Burden of Proof Issues in Gift Tax Matter

A recent case illustrates 3 important burden of proof issues.

The general facts of the case involved a merger of a company owned by parents with a company owned by children. The gift tax issue involved the relative value of the two companies to determine how much, if anything, was transferred to the children by the merger due to their resulting stock ownership in the merged company.

A rebuttable presumption of correctness cloaks an IRS notice of deficiency. Thus, the taxpayer typically bears the burden of proving by a preponderance of the evidence that the Commissioner's assessment is erroneous. However, there are some circumstances where the burden of proof shifts to the IRS.

One of these is if the deficiency notice is excessive and arbitrary - i.e., that the notice bears no factual relationship to the taxpayer's liability. In the case, the original deficiency notices assumed that the parents' company had no value. The IRS later conceded a portion of the original deficiency, allowing some value to the parents' company. The taxpayers argued that this backtracking from the original deficiency notice shifted the burden of proof to the IRS since the deficiency notice was thus excessive and arbitrary. The appeals court determined that the value shifting intent of the taxpayers, along with other associated documents, gave enough support to the IRS at the time it issued the deficiency notice so that its notice was not arbitrary and excessive. The issue here was a question of degree of a value shift, and not a lack of a rational foundation for the deficiency notice. The court noted that a finding of excessive and arbitrary usually arises when the IRS makes no evidentiary showing at all to support the deficiency notice.

The second burden of proof issue related to Rule 142(a) which allows a burden shift when a "new matter" is raised at trial. The taxpayers argued that the original theory in the notice of deficiency was that the parents' company was a worthless sham, and then the IRS later shifted to a theory that the taxpayers overvalued the parents' company - and thus, this involved a new matter. The notices of deficiency provided: "[U]nder IRC Section 2511[,] donor's merger of Knight Tool Co. into Camelot Systems, Inc. in return for 19% of the stock of Camelot Systems, Inc. resulted in a gift of $23,085,000.00 to the other shareholders of Camelot Systems, Inc. Accordingly, taxable gifts are increased $23,085,000.00." The appellate court did not read a sham argument into the notice of deficiency - instead, the issue originally was, and remained, the value of the parents' company - the taxpayers were on notice that the theory of liability was the valuation of the entities.

The last burden of proof issue involved a battle of the experts, and what a taxpayer must prove in challenging the government's expert. In the trial, the reports of the taxpayers' experts were rejected because they were based on the erroneous assumption (as determined by the Tax Court) that the childrens' corporation owned key business technology that the Tax Court determined to be owned by the parents' corporation. This left the only supported expert report with the government, which report treated the technology as owned by the parents' corporation.

Since the taxpayers had the burden of proof, the Tax Court placed on them the burden to show the proper amount of their tax liability. Since they had no valuations left standing to do so, the Tax Court did not allow the taxpayers to challenge the correctness of the government's expert and report, and adopted the valuation of that report in full, even while remarking on its arguably flawed analysis.

The appellate court found that the taxpayers did not have the obligation to prove the correct amount of their tax liability. Thus, they should have been allowed to challenge the government's expert report, and if successful, then the Tax Court should have determined for itself the correct tax liability rather than simply adopting the government's position. Thus, the appellate court remanded the case to the Tax Court to determine if the government's valuation has methodological flaws that makes it arbitrary and excessive, and if it does, the Tax Court should then determine the proper tax liability. In making that determination, it need not precisely establish the correct amount but can use reasonable approximations.

Cavallaro v. Comm., 118 AFTR 2d 2016-XXXX (CA1), 11/18/16