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Monday September 22, 2014

Washington News

Washington Hotline

Congress Votes and Departs to Campaign

Because the House and Senate have not yet passed a budget for the fiscal year starting on October 1, it was necessary to pass a continuing resolution. The House passed the resolution by a vote of 319 to 108 on September 17. The Senate followed on September 18 with approval by a vote of 78 to 22.

The continuing resolution funds the government at current levels until December 11. There are three specific impacts of the bill in addition to continuing spending at the current level.

First, the House had approved a reduction in the IRS budget. This reduced IRS budget will not take effect until the negotiations in the lame duck session are complete. Second, the prohibition against state taxes of sales over the Internet was expected to expire. It now will be continued until the anticipated Congressional review. Finally, President Obama requested funds to support moderate Syrian rebel forces in the conflict with the Syrian government and the Islamic State. The bill includes President Obama’s requested funding for support of the Syrian rebels.

Members of the House and Senate promptly departed for the 2014 campaign. They deferred action on several items until the lame duck session. A key bill that is expected to be passed during that session will be the tax extenders.

Senate Finance Committee Chairman Ron Wyden (D-OR) urged Congress to move promptly to pass the extenders. He stated, “Congress’ failure to renew expired tax provisions is forcing these companies to make ’no interest loans’ to the federal government through higher taxes. It’s unacceptable that inaction by Congress is denying American business the clarity and certainty they need to plan for tomorrow. This is a real issue that is impacting those at the heart of the country’s economic growth.”

Rep. Paul Ryan (R-WI) is expected to assume the chairmanship of the House Ways and Means Committee in January. He spoke at a conference in Washington this week and suggested that the tax extenders should not be factored into the revenue calculations because they have been regularly extended without offsets. Ryan noted, “The result of the extenders negotiations in the lame duck will help determine that.” He hopes to make several extenders permanent in the lame duck negotiations. The House has passed permanent versions for twelve of the fifty-four extenders.

Editor’s Note: This election will have a major impact on the potential in 2015 for tax reform. If the Democratic Party continues to hold the Senate, then Sen. Wyden has expressed intention to move forward on reform. If control of the Senate moves to the Republicans, Sen. Orrin Hatch (R-UT) is the likely incoming Chair of the Senate Finance Committee. He also is committed to moving forward with major tax reform next year.

Art Discount of 44.75%


In Estate of James A. Elkin Jr. et al. v. Commissioner; No. 13-60472 (15 Sep 2014), the Fifth Circuit reversed a Tax Court decision that permitted only a 10% discount on fractional interests in art.

Decedent Elkins owned 50% of three art items and 73% of sixty-one pieces. There was a GRIT and other various agreements between Elkins and his children who owned the other interests in the art.

Because of the fractional interests, the estate claimed a 44.75% discount for lack of control and lack of marketability. The IRS audited the estate, maintained that there should be no discount and assessed a deficiency of over $9 million.

Based on the testimony of the children that they had a very strong emotional attachment to the artwork and had no intention of ever selling the artworks, the Tax Court determined that the children were very likely to purchase the art. Therefore, the Tax Court determined that there should only be a 10% discount.

The Fifth Circuit reviewed all of the appraisal information. IRS appraiser Ms. Hanus-McManus claimed that there was no “recognized” market for the art. Therefore, there should be no discount.

However, the court noted, “Just as it was obvious to the Tax Court that the Commissioner had no viable basis for rigidly insisting that no fractional-ownership discount was applicable, it should have been equally obvious that, in the absence of any evidentiary basis whatsoever, there is no viable factual or legal support to the Courts’ own nominal 10% discount.”

Because the estate’s appraisers provided an “uncontradicted, unimpeached and eminently credible” valuation, the 44.75% discount was accepted. The estate is entitled to a refund of $14.36 million plus interest.

Editor’s Note: There was clear intent by the children to purchase the art if the fractional interests were offered for sale. However, the price of the art would be determined by the amount payable in a public sale. Even though the children intended to purchase, the “willing seller-willing buyer” test for a public sale is still the correct valuation method. This sale of fractional interests should lead to a discounted value. The IRS made a tactical error in claiming zero discount.

Family Business Stock Gift of $29.6 Million


In William Cavallaro et ux. v. Commissioner; T.C. Memo. 2014-189; Nos. 3300-11, 3354-11 (17 Sep 2014), the Tax Court determined that stock allocations in a merger of two family businesses resulted in a taxable gift of $29.6 million.

William and Patricia Cavallaro funded Knight Tool Co. (Knight) in 1979. The company produced custom tools for the defense, aerospace and other industries. In 1982, Knight began to develop machines to automate the production of computer circuit boards. The “CAM/ALOT” machines applied adhesive through various mechanical methods to facilitate construction of the circuit boards.

In 1987 Mr. Cavallaro formed Camalot Systems Inc. (Camalot). The stock in Camalot was divided among sons Ken, Paul and James.

Knight continued development of the Camalot machines from 1987 to 1995. The three sons were on the Knight payroll, and as machines were sold a payment was made from Camalot to Knight that the parties termed an “overhead burden rate.”

After discussions with Ernst and Young accountants and attorney Louis Hamel, the family determined that a merger of Knight and Camalot would be appropriate. Attorney Louis Hamel urged the Cavallaros to take the position that the technology for construction of the Camalot machines had been transferred to the three sons in 1987. The Ernst and Young accountants opposed that position and suggested that that there was no effective transfer of technology at that time.

On December 31 of 1995, Knight and Camalot entered into a tax-free merger. Based on a valuation by their CPA, the merged company was deemed to be valued at $70-75 million. The Knight valuation of $13-15 million resulted in the transfer of 19% of the stock to Mr. and Mrs. Cavallaro and 81% of the stock to their three sons. On July 1, 1996, the merged Camalot Corporation was sold to Cookson, American Inc. for $57 million in cash with contingent payments dependent on profits of up to $43 million.

Mr. and Mrs. Cavallaro each filed IRS Form 709 on July 7, 2005, reporting the 1995 gifts at zero value. The IRS audited the Cavallaros and determined that taxable gifts had been made in 1995. It assessed a $12.9 million deficiency for each person.

The taxpayer offered an appraisal by John Murphy of Atlantic Management Co. He determined that the merged corporations had a value of $70-75 million, with 18.8% of the value allocated to the Knight Corporation.

IRS appraiser Marc Bello of Edelstein & Co. determined the total value to be $64.5 million. However, he allocated the value of the Camelot technology to Knight and determined that 65% or $41.9 million in value was appropriately assigned to that entity owned by the parents. Therefore, there was a gift of $29.6 million with the transfers of stock to the three sons.

The court noted that the key issue was whether Knight or Camalot owned the relevant technology. First, there was no armslength merger. All of the members involved were part of the family. Second, the IRS valuation of $64.5 million is lower than the taxpayer valuation and therefore accepted.

Third, because taxpayers bear the burden of proof and failed to demonstrate that Camelot owned the key technology, “the expert valuations they provided comports with our fundamental finding that Knight owned the valuable Camalot technology before its merger with Camalot.”

Therefore, the IRS determination of a $29.6 million gift applies. However, because the Cavallaros had modest education and relied extensively on both their CPAs and attorneys, the Sec. 6662(a) penalty is not applicable. They demonstrated a reasonable cause for their underpayment.

Applicable Federal Rate of 2.2% for October -- Rev. Rul. 2014-26: 2014-41 IRB 1 (19 Sep 2014)


The IRS has announced the Applicable Federal Rate (AFR) for October of 2014. The AFR under Section 7520 for the month of October will be 2.2%. The rates for September of 2.2% or August of 2.2% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2014, pooled income funds in existence less than three tax years must use a 1.4% deemed rate of return. Federal rates are available by clicking here.

Published September 19, 2014
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