Law News and Tips

THE DEVIL IN THE DETAILS

Fred Vilbig - Friday, October 10, 2014

There was a recent US Tax Court case, Cavallaro v. Commissioner of Internal Revenue , that is a case study in what not to do in a family business. Formalities seem so out – of – place in family businesses.

In that case, a mother and father had a machine shop (“Knight”) that came up with a plan to build and sell a machine that could glue components onto computer circuit boards. That was back in 1982, a good time to invent that kind of a machine. They formed the company (“Camelot”) to make it.

The problem with a bright idea is that it can cost money to get it to market. After consulting with accountants and advisors, the parents’ three sons formed the sales company to market the machine. The idea was that Camelot would own the machine and hire Knight to manufacture it.

Here is where the informality tripped them up. The dad “transferred” the design of the machine to the sons by simply handing them the Camelot company records, saying, “Take it; it’s yours.” The sons, however, continued to get a paycheck from Knight, and not from Camelot or the sales company. In fact, it’s almost impossible to see where one of the companies ended and another began. They almost completely overlapped.

Over time, the sons (on the Knight payroll) modified the machine design, working with other Knight employees and engineers. The redesigned machine became very profitable. Sales boomed.

Then they got some more advice. They were told to merge the businesses. Working with an attorney and an accountant, they figured out relative values for the company’s and merged them, assuming that Camelot owned the machine design.

The IRS disagreed. To the tune of $12,900,000. The problem is, the Tax Court agreed with the IRS. The IRS determined that Mr. and Mrs. Cavallaro had given their sons the machine design (the value of which had grown immensely over time) in the process of the merger. Fortunately (or maybe not), the family had sold the business for almost $60 million in cash. However, Mr. and Mrs. Cavallaro received less than $11 million of that money, with the rest going to their sons. They were obviously about $1 million short. The case doesn’t explain how they made up that million dollar shortfall.

The moral of this story is that even in family businesses attention to formal details is important. A lot of times I see people letting things slide by on the basis of a discussion over a Sunday dinner or a brief exchange on the company floor. No one makes notes or keeps records, because it’s family. The problem is that when it comes to the IRS or selling your business, those details can become incredibly important. Hopefully you can attend to details without disrupting the family dynamic. That’s one of the the challenges for family businesses.
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