I focus here on the valuation issue of whether a gift was made. The law is clear that a gift can be made under such circumstances if one party shifts value to other related parties. The Court resolved the actual value issue on the basis of the burden of proof. Most of the time, valuation issues are decided after each side has proffered expert testimony with the Court finding a value somewhere in between. Even where the parties are reasonable in their valuations, they are usually reasonably aggressive positions and the value really is somewhere in between. In Cavallaro, however, the Court found the value the Commissioner claimed because, it found, that taxpayers had failed to meet the burden of proof imposed upon them. Basically, the potential for a shift in value from the parents to the children occurred only if the parents' company did not own certain valuable technology. The parents' claim was that the children's company owned the valuable technology, hence the parents did not receive less than they contributed to the merger and did not make a gift to the children. The parents' experts made their expert reports assuming the validity of the claim that the parents' company did not own the technology. The Court found, however, that the parents' company did own the technology, thereby rendering the parent's expert witness reports irrelevant. All the Court then had was the claim by the Commissioner (which had been reduced from the amount originally asserted in the notice of deficiency), supported, of course, by the Commissioner's expert report. The Court thus had no basis for doing anything other than sustaining the Commissioner based on the taxpayers' failure to meet the burden of proof.
Key components of the holding are:
1. The Court first held that the taxpayers had the burden of proof even though the IRS had substantially reduced its valuation from the amount originally asserted in the notice of deficiency. The Court reasoned.
In general, the IRS's notice of deficiency is presumed correct, "and the petitioner has the burden of proving it to be wrong". Welch v. Helvering, 290 U.S. 111, 115, 54 S. Ct. 8, 78 L. Ed. 212, 1933-2 C.B. 112 (1933); see also Rule 142(a). The Commissioner has conceded that the taxable gifts totaled not $46.1 million (as in the notices of deficiency) but instead $29.6 million (as yielded by Mr. Bello's analysis). Where the Commissioner has made a partial concession of the determination in the notice of deficiency, the petitioner has the burden to prove that remaining determination wrong. See Silverman v. Commissioner, 538 F.2d 927, 930 (2d Cir. 1976) [**52] (holding that the burden of proof does not shift where the Commissioner's change of position operates in favor of the taxpayer), aff'g T.C. Memo. 1974-285; cf. Rule 142 (shifting the burden "in respect of * * * increases in deficiency").2. The Court then rejected the argument that the reduction shifted the burden under Tax Court Rule 142(a)(1) which imposes the burden of proof on the commissioner "in respect of a new matter." For much the same reason as Silverman, the Court rejected the argument. The Court did say that the IRS's assertion of the accuracy related penalty rather than the fraud penalty was a new matter (even though the taxpayer's claim of reasonable cause would have been a defense to the fraud penalty originally asserted); and in any event, the Court found the defense proved so neither penalty applied.
3. The Court rejected the argument that the original deficiency notice was arbitrary and without foundation because the IRS had "abandoned" the original claim in favor of the reduced one for trial. (For more on that issue, see the discussion of Helvering v. Taylor below.)
4. In finding that the taxpayers had failed to meet their burden of proof, the Court held:
Petitioners' criticisms might have greater significance on the next sub-issue—i.e., determining what portion of that value is properly attributable to each of the two companies—but we need not resolve those criticisms or attempt to correct the Commissioner's figures. It is the Cavallaros who have the burden of proof to show the proper amount of their tax liability, and neither of the expert valuations they provided comports with our fundamental finding that Knight owned the valuable [**68] CAM/ALOT technology before its merger with Camelot. We are thus left with the Commissioner's concession, effectively unrebutted by the party with the burden of proof. The Cavallaros risked their cases on the proposition that Camelot had owned the CAM/ALOT technology (and on a valuation that assumed that proposition), but they failed to prove that proposition (and the evidence showed it to be false). That being so, "[i]t would serve no useful purpose to review our agreement or disagreement with each and every aspect of the experts' opinions." CTUW Georgia Ketteman Hollingsworth v. Commissioner, 86 T.C. 91, 98 (1986). We conclude that Mr. and Mrs. Cavallaro made gifts totaling $29.6 million on December 31, 1995. n36For background about the issues decided, I now offer the discussion from my Tax Procedure Book with all footnotes omitted except a new footnote discussing Cavallero. All of the quote below is from the book, so I do not indent any of it.
n36 Since we base this conclusion on petitioners' failure of proof, it is all but immaterial that the Commissioner's expert reached this $29.6 million gift number by an arguably flawed analysis under which the total value of the merged entity was $64.5 million, Knight's value was $41.9 million (i.e., 65% of the total), and Camelot's value was $22.6 million (i.e., 35% of the total). Given petitioners' failure of proof and our consequent finding of a $29.6 million gift, if we assume instead the total value that petitioners' expert determined—$72.8 million—then [**69] arithmetic shows us that Knight's value must have been $43.4 million (i.e., 59.6% of the total) and Camelot's value must have been $29.4 million (i.e., 40.4% of the total). We do not choose between these two possibilities.
2. The General Tax Rule - Taxpayer Bears the Burdens.
The general rule is that the taxpayer bears the burden of persuasion as to fact issues that must be resolved in deciding a civil tax case. As noted above, the party bearing the burden of persuasion usually bears the burden of production -- if there is no evidence for the key fact, there is nothing to submit to the trier of fact. Accordingly, the burden of persuasion is normally the key burden. The reasons for assigning the burden of persuasion to the taxpayer are variously stated, and I do not review them here. The burden of persuasion in a civil tax case means that the trier of fact (judge or jury) must find the fact in issue to be more likely than not, otherwise the bearer of the burden of persuasion loses.
3. The Key Cases and Nuances.
I have just stated what I think is, or ought to be, the general rule in traditional burden of proof terms. Now, I will introduce you to the key cases where the Courts have sallied forth on burden of proof in tax cases. In broad strokes, the Courts have divided tax litigation into two categories which are based upon who seeks judgment against whom. The first category is Tax Court litigation which, as you will recall, is prepayment litigation. In Tax Court litigation, the taxpayer nominally brings the suit (taxpayer is the petitioner, the role of plaintiff in normal civil litigation), but does so only in response to the IRS’s first move – the notice of deficiency. In Tax Court litigation, the IRS seeks to have the Tax Court enter a decision document for a deficiency so that the IRS can then assess that deficiency amount against the taxpayer. So, the IRS seeks, in effect, a judgment against the taxpayer so that it can collect the amount of the “judgment” (to wit, the amount in the decision that is assessed) from the taxpayer. The second category is refund litigation where the taxpayer, not only the nominal plaintiff but the real plaintiff, seeks a judgment against the United States so that the taxpayer can get money from the United States.
Prior to the modern income tax in 1916, refund suits were the only way to litigate tax controversies with the Government. Refund suits essentially assert that the Government has the taxpayer’s money and is not entitled to it because the taxpayer does not owe the tax. Such suits are classic common law “had and received” law suits. In such suits, the plaintiff – the taxpayer suing the Government – must prove his right to recover – which means both liability to return money and the amount to be returned, as the Supreme Court held early on in the seminal case of Lewis v. Reynolds, 284 U.S. 281 (1931).
Congress early recognized that the refund suits with the prepayment requirement and the then traps for the unwary in district court litigation prior to the modern rules of civil procedure were ill suited to orderly and fair litigation of tax controversies under the modern tax codes. In the early 1920s, therefore, Congress created the Board of Tax Appeals, the predecessor to the Tax Court, and established the deficiency procedures whereby the taxpayer could invoke a prepayment remedy in the Tax Court. Moms and Pops running the corner grocery store could come forward, even without benefit of counsel, in a user-friendly forum to get justice in their disputes with the IRS. That prepayment remedy requires the IRS to issue a notice of deficiency asserting the amount of tax the IRS intends to assess and then, upon the taxpayer’s petition, have the Tax Court redetermine the amount of the deficiency, if any, before the assessment is made. The Tax Court litigation thus seeks to determine the amount of tax that the IRS will collect from the taxpayer. The taxpayer is the nominal plaintiff (or petitioner, as used in the Tax Court), but the Government is really the moving party and seeks to collect money from the taxpayer. If the classic common law “had and received” analogy were applicable, one could argue that perhaps the Government should have the burden of proof in Tax Court cases because it wants to quantify an amount that it is entitled to get from the taxpayer. However, Congress established the Tax Court as a prepayment and less technical forum alternative to the refund suit in the district court and apparently did not intend to make that radical a change in proof, specifically the burden the taxpayer would bear in refund litigation. Accordingly, the Tax Court early on adopted the rule that the taxpayer bears the burden of proof – meaning the burden of persuasion – in Tax Court cases. In other words, it appeared early on as if the Tax Court would have a burden of proof rule patterned on that applying in the district courts in refund suits. Stated in the context of a prepayment remedy, that rule would be that the taxpayer bears the burden of reducing the amount asserted in the notice of deficiency and, in risk of nonpersuasion terms, would bear the risk that the Tax Court were not persuaded as to any lesser amount.
In Helvering v. Taylor, 293 U.S. 507 (1935), the Court held that Tax Court proceedings would have a slightly different burden of proof rule than was imposed in refund suits. Specifically, whereas in refund suits the taxpayer bore the burden of showing entitlement to a refund and the amount thereof, in Tax Court suits the taxpayer need merely show that the IRS’s determination in the notice of deficiency was “arbitrary and excessive” whereupon the IRS would lose unless the evidence were sufficient to establish that amount of deficiency that could be incorporated into the decision document that is then the basis for assessment and collection. In burden of persuasion and risk of nonpersuasion terms, upon the required showing, the IRS would bear the burden of persuasion or risk of nonpersuasion that a deficiency is due and the amount thereof.
The Supreme Court’s pronouncement in Helvering v. Taylor has led to some confusion in the courts as to precisely how to apply the “arbitrary and excessive” predicate to the shift of the burden of persuasion. I do not expect you to know the nuances of the confusion thus spawned, but let me illustrate the genre of confusion in the context of a recent case – Estate of Paul Mitchell v. Commissioner, 250 F.3d 696 (9th Cir. 2001). In an estate tax case, the IRS valued the stock owned by a slightly less than 50% shareholder. An unrelated shareholder owned 50% and other unrelated shareholders owned small percentages. Apparently ignoring the unrelated shareholder’s 50% ownership, the IRS valued the decedent’s shares as a controlling interest. Indeed, the IRS’s own expert initially had not valued the shares as a controlling interest and, for some unexplained reason, the IRS directed him to do so. Valuing the less than 50% interest in these circumstances as a controlling interest was just stupid – in the language of Helvering v. Taylor, it was “arbitrary.” And, moreover, it resulted in a plain and grossly excessive asserted deficiency. The Tax Court held that the taxpayer still bore the burden of persuasion, but on appeal the Ninth Circuit easily found that the circumstances of Helvering v. Taylor were present and reversed for reconsideration with the IRS bearing the burden of persuasion as to the amount of the deficiency, if any.
Judge Posner made the same point succinctly in a refund suit. In Kohler v. United States, 468 F.3d 1032 (7th Cir. 2006), the parties fought over a valuation issue. The Government’s valuation proffered at trial – $19.5 million – was simplistic and clearly excessive, at least Judge Posner for the panel so concluded in his inimitable fashion of bringing pure logic to the task. The taxpayer’s valuation proffered at trial – $11.1 million – was clearly too low. The record offered no persuasive evidence as to a point in between these two erroneous extremes. In traditional refund suit theory, requiring the taxpayer to show not only that the IRS erred but the amount of the refund to which it is entitled, this lacuna should theoretically have permitted to the IRS to prevail. However, perhaps perceiving the Government’s erroneous position as more outrageous than the taxpayer’s erroneous position, Judge Posner side-stepped the traditional refund theory by declaring the assessment to be a “naked assessment” “without any foundation whatsoever.” (Citing United States v. Janis, 428 U.S. 433, 440 (1976); and Taylor.) Where the IRS is plainly excessive even in a refund suit, the taxpayer has no burden. The IRS loses. Judge Posner concluded his opinion:
The Service could have justified a more modest estimate yet one well above $11.1 million, but clinging stubbornly to its untenable valuation it suggested no alternative to $19.5 million. It played all or nothing, lost all, so gets nothing.So, the taxpayer wins, even though the taxpayer’s affirmative proof at trial was not persuasive or even credible simply because the Government was more off base than even the taxpayer.
But, let’s test what Judge Posner was saying. Let’s say that the IRS had asserted an $18 million valuation in Kohler, with at least some modicum of basis for that amount. Then, at trial, the trier of fact finds that the taxpayer’s proffered valuation of $11.1 million is too low, that IRS’s proffered valuation of $18 million is too high, that the real valuation is somewhere in between, but that the evidence is so inconclusive that it does not permit the trier to pick the in-between point by a preponderance of the evidence. Would or could Judge Posner have applied the naked assessment side-step to shut the IRS out? Wouldn’t the IRS then have prevailed under the standard formulation for refund suit burden of proof? Isn’t Kohler just a specific adaptation in a litigation context of the adage that “bulls make money, bears make money, pigs get slaughtered?”
Kohler does help in a discussing the warp and woof of tax burden of proof theory, but the circumstances will rarely be present in the real world. At a trial on a valuation issue, even if the IRS original assessment were excessive the IRS is unlikely to rest on an excessive valuation and will get reasonable in order to maintain credibility before the court. So, in the above example, even if the original assessment were based on $19.1 million, if at trial the IRS admitted that the value did not exceed $18 million and offered some basis for that amount, the court would not dump the IRS out simply because of the admission that the original $19.1 million was wrong. n1795 Rather, the $18 million would be the number from which to measure and the above analysis would apply because, even if wrong, the IRS’s position was not arbitrary. In other words, it appears that DOJ Tax's counsel in Kohler just botched it and suffered the consequences of irritating Judge Posner in the process.
n1795 See Silverman v. Commissioner, 538 F.2d 927, 930 (2d Cir. 1976) (where IRS makes partial concession in taxpayer’s favor, the burden of proof remains on the taxpayer as to the unconceded adjustments, citing Tax Court Rule 142(a) that imposes the burden on the taxpayer except inter alia for increases in deficiency); and Cavallaro v. Commissioner, T.C. Memo 2014-189 (citing Silverman)). In Cavallaro, the issue was whether the taxpayers received less value in a merger than the value of the company they contributed, thereby making a gift to the other shareholders (their children). The key fact upon which valuation turned was whether the parent’s company or the children’s company owned valuable technology. If the parents company owned the technology, the parents made a gift; if the children’s company owned the technology, the parents did not make a gift. The Court held that the parent’s company owned the technology, meaning that a gift had been made. Before trial, the IRS reduced its valuation, but still stuck to the factual argument that excess value was contributed. At trial, the taxpayers (the parents) entered only a valuation claim based on expert reports which assumed as a fact that the children’s company owned the technology. The court found as a fact that the parent’s company owned the technology, thus rendering the taxpayers’ expert reports not relevant to the issue of the value of the parent’s stock inclusive of the value of the technology. The taxpayers thus had a failure of proof and did not meet their burden of proof to show the IRS’s revised valuation wrong. Even with questions about the IRS’s expert’s report, the Court had no basis for a lower founding because of the failure of proof.