In the annals of family business succession planning, this article discusses some clever, albeit flawed, attempts to transfer ownership interests in a mature enterprise to family members while avoiding the transfer tax toll.
The Saga
This is not a new story but is an interesting one that bears revisiting. Cavallaro v. Commissioner, 842 F.3rd 16 (1st Cir. 2016), affirming in part, reversing in part, and remanding, T.C. Memo. 2014-189, is one such instance. (In this connection, see also the final Tax Court decision on remand at T.C. Memo 2019-144.) In 1979, William Cavallaro and his wife Patricia founded the contract manufacturing company known as Knight Tool Co. (Knight). William owned 49% of the stock and Patricia owned 51%. Their sons, Ken, Paul and James began working in the business.
Some years later, on Nov. 30, 1987, Camelot Systems Inc. (Camelot) was formed by Ken, Paul and James with its capital stock being issued equally among them. Camelot was organized for the purpose of further developing certain technology owned by Knight.
Regarding its technology, commencing about 1982, Knight had developed a liquid-dispensing system for adhesives which was called CAM/ALOT. Knight devoted its attention and substantial resources to CAM/ALOT. Ultimately, however, William became disenchanted with further investment in the technology due to the system’s perceived flaws and substantial cost. Ken, on the other hand, remained a believer and convinced the family to allow Camelot to further refine and develop the technology.
Continuing the endeavor, Ken, William, and other Knight personnel ultimately succeeded in redesigning the CAM/ALOT system. Knight then began commercially manufacturing the system and selling it to Camelot, so that a significant portion of the profits could be captured by Camelot, which in turn, would then sell the system to the end user customer.
Although Knight and Camelot were separate corporate entities, with separate ownership, at least on paper, it appears that Knight paid for everything, including all of Camelot’s operating expenses, including its payroll. Furthermore, and most notably, Knight bore the risk of a customer defaulting in paying for the system. In other words, Camelot’s substance seemed somewhat murky.
The Analysis
A key document shedding light on the story was the Dec. 15, 1994, letter sent to William by an Ernst and Young accountant recommending the merger of Knight and Camelot as part of a strategy to allocate some of the proceeds from a future sale of the business to the sons while minimizing potential transfer taxes. The accountant believed that the technology underlying the CAM/ALOT system was owned by Knight.
The letter stated that “based on the facts that exist today, it would be hard to justify Camelot taking more than a small amount of the allocated proceeds” from a sale. The letter said that upon such a merger about 85% of the shares in the surviving entity would go to William and Patricia and about 15% to the sons. The letter then proposed utilizing GRATs or grantor retained annuity trusts to implement a gifting strategy.
Did the accountant know the full story? At the prodding of their Hale & Dorr estate planning attorney, the family and, apparently, the accountant were soon convinced that the technology was transferred to Camelot in 1987 when it was formed. In a letter to the accountant, the attorney had declared that “[h]istory 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.” As a result, in May 1995, William and Ken signed affidavits confirming that Knight transferred the technology to Camelot in 1987. Unfortunately, as it turned out there was no contemporaneous documentation of any such transfer.
There was only William’s ceremoniously “handing off” of the corporate minute book to Ken when in 1987 the family had gathered for the purpose of having the sons sign Camelot’s certificate of incorporation. The estate planning attorney had argued that the ceremonial handing over of the minute book constituted the transfer of the technology. The courts disagreed.
Jumping ahead to Dec. 31, 1995, Knight and Camelot merged with Camelot as the surviving entity. The result of the family’s position on the ownership status post-merger, was that 81% of the Camelot shares were allocated among Ken, Paul and James, for their interest in premerger Camelot, and 19% of the shares were allocated between William and Patricia, for their interest in Knight. The allocation of course was premised on the mistaken belief that Camelot owned the technology.
Lo and behold, seven months later in 1996, Camelot was sold for $57 million in cash with approximately $46 million (81%) allocated among Ken, Paul and James and $11 million (19%) to William and Patricia. A neat generational shift to say the least. (There was also a contingent portion of the consideration, but it was never realized.)
How did this magic happen? How did most of the value of the family business end up in Camelot, the entity owned by the sons?
Failure To Launch
The family’s contention was that Camelot owned the CAM/ALOT technology, thus, the ownership sharing ratio after the merger was based on an accurate reflection of the respective fair market values of Knight and Camelot.
It should be noted that in a merger transaction like this, where the parties, because of family relationships are presumed not to be dealing at arm’s length, an independent appraiser is required to determine the comparative values of the family-owned companies, in this case, Knight and Camelot. Of course, an appraiser must as an initial step analyze the separate assets and earnings of each company.
The inconvenient fact in this case was that the CAM/ALOT technology was never owned by Camelot, rather it was always owned by Knight. No credible evidence was presented that Knight ever transferred the technology to Camelot. The artful spin suggested by the estate planning attorney, and acquiesced in by the accountants, was not supported by any evidence. Camelot, in effect merely the sales agent, was thus substantially overvalued, causing the disproportionate allocation of share ownership among the family resulting from the merger. In effect, upon the merger in 1995, that disproportion caused a significant taxable gift of $22.8 million deemed to have been made by William and Patricia to their sons.
Some of the other damning facts included that Camelot: had no employees; lacked a bank account; did not maintain books of account; did not bear any costs of sales; did not service or provide any warranty coverage on the product; bore no risk with respect to product development, and, at first, did not take research and development credits, which were taken by Knight in 1992, only to be corrected later in 1994/5 when the credits were shown as shared by Knight and Camelot.
Although there was much back and forth in connection with valuation issues and the government’s appraisals, the important point for lawyers and others planning opportunity type transactions was that the Tax Court found that the key asset of the business, i.e., the CAM/ALOT technology, was always owned by Knight, and never transferred to Camelot, a holding that the U.S. Court of Appeals for the First Circuit affirmed.
In addition to the taxable gift of $22.8 million, the government asserted failure to file and underpayment penalties under Internal Revenue Code sections 6651(a) and 6662, respectively. The Tax Court rejected the application of the penalties since it found that the Cavallaros acted reasonably and in good faith when relying on the advice of their lawyers and accountants. (The Cavallaros, not happy with the outcome, sued the lawyers and accountants for malpractice.
Planning Ahead
Perhaps the lesson here is to recognize that as a first step the family was on the right track when forming Camelot. The idea being to establish a separate entity before significant value attaches, to be owned by members of the next generation. At that point, the new entity could then be put on a path to grow, with opportunities presented, for example, through the existing Knight business, and facilitated through the granting on an arms-length basis, contractual rights, technology licenses, leases, loans, etc., depending of course on what would make sense in the context of ongoing business operations.
It is also important to recognize that opportunity planning is not an overnight magic bullet to exploit an immediate exit strategy. Rather, it is something that takes time and planning to effectively nurture and grow the business of the new entity, and hence, its value.
Reprinted with permission from the New York Law Journal, An ALM Publication