United States: Tax Court Holds That Certain Shareholders Received A Gift In A Merger Of Two Corporations

The Tax Court held that certain shareholders received a gift from other shareholders, to the extent that the value of the shares of stock received in a merger exceeded the value of the shares of stock transferred. The court's holding hinged on which party in the merger had ownership of a certain asset for federal income tax purposes.

In Cavallaro vs. Commissioner, T.C. Memo 2014-189 (Sept. 17, 2014), a husband and wife (Taxpayer) formed a corporation (Corporation A), to develop and manufacture certain products, including a liquid-dispensing machine (Machine). After incurring losses on the sale of the Machine, Corporation A decided to stop its manufacture. The Taxpayer's three sons formed a corporation (Corporation B) to further develop the Machine, by utilizing the services of engineers of Corporation A.

Once development of the Machine was completed, Corporation B sold the Machine to third-party customers. Corporation B utilized Corporation A to manufacture the Machine and paid a fee to Corporation A, which included Corporation A's direct costs plus an "overhead burden rate." For estate planning and other reasons, Corporation A and Corporation B merged in a tax-free merger, with Corporation B surviving. The existing shareholders of Corporation B held more than 50% of the value of Corporation B after the merger, based on the Taxpayer's values of Corporation A and Corporation B prior to the merger. These values were based on the Taxpayer's assertion that Corporation B owned the Machine as of the date of the merger for federal income tax purposes.

In holding whether the shareholders of Corporation B received a taxable gift in the merger, the Tax Court addressed whether Corporation A or Corporation B owned the Machine as of the merger date. In establishing ownership, the Tax Court first looked at the relationship between Corporation A and Corporation B. At the time of the merger, Corporation B had no bank accounts, and generally used intercompany accounts from Corporation A to ensure expenses were paid. In addition, Corporation B had no employees, and used Corporation A's personnel, facilities and manufacturing equipment to manufacture the Machine. Corporation B did not have to pay Corporation A for these services until the ultimate customer paid Corporation B. The Tax Court held that Corporation A, and not Corporation B, was at risk for nonpayment.

After paying the fee to Corporation A, Corporation B generally made a profit on the sale of the Machine that was more than it should have made as a mere seller of the Machine. The Tax Court attributed this profit not to the value of the corporations but to the fact that the relationship between Corporation A and Corporation B was not at an arm's-length because of the family relationship. As a result, the Tax Court determined that Corporation A was the manufacturer of the Machine, and Corporation B was acting as the sales agent for Corporation A.

After establishing the relationship of the corporations, the Court next looked at the documentation between Corporation A and Corporation B. Corporation A and Corporation B had never prepared documentation establishing that Corporation A transferred ownership or any rights of the Machine to Corporation B. In addition, there was no documentation restricting Corporation A from licensing the Machine, nor from using any Machine technology in other products that Corporation A manufactured. Corporation A owned the few public registrations related to the intellectual property on the Machine. Although the Machine was never patented, Corporation A owned the patents to various components used in the Machine. The Court therefore held that the evidence supported the conclusion that Corporation A, not Corporation B, owned the Machine as of the date of the merger for federal income tax purposes.

Because Corporation A owned the Machine, the value of Corporation A was greater than the value of Corporation B as of the date of the merger. Because the shareholders of Corporation B received more than 50% of the value of Corporation B after the merger, the Tax Court held that the shareholders of Corporation A had made a taxable gift to the shareholders of Corporation B for the excess value.

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