Cavallaro v. Commissioner Taxpayers allowed to vet valuations from IRS experts

Abstract: It’s critical for taxpayers to be given the chance to evaluate whether assessments made by the IRS are “arbitrary and excessive.” This article summarizes a recent gift tax case that the First Circuit Court of Appeals remanded to the U.S. Tax Court for further proceedings related to the valuation of the taxpayers’ business that the IRS relied on when computing its assessment against them — potentially giving the taxpayer a second chance at offering its own valuation evidence. A sidebar discusses why the appellate court wouldn’t shift the burden of proof to the IRS.

Cavallaro v. Commissioner, No. 15-368, 1st Cir., Nov. 18, 2016

Cavallaro v. Commissioner

Taxpayers allowed to vet valuations from IRS experts

Is an IRS assessment based on business valuation evidence provided by its expert “arbitrary and excessive”? If a taxpayer raises that issue, the Tax Court should settle it before deciding on the correct tax liability, according to the recent opinion published by the First Circuit Court of Appeals in Cavallaro.

Tax scenario under examination

In 1979, a married couple started a contract manufacturing company that made custom tools and machine parts. Their three sons eventually joined the family business.

The company developed a liquid-dispensing system for adhesives in 1982. When the couple decided to refocus on the core business, their sons formed a new company to further develop the liquid-dispensing system. The original company manufactured the redesigned system, and the sons’ company sold and distributed it. The two companies’ financial affairs overlapped significantly.

In 1995, the companies engaged in a tax-free merger that left the sons’ business as the surviving corporation. Before the merger, the taxpayers’ accountant estimated that the combined entity would be worth between $70 million and $75 million, allocating only $13 million to $15 million to the parents’ original business. The accountant assumed the sons’ company already owned the technology for the liquid-dispensing system and that the original company was merely a contractor.

Tax deficiencies

The IRS issued deficiency notices to the parents, finding that the sons’ company had no premerger value. As a result, when the companies merged, the taxpayers each made a taxable gift of about $23 million to their sons.

The taxpayers appealed to the Tax Court. Before trial, the IRS obtained a valuation of the two companies on the merger date. The expert assumed the original company owned the technology. He valued the combined entity at $64.5 million, allocating $22.6 million to the sons’ business. Based on that valuation evidence, the IRS reduced its initial deficiencies.

At trial, the taxpayers introduced their premerger valuation and another consistent valuation. Both of these valuation experts assumed the sons’ company owned the technology. The Tax Court, however, concluded that the original company owned the technology. Based solely on the valuation opinion provided by the IRS expert, the court found gift tax deficiencies in the amount of $7.6 million for the husband (who owned 49% of the original company) and $8 million for the wife (who owned 51%).

First Circuit ruling

On appeal, the taxpayers argued that their burden was to establish that the alleged deficiencies were erroneous — not, as the Tax Court said, to show the proper amount of their tax liability. They claimed that this “legal error” led to another — that is, the court’s refusal to consider their evidence that the IRS valuation was fatally flawed.

The First Circuit agreed that the Tax Court had misstated the burden of proof. The appellate court found that the taxpayers merely had to show that the IRS determination was arbitrary and excessive — once a taxpayer does so, it can’t be forced to pay the amount assessed, even if it doesn’t prove the correct amount owed.

The taxpayers tried to show the IRS’s assessment was arbitrary and excessive by challenging its expert’s valuation methodology. However, the Tax Court wouldn’t hear those arguments. Why? The court reasoned that, even if the taxpayers were correct in their characterization of the assessment, their valuation experts had incorrectly assumed the sons’ company owned the technology, so they would be unable to show the proper amount of their tax liability. In the Tax Court’s view, this made it pointless to consider the arguments.

The First Circuit, however, ruled that the taxpayers should have been given the opportunity to rebut the valuation and show that the assessment was arbitrary and excessive. If the taxpayers succeeded, the Tax Court should have quantified the tax liability itself.

Next steps

The First Circuit remanded the case for evaluation of the taxpayers’ challenges to the IRS valuation. If the Tax Court determines the assessment was arbitrary and excessive, it then must determine the proper tax liability. In doing so, the appellate court said that the Tax Court may consider additional evidence, including a new valuation. So, the taxpayers may, at the Tax Court’s discretion, be given a second shot at offering an expert opinion — one not based on a faulty assumption.

Sidebar: Burden of proof arguments fail

The taxpayers in Cavallaro unsuccessfully argued that the Tax Court should have shifted the burden of proof to the IRS. The appellate court noted that IRS notices of deficiency come with a rebuttable presumption of correctness. The taxpayer bears the burden of proving the tax assessment wrong, except in limited circumstances.

Under the excessive-and-arbitrary exception, the presumption of correctness is overcome when the assessment is shown to be utterly without foundation. The First Circuit found that the taxpayers didn’t show that the IRS assessments utterly lacked rational foundation. The fact that the IRS subsequently reduced its original deficiency didn’t mean the initial assessment lacked such a foundation.

The presumption also fails if the IRS seeks to establish a deficiency on a theory not included in the original notice. However, the court in Cavallaro found that the IRS’s theory at trial was simply a refinement of its theory in the initial assessment.