Property, intangible

a blog about ownership of intellectual property rights and its licensing

Having Documents Helps

I usually write about ownership issues in the context of infringement claims. But I ran across a tax case where management (or actually, lack of management) of the ownership of the intellectual property ended up creating a tax deficiency on 29.6 million dollars.

In 1976 William and Patricia Cavallaro started a contract manufacturing company, Knight Tool Co., Inc., that made custom tools and machine parts. Their sons were 15, 13 and 12 years old at the time. The sons all eventually joined the family business.

Sometime before 1982, father William and son Ken saw an opportunity for a computerized liquid dispensing tool that could be sold to manufacturers. Engineers and employees at Knight worked on the initial prototypes and Knight began selling the machine under the name “CAM/ALOT” (for “computer-assisted machine” that would be used “a lot”). Knight spent so much time and attention on the project that it affected the stability of the company. Mrs. Cavallaro eventually insisted that Knight had to revert to its original tool-making business; Mr. Cavallaro agreed and the project was shelved.

But not for long. Ken wasn’t willing to give up on the project, so he asked his parents if he and his brothers could take over the CAM/ALOT business. His parents agreed and in 1987 Camelot Systems, Inc. was incorporated, each son contributing $333.33 and owning equal share. When the family signed the formation documents, the lawyer handed the minutes book for the new corporation to Mr. Cavallaro but he handed the minutes book to Ken, saying “take it; it’s yours.”

But of course $1000 isn’t enough to develop a product. It was Knight that kept investing in the development of the CAM/ALOT product; even Ken was on the Knight payroll instead of the Camelot payroll. Camelot had no bank accounts or its own books. Mr. and Mrs. Cavallaro’s position was that Camelot was the manufacturer and Knight the contractor, but the contemporaneous documents showed that Knight was the manufacturer and Camelot merely the seller, with Camelot bearing none of the business risk. There were no documents reflecting the transfer of any intellectual property rights from Knight to Camelot; the only evidence of ownership by Camelot was that some technical drawings and software were marked as copyrighted by Camelot. The CAM/ALOT trademark was originally registered by Knight and only assigned to Camelot more than ten years later when the two companies were merged. There were no patents on the original machine, but patent applications for later improvements identified Knight, not Camelot, as the assignee. In 1992, an accounting firm determined that Knight, not Camelot, was eligible for R&D tax credits and prepared tax returns reflecting that.

Then we get to estate planning. Both the accounting firm and a law firm were involved. The law firm had a theory that the transfer of the minutes book was a transfer of the technology. The accounting firm originally disagreed, but everyone eventually fell in line. A confirmatory bill of sale was signed and the tax returns that had originally claimed the R&D credits for Knight were refiled, disclaiming them for Knight and claiming them for Camelot.

In 1995 the two companies merge, with Camelot the surviving corporation. The shares of the new company were distributed according to the relative value of each company, that is, 19% of the combined entity to the former shareholders of Knight, Mr. and Mrs. Cavallaro, and 81% of the combined entity to the founding shareholders of Camelot, Ken, Paul, and James Cavallaro. This valuation was based on the assumption that Camelot owned the CAM/ALOT technology pre-merger.

Ultimately the IRS investigates whether the parents had made an untaxed gift to the sons. The legal question was whether the merger was in the ordinary course of business, that is, a bona fide arm’s-length transaction free from donative intent.

And there was no arm’s length transaction:

If Camelot had offered itself to the market for acquisition claiming ownership of the CAM/ALOT technology, it is inconceivable that a hypothetical acquirer would do anything other than demand to see documentation of Camelot’s ownership interest—documentation that we have found does not exist. An unrelated hypothetical acquirer would never have been be satisfied with Camelot’s mere assertions of ownership, or its statements that an oral agreement effecting the transfer occurred at some point after Camelot’s incorporation. Instead, upon realizing no such documentation was available, an unrelated party either would have offered to purchase Camelot at a much lower price or (more likely) would have walked away from the deal altogether. Likewise, if Knight were dealing with an unrelated party which sold machines that had been manufactured at Knight’s risk by Knight employees on Knight premises using technology developed by Knight personnel, where Knight had owned the only public registrations of intellectual property and had claimed ownership of the technology in prior tax filings, it defies belief to suggest that Knight would have simply disclaimed the technology and allowed the unrelated party to take it. If an unrelated party had purchased Camelot before the merger and had then sued Knight to confirm its supposed acquisition of the CAM/ALOT technology, without doubt that suit would fail. Camelot did not even own the CAM/ALOT trademark registration.
But these cases, unlike those hypothetical scenarios, involve parents who were benevolent to their sons and involve sons who could therefore proceed without the caution that normally attends arm’s-length commercial dealings between unrelated parties. The Cavallaros manifestly gave no thought in 1987 to the question of which entity would own what intangibles. They gave no thought thereafter to who was paying for the further development of the technology. When the question of technology ownership came up in the context of claims for R & D credits, the professionals comfortably assumed—without challenge—that of course Knight owned the technology. And when the question finally arose explicitly, it arose in an estate-planning context, when the question was “How can we best convey wealth to our sons?” and donative intent was front and center. In that context, the “confirmatory” bill of sale confirmed a fiction.
There is no evidence of any arm’s-length negotiations occurring between the representatives or executives of the two companies. Instead (and despite a wholesale lack of evidence as to Camelot’s ownership of the technology), Knight agreed to take a less than 20% interest in the merged company, effectively valuing Camelot at four times the value of Knight…. Accordingly, we find that the merger transaction between Knight and Camelot was not engaged in at arm’s length and was not in the ordinary course of business.

Instead, it was a $26.9 million gift.

Cavallaro v. C.I.R., T.C. Memo. 2014-189 (2014).

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