Taxpayer Proves IRS Valuation Was Arbitrary and Excessive
The U.S. Tax Court recently ruled that a tax-free merger of two family-owned manufacturing businesses resulted in a taxable gift to the sons because the parents undervalued their company. On appeal, Cavallaro was remanded to the court to allow the taxpayers to prove that the tax deficiency was based on an “arbitrary and excessive” valuation performed by the IRS expert. Here's how the taxpayers prevailed.
For estate and gift tax purposes, fair market value is, “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Under tax law, a taxable gift occurs when property is transferred for less than “full and adequate” consideration.
Consideration may be in the form of cash or other assets. In the case of a merger between two companies, shares in the newly merged entity should be allocated to the shareholders of the premerger companies in proportion to the fair market value of their respective shares. To the extent that one premerger company is undervalued relative to the other, a gift has occurred.
Case in Point
In Cavallaro, the Tax Court determined that the merger of two companies — one owned by the parents and another owned by their sons — resulted in a taxable gift. The stock in the merged company was distributed 19% to the parents and 81% to the sons, based on their accountant's valuations of both pre-\merger companies. That allocation was based on the incorrect assumption that the sons' company-owned certain key intangible assets that were actually owned by the parents' company.
The Tax Court determined that the fair market value of the merged company was approximately $64.5 million based on the IRS expert's discounted cash flow analysis, and that 65% of the value of the merged company (roughly $41.9 million) should have been allocated to the parents' company (not 19% or $12.2 million of the total value as the taxpayers contended). Because the parents didn't receive full and adequate consideration in the merger, the disproportionate distribution of shares resulted in a disguised gift to their sons worth $29.7 million.
The taxpayers appealed, claiming that the Tax Court refused to consider evidence that the IRS expert's valuation contained methodological flaws that made it “arbitrary and excessive.” The First Circuit reversed in part and remanded the decision to the Tax Court.
On remand, the Tax Court found that the IRS expert had made a mistake when he allocated value between the premerger companies. He mistakenly used a 7.5% profit margin for the sons' company, which resulted in an allocation of 35% of the merged company's value to the sons' company and 65% to the parents' company. However, the correct profit margin was 9.66%, which resulted in a 45% allocation of the merged company's value to the sons' company and 55% to the parents' company.
This seemingly small difference had a big impact on value: The court ruled that using the correct profit margin (9.66%, not 7.5%) for the sons' company reduced the value of the disguised gift by $6.9 million. Therefore, the court adjusted its value from $29.7 million to $22.8 million.
Value in the Eye of the Beholder
Taxpayers often disagree with the IRS when it comes to the fair market value of a privately held business interest. Taxpayers want the lowest possible value to minimize taxes, and the IRS wants the highest possible value to generate additional tax revenue. In estate and gift cases, it's important to review the assumptions that underlie the experts' analyses, because small errors can have a big impact on value.
Cavallaro v. Commissioner, T.C. Memo. 2019-144, Oct. 29, 2019