Identifying Ownership of Intellectual Property is Key

Improper Ownership Transfer Results in Huge Tax Bill

A mistake in identifying who owned the intellectual property of a new product has one family paying tax on a gift of $29.6 million. In Cavallaro v. Commissioner, T.C. Memo 2014-189, the U.S. Tax Court decided that the merger of two family-owned companies was a disguised gift to the next generation of owners.

Mr. and Mrs. Cavallaro started Knight Tool Co. in 1979 as a contract manufacturing company that made tools and machine parts. In 1982, Mr. Cavallaro and his eldest son developed an automated liquid dispensing machine they called CAM/ALOT. In 1987, the three Cavallaro sons incorporated Camelot Systems, Inc. for the purpose of selling of CAM/ALOT machines made by Knight.

The initial and only capital contribution in the formation of Camelot was a total of $1,000. There was no formal transfer of the CAM/ALOT rights or technology from Knight to the company. After the incorporation, the eldest Cavallaro son – working on the Knight payroll – began exploring ways to improve the CAM/ALOT product working with Knight engineers.

However, the companies’ own financial statements and tax returns characterized Knight as a manufacturer of machine parts and tools and Camelot merely as the seller. The two companies operated out of the same building, shared payroll and accounting services, and collaborated in further development of the CAM/ALOT product line. Knight funded the operations of both companies and paid the salaries and overhead costs for both. Furthermore, Knight was at risk for non-payment from customers who bought the CAM/ALOT machine while Camelot had no employees, everyone being on the Knight payroll. Camelot did not even have its own bank accounts. Its bills were paid by Knight and accounted for using intercompany accounts created on Knights accounting records. Knight even claimed the R&D tax credit for their expenditures.

Who Owned the Intellectual Property?

In 1995, as a result of some estate planning advice, the Cavallaros and their sons merged Knight and Camelot with Camelot as the surviving entity. Using the assumption that the intellectual property belonged to Camelot, a national accounting firm valued Knight and the newly formed merged entity while stating that no suitable comparables for the pre-merger Camelot could be found. The value of the combined entity was between $70 and $75 million, with Knight’s portion of that value being between $13 and $15 million.  This division gave Mr. and Mrs. Cavallaro a 19% interest in the surviving company while the sons owned 81%.

The Tax Court, however, ruled that the ownership of the intellectual property was attributed to the wrong company, and the allocation of the ownership in the surviving entity was distorted, effectively transferring $29.6 million out of the Cavallaros’ estate.

We normally think of gift and estate tax valuation issues when considering a gift or sale of stock but this case highlights the fact that these issues can surface in any number of ways.  Contact Mike Stover of Brady Ware at mstover@bradyware.com or 937-913-2507 if you have a question concerning the value of a company or if you want to learn how gift and estate tax implications might impact an ownership transfer.


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