Three weeks ago, the First Circuit handed down its opinion in Cavallaro v. Commissioner. And although the court mostly affirmed the findings of the Tax Court – specifically concerning a crucial issue of ownership of a business asset, it ultimately remanded the case for further proceedings on valuation after finding that the Tax Court had, in effect, heightened the taxpayer’s burden of proof in the case. The end result could signal a more taxpayer-friendly landscape in valuation cases coming before the courts.
First, a quick summary of the key facts in Cavallaro. The taxpayers, William and Patricia Cavallaro owned a custom tool manufacturing business (Knight Tool Co.). After attempting development of a new product that it did not get off the ground, Knight allowed the taxpayers’ sons to continue work on the product. The sons incorporated a new entity (Camelot) that sold and distributed the product, though the development and production work was all still paid for by Knight. When the taxpayers sought to retire from the business they arranged a merger of Knight and Camelot. Shares of the merged entity were distributed (19% to the taxpayers, 81% to the sons) based on appraisals that assumed that Camelot owned the rights to the product.
The IRS challenged the transaction, believing it to be a disguised gift by the taxpayers. The IRS issued a notice of deficiency, admittedly prior to receiving any sort of appraisal or other expert opinion as to value, that asserted that Camelot had a value of $0 and that the entire 81% of the merged company stock distributed to the sons was a taxable gift. The Cavallaros challenged the determination, arguing in the Tax Court that Camelot did in fact own the product (a fact the Tax Court found not to be the case) and that, even in the absence of an ability to prove the correct value (given that their appraisals had assumed Camelot ownership of the product), it was sufficient that they show that the IRS’s value was arbitrary and excessive. The Tax Court also rebuffed the latter argument on what seemed to me to be the perfectly sound (and somewhat boilerplate) ground that the burden in a deficiency case is on the taxpayer to show the proper amount of their tax liability.
Although the First Circuit affirmed virtually all of the Tax Court’s findings (notably those refusing to shift the burden of proof to the IRS and that Knight owned the product underlying the entire controversy), on the valuation question the court reversed. According to the First Circuit the taxpayers should have been permitted to rebut the IRS’s appraisal, even if they could not prove an alternate “correct” value. If they had been able to do so, it would have been incumbent on the Tax Court to determine the correct valuation (and therefore tax liability) for itself, either by conducting further proceedings so the parties could present evidence or by determining (and explaining in its opinion) the proper adjustments or approximations that should be used in determining value.
The First Circuit’s decision struck me as incredibly favorable to the taxpayer – as a former Tax Court clerk, the framing of the burden of proof by the appeals court went against much of what I learned during my time there – when coupled with the presumption of correctness, a failure of the taxpayer to establish the correct amount meant that the determination would be sustained. If the First Circuit’s logic is applied beyond this individual case, it could make the IRS’s task in valuation cases increasingly difficult. Although the ability to challenge or rebut a government appraisal does not appear to be easily limited, I could see a future opinion work to limit this new taxpayer weapon to cases in which the IRS sets a value and determines a deficiency without soliciting any opinions as to whether the value is at all justified – as the IRS admits it did in issuing the Cavallaros’ deficiency notice.
Although I could be overstating the significance of this, especially in light of the caveat I just noted, this decision would appear to be a boon for taxpayers challenging the government’s valuation decisions. The logic employed in the case would allow taxpayers to chip away at the government’s case even where they have no ability to conclusively prove an alternate value. Further, taxpayers could have the chance to “take a mulligan” on expert reports and appraisals in such cases where the trial court does need, as the First Circuit suggested, additional hearings and evidence to resolve the issue. The conclusion – the IRS’s task appears to have gotten ever so much more difficult when it comes to valuation issues.
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