes due: William Cavallaro owed $7.6 million, and Patricia Cavallaro owed $8 million.
The Cavallaros appealed, claiming the Tax Court made numerous errors:
- not shifting the burden of proof to the Commissioner;
- concluding Knight owned the intangibles; and
- misstating their burden of proof, which led to the court failing to consider alleged flaws in Bello's valuation.
In Cavallaro v. Commissioner, 842 F.3d 16 (2016), the federal Court of Appeals dismissed the first two claims, but agreed that the Cavallaros should have had the opportunity to rebut the Bello report.
If they succeeded in finding methodological errors, the Appellate Court reasoned, the Tax Court should then determine for itself the correct amount of tax liability rather than simply adopting the Commissioner's position, remanding in part.
On remand to the Tax Court, the Cavallaros made numerous challenges, including several new ones. The Tax Court dismissed all except the challenge to Bello's methodology.
The Cavallaros had pointed out an error in Bello's calculation of Camelot's profit margin that would place each company in the 90th percentile of its industry, having a significant impact on the company's value. Bello only knew the mean profit margin from the RMA data, 4.1%, so he
… assumed that the mean profit margin would not be that far off from the median or 50th percentile, so he inferred that the theoretical 100th percentile would be 8.2% and that the 90th percentile would be 7.38% (making the 7.5% figure that he employed in the profit reallocation calculation greater than his inferred 90th percentile).
Bello assumed incorrectly. The underlying data was available, and it showed that “a profit margin of 7.5% would place Camelot in the 88.3rd percentile.”
The IRS Commissioner acknowledged the error, but defended Bello's profit margin claiming that the intent was to show that Camelot was a “top performer”, not specifically in the 90th percentile, calling the overall valuation “generous” to the Cavallaros.
The Tax Court disagreed. A profit margin in the 88.3rd percentile versus the 90th percentile resulted in Camelot having a valuation of $29.14 million, rather than Bello's $22.6 million, which reduced the disguised gift by $6.9 million — a substantial sum.
After correcting for the error, the Tax Court found that the Cavallaros made gifts totaling $22.8 million on December 31, 1995.
After some 20 years, this case is grinding to an end, where an expert witness error made a $6.9 millon difference, between mean and median.