Michael T. Caracci and Cindy W. Caracci v. Commissioner

118 T.C. No. 25UNITED STATES TAX COURT
MICHAEL T. CARACCI AND CINDY W. CARACCI, ET AL.,1
Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 12481-99, 12482-99, Filed May 22, 2002.
12483-99, 14711-99X,
17333-99, 17334-99,
17335-99, 17336-99X,
17337-99, 17338-99,
17339-99X,17340-99,
17341-99, 17342-99.
1
Cases of the following petitioners are consolidated
herewith: Vincent E. and Denise A. Caracci, docket No. 12482-99;
Christina C. and David C. McQuillen, docket No. 12483-99;
Sta-Home Home Health Agency, Inc., of Grenada, Mississippi,
docket No. 14711-99X; Sta-Home Health Agency of Carthage, Inc.,
docket No. 17333-99; Sta-Home Health Agency of Greenwood, Inc.,
docket No. 17334-99; Michael Caracci, docket No. 17335-99;
Sta-Home Home Health Agency, Inc., of Forest, Mississippi, docket
No. 17336-99X; Victor Caracci, docket No. 17337-99; Christina C.
McQuillen, docket No. 17338-99; Sta-Home Home Health Agency,
Inc., docket No. 17339-99X; Joyce P. Caracci, docket No.
17340-99; Vincent E. Caracci, docket No. 17341-99; and Sta-Home
Health Agency of Jackson, Inc., docket No. 17342-99.
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Members of the C family wholly own three home
health care organizations (P1, P2, and P3) exempt from
Federal income taxes under sec. 501(c)(3), I.R.C. In
1995, the C family created three S corporations (S1,
S2, and S3) and collectively received all of the
resulting stock. P1, P2, and P3 then transferred all
of their assets to S1, S2, and S3, respectively, in
exchange for each transferee’s assumption of the
transferor’s liabilities. R determined that the fair
market value of the transferred assets substantially
exceeded the consideration received in exchange.
Accordingly, R determined S1, S2, S3, and members of
the C family were liable for excise taxes under sec.
4958, I.R.C., and members of the C family who received
stock in S1, S2, or S3 but did not have an ownership
interest in P1, P2, and P3 were liable for income taxes
on the value of the stock received. R also revoked the
tax exemptions of P1, P2, and P3. Held: The
transferred assets’ value at the time of transfer
decided. Held, further, the value of the transferred
assets exceeded the value of the consideration
received; thus, S1, S2, S3, and members of the C family
are “disqualified persons” subject to excise taxes
under sec. 4958, I.R.C., as beneficiaries of “excess
benefit transactions”. Held, further, although P1, P2,
and P3 engaged in “excess benefit transactions”, a
revocation of their tax-exempt status is inappropriate
given the “intermediate sanctions” under sec. 4958,
I.R.C. Held, further, the three members of the C
family are not liable for the income taxes determined
by R.
David D. Aughtry and Vivian D. Hoard, for petitioners.
Robin W. Denick and Mark A. Ericson, for respondent.
LARO, Judge: These cases are before the Court consolidated.
Petitioners seek review of respondent’s determinations for 1995
of income tax deficiencies, excise tax deficiencies under section
4958, accuracy-related penalties under section 6662(a), and
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revocations of exempt status under section 501(c)(3).2
Respondent determined the following income tax deficiencies and
accuracy-related penalties:
Accuracy-related penalty
Petitioner Deficiency sec. 6662(a)
Michael T. and Cindy W. Caracci $2,192,643 $438,528.60
Vincent E. and Denise A. Caracci 1,272,216 254,443.20
Christina C. and David C.
McQuillen 1,272,307 254,461.40
Respondent determined the following excise tax deficiencies:
Deficiency
Sec. 4958 Sec. 4958 Sec. 4958
Petitioner (a)(1) (a)(2) (b)
Sta-Home Health Agency $1,948,559 -0- $15,588,474
of Carthage, Inc.
Sta-Home Health Agency 1,384,944 -0- 11,079,522
of Greenwood, Inc.
Sta-Home Health Agency 1,302,420 -0- 10,419,362
of Jackson, Inc.
Joyce P. Caracci 4,635,923 $30,000 37,087,388
Michael Caracci 4,635,923 30,000 37,087,388
Victor Caracci 4,635,923 -0- 37,087,388
Vincent E. Caracci 4,635,923 -0- 37,087,388
Christina C. McQuillen 4,635,923 30,000 37,087,388
Respondent determined that the three Sta-Home tax-exempt entities
failed to qualify for tax-exempt status under section 501(c)(3).3
2
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the year in issue, and Rule
references are to the Tax Court Rules of Practice and Procedure.
3
The three Sta-Home tax-exempt entities are Sta-Home Home
Health Agency, Inc., Sta-Home Home Health Agency, Inc., of
Forest, Mississippi, and Sta-Home Home Health Agency, Inc., of
Grenada, Mississippi. The three entities against which
respondent determined excise tax deficiencies are the Sta-Home
for-profit entities.
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Following respondent’s concession that none of petitioners
are liable for section 4952(a)(2) excise taxes or section 6662(a)
accuracy-related penalties, we are left to decide: (1) Whether
Joyce Caracci, Michael Caracci, Victor Caracci, Vincent Caracci,
Christina McQuillen, and the Sta-Home for-profit entities are
liable for excise taxes under section 4958 because of the
transfers of assets from the Sta-Home tax-exempt entities to the
Sta-Home for-profit entities in exchange for the transferees’
assumption of the transferors’ liabilities (the asset transfer);
(2) whether Michael Caracci, Vincent Caracci, and Christina
McQuillen, as shareholders of the Sta-Home for-profit entities
but not of the Sta-Home tax-exempt entities, are liable for
income taxes in connection with the asset transfer; and
(3) whether the asset transfer resulted in a revocation of the
Sta-Home tax-exempt entities’ tax-exempt status on account of a
violation of section 501(c)(3); i.e., the transfer resulted in
the Sta-Home tax-exempt entities’ being operated for a
substantial nonexempt purpose, constituted prohibited inurement,
and impermissibly benefited private interests.4
4
The parties also dispute who bears the burden of proof as
to the central issue in this case; namely, the value of the
transferred assets. We do not decide that dispute. Our findings
of value are based on our examination of the evidence in the
well-developed record, which, in relevant part, includes
stipulated facts, expert reports, other exhibits, and witness
testimony.
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FINDINGS OF FACT
Some facts have been stipulated. We incorporate herein by
this reference the parties’ stipulation of facts and the exhibits
submitted therewith. We find the stipulated facts accordingly.
The couples, Michael and Cindy Caracci, Victor and Joyce Caracci,
Vincent and Denise Caracci, and Christina and David McQuillen,
are husband and wife, each of whom resided in Mississippi when
the petitions were filed. Christina McQuillen is the sister of
Michael and Vincent Caracci, and the three of them are the
children of Victor and Joyce Caracci (the father, mother, and
three children are referred to collectively as the Caracci
family). The principal place of business of the various Sta-Home
entities also was in Mississippi at that time.
From 1973 to 1976, Joyce Caracci served as a consulting
nurse for the State of Mississippi Board of Health, surveying
health care facilities for participation in the Medicare/Medicaid
programs. On May 3, 1976, Joyce Caracci, Victor Caracci, and a
third individual not relevant herein started Sta-Home Home Health
Agency, Inc. Approximately 1 year later, Joyce Caracci, Victor
Caracci, and a third individual not relevant herein formed the
other two Sta-Home tax-exempt entities. Each of the Sta-Home
tax-exempt entities was formed as a nonstock corporation under
Mississippi law, with Victor and Joyce Caracci as the owners
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during all relevant times. In the early years of their business,
Victor and Joyce Caracci borrowed money collateralized by their
residence to fund the Sta-Home tax-exempt entities’ operations,
and they (the individuals) guaranteed the extension of credit to
the entities. Throughout the years, the managers of the three
separate entities generally operated the entities as one
integrated unit. (Because the parties also generally treat the
three separate entities as one integrated unit, so do we.)
During the subject year, Joyce Caracci, Michael Caracci, and
Christina McQuillen were the Sta-Home tax-exempt entities’ only
directors and officers. Those entities employed or retained the
following Caracci family members or spouses in the corresponding
position:
Individual Position
Victor Caracci Consultant
Joyce Caracci Chief operating officer/administrator
Michael Caracci Chief executive officer
Christina McQuillen Director of personnel
Vincent Caracci General counsel
Denise Caracci Nurse (from August 1991 to May 1995)
David McQuillen Maintenance man
The Sta-Home tax-exempt entities participated in the
Medicare program. Medicare was established in title XVIII of the
Social Security Act, Pub. L. 89-97, 79 Stat. 291 (1965), and is
the principal health care insurance for individuals who are
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either disabled or aged 65 or older. It is administered by the
Healthcare Financing Administration (HCFA), a division of the
U.S. Department of Health and Human Services, with whom private
insurance companies in different regions of the country have
contracted to serve as fiscal intermediaries.
In 1995, Medicare reimbursed home health care providers at
an amount that equaled the lesser of the actual reasonable cost
or customary charges, up to the maximum “cost cap”; i.e., the
aggregate per-visit costs limitation under the law applicable to
Medicare. During 1995, Medicare paid home health care agencies
for the necessary services they provided to covered beneficiaries
on a retrospective cost system under which Medicare sent a
“periodic interim payment” (PIP) every 2 weeks to home health
care agencies to cover claims activity. The Sta-Home tax-exempt
entities used the PIP payments to fund their payroll, which was
paid biweekly. Home health care agencies also submitted
quarterly reports and filed annual cost reports with the fiscal
intermediary. If PIP payments differed from the payments
allowable as ascertained from the cost report, the fiscal
intermediary made the appropriate adjustment by reimbursing the
home health care agency for an underpayment or requiring the
agency to remit an overpayment. The Aetna Insurance Co., which
was the fiscal intermediary for the Sta-Home tax-exempt entities,
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disallowed the Sta-Home tax-exempt entities’ claimed costs on
various items such as advertisements, pencils, cell phones,
pagers, desks, and nurse recruiting. The average amount of
disallowed costs annually was .7 percent.
Under Mississippi law, a certificate of need (CON) is
required to operate a licensed home health agency. Since 1983,
Mississippi has had a moratorium on issuing new home health care
licenses. In 1995, the only method of establishing a new home
health care agency business in Mississippi was to purchase the
license of an existing licensed home health care agency.
Although several bills have been introduced in the Mississippi
legislature to lift the moratorium, none has ever been enacted.
Michael Vincent, the chief executive officer of the Sta-Home
corporations, had personally contacted members of the Mississippi
legislature to urge them not to lift the moratorium. He also had
urged others to ask the Mississippi legislators not to lift the
moratorium. From 1986 to 1993, the home health care business in
Mississippi increased 340 percent (as compared to doubling
nationally), but no new home health care agencies had entered
that State.
In 1995, the Sta-Home tax-exempt entities ranked first or
second in market share in 14 of the 19 counties in their service
area. “Sta-Home” was a recognized name in home health care in
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Mississippi, and it had a generally good reputation among
Mississippi’s elderly population. In 1993, the Sta-Home tax-
exempt entities were the first freestanding agencies in
Mississippi to become accredited by the Joint Commission on
Accreditation of Healthcare Organizations (JCAHO). JCAHO
accreditation required achieving or exceeding certain regulatory
standards, including conditions as to the quality of patient
care. During 1995, the Sta-Home tax-exempt entities provided
834,596 home health care visits, and over 95 percent of the
entities’ services were to Medicare beneficiaries. The Sta-Home
tax-exempt entities also had several manuals that they had
developed in-house regarding policies and procedures, including
personnel, nursing, home health aid, physical therapy, and social
work manuals.
It was generally recognized that under the Medicare
reimbursement system in place in 1995, there was no ability for
home health agencies to realize profits beyond costs and that the
reimbursement system provided little incentive for providing
services efficiently. This situation prevailed because Medicare
reimbursed a home health agency only for “allowable” costs at its
discretion. Therefore, any denied claim for reimbursement
produced a cash outflow to the business. The Sta-Home tax-exempt
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entities generated gradually increasing revenue, but also
commensurate losses, in the 3 years preceding October 1, 1995.
The Sta-Home tax-exempt entities’ accounting firm prepared
unaudited combined financial statements. The results from
operations reported by the combined Sta-Home tax-exempt entities
on their returns for fiscal years ended September 30, 1991
through 1995, were:
Year Revenue Expenses Net Income (Loss)
1991 $11,736,061 $11,799,721 ($63,660)
1992 18,442,072 18,414,315 27,757
1993 25,162,701 25,208,255 (45,554)
1994 36,882,957 37,141,686 (258,729)
1995 44,101,849 44,535,239 (433,390)
According to those combined financial statements, the total
assets and liabilities of the Sta-Home tax-exempt entities for
those years were:
Year Assets Liabilities Deficit
1991 $3,203,759 $3,787,285 ($583,526)
1992 5,404,925 5,960,696 (555,771)
1993 6,910,710 7,639,855 (729,145)
1994 7,515,492 8,417,027 (901,535)
1995 10,736,407 12,144,655 (1,408,248)
To ease their financial statuses, the Sta-Home entities
required their employees–-including the Caracci family members
themselves--to forgo payment for the first 6 weeks of employment.
After that initial period, the employees were entitled to collect
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a paycheck for 2 weeks’ work. The 4 weeks’ initial earnings were
withheld until the employees left the companies.
The Sta-Home tax-exempt entities had a policy of giving its
employees discretionary bonuses. For the pay period ended
December 12, 1994, the entities paid bonuses totaling $966,204 to
all personnel with the exception of new hires. On April 10,
1995, the entities also approved for the directors bonuses of 15
percent. For the pay period ended June 23, 1995, the entities
approved additional bonuses totaling $664,116. On September 29,
1995, the entities approved further bonuses totaling $2,314,086;
this bonus created a $2,314,086 liability that was assumed by the
Sta-Home for-profit entities incident to the asset transfer.
Mississippi historically reports the lowest per capita
income of any State with corresponding high unemployment and low
education levels. An official Mississippi State Health Plan,
prepared in 1995, indicated that poorly educated, low-income, and
ill-housed people often had greater health care needs than other
members of society. The socioeconomic characteristics of the
Sta-Home tax-exempt entities’ service territory produced a higher
use of home health care services in comparison to other areas of
the country. In 1992, Medicare paid an average of $13,432 per
Mississippi patient, ranking the State highest in Federal
payments per recipient among all States. During 1994 and 1995,
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95 percent of all visits made by home health agencies operating
in Mississippi were paid for by Medicare.
During 1994 and 1995, the prospect arose of Medicare’s
shifting from a PIP cost reimbursement system to a prospective
payment system (PPS). Several groups discussed the proposal in
theory, but no one knew exactly what form PPS might take. The
Sta-Home tax-exempt entities, through Vincent Caracci, an
attorney whose job included keeping abreast of current events,
learned of these proposed changes. Petitioners came to
understand that the Sta-Home tax-exempt entities would not under
a PPS receive a check every 2 weeks but would have to file a
claim for every service rendered and wait for the claim to be
processed and paid. Petitioners became concerned about the lack
of cashflow under a PPS. They also believed that a PPS would
reduce the Sta-Home tax-exempt entities’ income.
Late in December 1994, the Caracci family consulted an
attorney named Thomas Kirkland (Kirkland) about converting the
Sta-Home tax-exempt entities into for-profit corporations.
Kirkland’s firm represented many home health care agencies, and
he had recommended that all of those agencies make such a
conversion. Kirkland’s recommendation was based, in part, on his
discussions with bankers who were reluctant to lend money to
nonprofit home health care agencies. By 1991, petitioners’
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regular accountant, Danny Hart (Hart), also recommended that the
Sta-Home tax-exempt entities convert to nontax-exempt status.
Kirkland retained a tax attorney named James Pettis (Pettis)
to help Kirkland convert the Sta-Home tax-exempt entities into
for-profit entities. Subsequently, Pettis learned that
Kirkland’s firm had not obtained an appraisal for any of its
previous conversions. Pettis informed Kirkland that Pettis
“strongly [disagreed]” with that approach. By letter dated July
7, 1995, Kirkland’s firm retained Hart’s accounting firm to
appraise the Sta-Home tax-exempt entities’ net assets as of a
proposed transaction date of October 1, 1995.
The appraisal was slow in coming. Pettis, the tax adviser,
insisted on seeing the appraisal before proceeding with any
transaction that would effect a conversion. After reading the
appraisal, Pettis was concerned that it failed to deal with
issues concerning intangible assets. He believed that the mere
fact that an entity had lost money or had a negative cashflow did
not mean that the entity was worthless. He also was concerned
that the appraisal failed to address Rev. Rul. 59-60, 1959-1 C.B.
237, where the Commissioner has set forth standards on valuation
for Federal income tax purposes. Upon Pettis’s request, he
received a second appraisal. Because some of his concerns as to
intangible assets remained after reading the second appraisal, he
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sought and received assurance that the Sta-Home tax-exempt
entities’ liabilities far exceeded the value of their assets and
that the value of the intangibles would not give the entities a
positive fair market value.
On July 11, 1995, the Sta-Home tax-exempt entities’ boards
of directors authorized the conversion of those entities into S
corporations. The S status was chosen so that the shareholders
could deduct the new entities’ future losses. On August 22,
1995, in anticipation of a transfer of the Sta-Home tax-exempt
entities’ assets, Kirkland’s firm, with petitioners’ approval,
formed the Sta-Home for-profit entities under Mississippi law.
Each of those corporations subsequently elected to be taxed as an
S corporation for Federal income tax purposes. Since their
formation, the only shareholders of each of the Sta-Home for-
profit entities have been Joyce Caracci (17.5 percent), Victor
Caracci (17.5 percent), Michael Caracci (30 percent), Christina
McQuillen (17.5 percent) and Vincent Caracci (17.5 percent). The
only directors and officers have been members of the Caracci
family.
On August 28, 1995, Hart’s accounting firm tendered an
appraisal stating that the value of the Sta-Home tax-exempt
entities’ assets was less than their liabilities. Kirkland had
assumed that this would be the case. On September 1, 1995,
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Kirkland executed and filed on behalf of each of the Sta-Home
tax-exempt entities “Notices of Intent to Change Ownership” with
the State of Mississippi Department of Health.
Effective October 1, 1995, Sta-Home Home Health Agency,
Inc., transferred all of its tangible and intangible assets to
Sta-Home Health Agency of Jackson, Inc., Sta-Home Home Health
Agency, Inc., of Forest, Mississippi, transferred all of its
tangible and intangible assets to Sta-Home Health Agency of
Carthage, Inc., and Sta-Home Home Health Agency, Inc., of
Grenada, Mississippi, transferred all of its assets to Sta-Home
Health Agency of Greenwood, Inc. The consideration paid by each
transferee was the assumption of the related transferor’s
liabilities. Since the transfers, the transferors have not
engaged in any activities, charitable or otherwise, nor have they
been dissolved under Mississippi law.
On October 19, 1995, Robert Crowell, Hart’s accounting
partner, sent a letter to Kirkland setting forth several reasons
that Sta-Home should convert to a profit corporation from a
nonprofit. These included the need to raise capital and/or enter
into profit-making ventures, in view of the past losses and
accumulated deficit; the ability to participate in major changes
taking place in the health care industry, including mergers and
acquisitions; the provision of ownership interests for succession
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plans to keep key management in place; and the ability to deal
with changes in the reimbursement system within the near future.
Four days later, the documents were executed that constitute the
contract under which all of the transferors’ assets were
transferred to the transferees.
Other than State and Federal filing requirements and the
slight changes in the names of the entities, the Sta-Home
operations remained the same after the transfer as they were
before. The Sta-Home for-profit entities continued to use a
fiscal year ending on September 30 for financial accounting and
Medicare reporting purposes, although not for tax purposes. As
part of the transfers, the Sta-Home for-profit entities accepted
assignment of the Sta-Home tax-exempt entities’ Medicare provider
agreements and continued to use the provider numbers of the Sta-
Home tax-exempt entities. The Sta-Home for-profit entities
continued to receive PIP payments and lump-sum settlements from
the Medicare program, including quarterly payments based on
quarterly PIP reports. The Sta-Home for-profit entities received
a net preacquisition payment relating to settlement of the Sta-
Home tax-exempt entities’ 1987 fiscal year. Substantially, the
same employees continued to do the same work, and the same assets
were used in the same three locations. The Caracci family
members continued to be employed by the Sta-Home for-profit
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entities in the same positions in which they were employed by the
Sta-Home tax-exempt entities, and each member’s compensation and
employment benefits remained subject to review by HCFA through
the cost reporting process. The 1995 and 1996 combined salaries
paid to Joyce Caracci, Michael Caracci, Vincent Caracci, and
Christina McQuillen5 by the Sta-Home entities were as follows:
Individual 1995 1996
Joyce Caracci $140,472 $141,685
Michael Caracci 226,483 232,686
Vincent Caracci 70,180 65,434
Christina McQuillen 64,514 55,952
The mid-1990's showed significant growth in the home health
care industry. Natl. expenditures for home nursing care grew
from $3.8 billion in 1990 to $20.5 billion in 1997. There was
also substantial activity in home health care agency
acquisitions. There were 42 such acquisitions in 1994, 60 in
1995, 112 in 1996, and 139 in 1997.
During 1995, the primary buyers of home health agencies were
hospitals, nursing homes, and other home health agencies. They
were able to take advantage of a mechanism known as “cost-
shifting”. This attribute enabled a buyer such as a hospital
(which generally received reimbursement under the PPS) to shift
some of its costs to a cost reimbursement system for payment by
5
Victor Caracci was paid on a consulting basis that varied
significantly from year to year.
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the Medicare program. Cost shifting was possible because:
(1) The purchased home health care agencies had room under their
cost cap because they had sought less than the maximum
reimbursement allowed by Medicare and (2) Medicare reimbursed
home health care providers for costs, such as overhead, that were
not directly related to home visits. Hospitals and nursing homes
could benefit by acquiring a home health care agency and shifting
some of their overhead costs to that agency to the extent that
there was room under its cost cap.
During 1994 and 1995, a number of home health agencies in
Mississippi were sold. The State Board of Health identified 11
such acquisitions. Seven were by hospitals; two were by home
health care agencies; one was by an individual from a bankruptcy
trustee, and one was a corporate reorganization. All of the
acquisitions by hospitals involved home health agencies in or
near Mississippi, although on occasion the corporate headquarters
of the acquiring corporations were located outside Mississippi.
In 1995, the Deaconess Hospital Corp. of Cincinnati, Ohio,
acquired the stock of Southern Mississippi Home Health, Inc., a
Mississippi corporation.
Home health agencies remained under a cost reimbursement
system until September 30, 1999, when legislation passed by
Congress in 1997 providing a PPS for home health agencies took
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full effect. HCFA encountered problems implementing the system,
and it was not finally implemented until October 1, 2000.
OPINION
I. Introduction
Respondent has determined that petitioners’ participation in
the asset transfer made them liable for deficiencies totaling
$256,114,435.6 Respondent’s determination rests on his expert’s
determination that the fair market value of the transferred
assets exceeded the assumed liabilities by approximately $20
million. Petitioners argue that the assumed liabilities exceeded
the fair market value of the transferred assets. Petitioners
rely on their expert, who concluded similarly. It is with this
backdrop that we proceed to decide the assets’ value at the time
of the transfer. We bear in mind the wide difference in values
ascertained by the experts.
II. Fair Market Value
A. Overview
A determination of fair market value is factual, and a trier
of fact must weigh all relevant evidence of value and draw
6
Of course, were the respondent to prevail in full, he
would be entitled to only $46,460,477 of approximately
$256,114,435. The lion’s share of the $256,114,435 is
attributable to excise taxes under sec. 4958(a)(1) and (2) and
(b) totaling $41,753,311 ($4,635,923 + $30,000 + $37,087,388),
for all or part of which respondent has determined that eight
petitioners are jointly and severally liable.
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appropriate inferences. Commissioner v. Scottish Am. Inv. Co.,
323 U.S. 119, 123-125 (1944); Helvering v. Natl. Grocery Co.,
304 U.S. 282, 294 (1938); Zmuda v. Commissioner, 79 T.C. 714, 726
(1982), affd. 731 F.2d 1417 (9th Cir. 1984); Mandelbaum v.
Commissioner, T.C. Memo. 1995-255, affd. without published
opinion 91 F.3d 124 (3d Cir. 1996). Fair market value is the
price that a willing buyer would pay a willing seller, both
persons having reasonable knowledge of all relevant facts and
neither person being under any compulsion to buy or to sell.
United States v. Cartwright, 411 U.S. 546, 551 (1973); Kolom v.
Commissioner, 644 F.2d 1282, 1288 (9th Cir. 1981), affg. 71 T.C.
235 (1978); Estate of Hall v. Commissioner, 92 T.C. 312, 335
(1989). See generally Rev. Rul. 59-60, 1959-1 C.B. 237. The
willing buyer and the willing seller are hypothetical persons,
rather than specific individuals or entities, and the
characteristics of these hypothetical persons are not necessarily
the same as the personal characteristics of the actual seller or
a particular buyer. Propstra v. United States, 680 F.2d 1248,
1251-1252 (9th Cir. 1982); Estate of Bright v. United States,
658 F.2d 999, 1005-1006 (5th Cir. 1981); Estate of Jung v.
Commissioner, 101 T.C. 412, 437-438 (1993); Mandelbaum v.
Commissioner, supra.
Fair market value reflects the highest and best use of the
relevant property on the valuation date and takes into account
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special uses that are realistically available because of the
property’s adaptability to a particular business. Mitchell v.
United States, 267 U.S. 341, 344-345 (1925); Symington v.
Commissioner, 87 T.C. 892, 896 (1986); Stanley Works v.
Commissioner, 87 T.C. 389, 400 (1986); Estate of Proios v.
Commissioner, T.C. Memo. 1994-442. Fair market value is not
affected by whether the owner has actually put the property to
its highest and best use. The reasonable and objective possible
uses for the property control the valuation thereof. United
States v. Meadow Brook Club, 259 F.2d 41, 45 (2d Cir. 1958);
Stanley Works v. Commissioner, supra at 400. The hypothetical
willing buyer and seller are presumed to be dedicated to
achieving the maximum economic advantage, Estate of True v.
Commissioner, T.C. Memo. 2001-167, and the “hypothetical sale
should not be construed in a vacuum isolated from the actual
facts”, Estate of Andrews v. Commissioner, 79 T.C. 938, 956
(1982).
Here, the parties dispute whether any value should be given
to the Sta-Home tax-exempt entities’ cost-shifting attribute.
Cost-shifting could attract prospective purchasers, such as
hospitals, that desired to acquire a home health care agency and
use its cost-shifting capacity. At our request, the parties have
discussed whether attributing value to this mechanism is
consistent with the requirement that fair market value be
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determined using a “hypothetical” buyer. We conclude that it is.
A hypothetical buyer may be one of a class of buyers who is
positioned to use the purchased assets more profitably than other
entities. Accordingly, we have held that fair market value takes
into account special uses that are realistically available
because of a property’s adaptability to a particular business.
Stanley Works v. Commissioner, supra at 400. Acknowledging the
existence of such businesses in the universe of hypothetical
buyers also is consistent with the standard that assets are not
valued in a vacuum but, instead, are valued at their highest and
best use.
The cases petitioners cite do not require a different
conclusion. The cases of Morrissey v. Commissioner, 243 F.3d
1145 (9th Cir. 2001), revg. and remanding Estate of Kaufman v.
Commissioner, T.C. Memo. 1999-119, Estate of Andrews v.
Commissioner, supra, and Estate of Magnin v. Commissioner, T.C.
Memo. 2001-31, stand for the proposition, which we accept, that
the attributes of a hypothetical willing buyer cannot be limited
to those of a particular buyer. That proposition is inapplicable
where, as here, we do not confine the hypothetical buyer to a
specific and identifiable buyer but include the entire class of
buyers for whom the Sta-Home tax-exempt entities’ cost-shifting
attributes could be especially adaptable. Stanley Works v.
Commissioner, supra.
- 23 -
Nor are petitioners assisted by citing Estate of Davis v.
Commissioner, 110 T.C. 530 (1998). There, we rejected the
Commissioner’s attempt to narrow the field of hypothetical
willing buyers. The Commissioner had done so by advancing the
unwarranted assumption that a hypothetical buyer would cause the
acquired corporation to escape its potential tax liabilities by
having it elect S corporation status and by not permitting it to
sell any of its assets for 10 years thereafter. Unlike the
assumption there, the assumption here that the cost-shifting
attribute is a valuable asset is fully warranted. In fact, as
explained below, both experts have ascribed value to the Sta-Home
tax-exempt entities’ cost-shifting mechanism. In addition,
petitioners’ expert, Alfred D. Hahn (Hahn), has elsewhere written
that “transaction prices reflect the value to a buyer to shift
overhead costs”. Hahn et al., “Home Health Agency Valuation:
Opportunity Amid Chaos”, Intrinsic Value (Spring 1998).
B. Role of the Expert
As typically occurs in a case of valuation, each party
relies primarily upon an expert’s testimony and report to support
the respective positions on valuation. A trial judge bears a
special gatekeeping obligation to ensure that any and all expert
testimony is relevant and reliable. Kumho Tire Co. v.
Carmichael, 526 U.S. 137, 147 (1999); Daubert v. Merrill Dow
Pharm., Inc., 509 U.S. 579, 589 (1993).
- 24 -
The Court has broad discretion to evaluate the cogency of an
expert’s analysis. Neonatology Associates, P.A. v. Commissioner,
115 T.C. 43, 85 (2000). Sometimes, an expert will help us decide
a case. E.g., Booth v. Commissioner, 108 T.C. 524, 573 (1997);
Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274, 302
(1996); see also M.I.C., Ltd. v. Commissioner, T.C. Memo.
1997-96; Estate of Proios v. Commissioner, supra. Other times,
he or she will not. E.g., Estate of Scanlan v. Commissioner,
T.C. Memo. 1996-331, affd. without published opinion 116 F.3d
1476 (5th Cir. 1997); Mandelbaum v. Commissioner, T.C. Memo 1995-
255 Aided by our common sense, we weigh the helpfulness and
persuasiveness of an expert’s testimony in light of his or her
qualifications and with due regard to all other credible evidence
in the record. Neonatology Associates, P.A. v. Commissioner,
supra at 85. We may embrace or reject an expert’s opinion in
toto, or we may pick and choose the portions of the opinion to
adopt. Helvering v. Natl. Grocery Co., 304 U.S. at 294-295;
Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976),
affg. T.C. Memo. 1974-285; IT & S of Iowa, Inc. v. Commissioner,
97 T.C. 496, 508 (1991); see also Pabst Brewing Co. v.
Commissioner, T.C. Memo. 1996-506. We are not bound by an
expert’s opinion and will reject an expert’s opinion to the
extent that it is contrary to the judgment we form on the basis
of our understanding of the record as a whole. Orth v.
- 25 -
Commissioner, 813 F.2d 837, 842 (7th Cir. 1987), affg. Lio v.
Commissioner, 85 T.C. 56 (1985); Silverman v. Commissioner, supra
at 933; IT & S of Iowa, Inc. v. Commissioner, supra at 508; Chiu
v. Commissioner, 84 T.C. 722, 734 (1985).
Here, the experts began by observing that the methodology
traditionally used in business appraisals includes an income
approach, a cost approach, and a market approach. In an income
approach, value depends upon the present value of future economic
benefits to be derived from ownership. An enterprise’s price-
per-share value is then estimated by discounting the net
cashflows available for distribution back to their present value,
at market-based rates of return. The cost approach uses
estimates of current costs to replace the enterprise’s fixed
assets and certain intangible assets. The market approach
establishes the value of a privately held corporation through
analyses of sales or transfers of guideline companies. The
information derived from this analysis is then used to form an
opinion of market value for a subject company.
C. Expert Testimony for Petitioners
To support their contention that the value of the Sta-Home
tax-exempt entities’ assets was less than the liabilities
assumed, petitioners rely upon the report and testimony of Hahn.
Hahn, a director in PricewatershouseCoopers Northeast Region
Corporation Valuation Consulting Group, has written extensively
- 26 -
on the valuation of home health care agencies and has frequently
appeared as an expert witness.
Hahn started by noting that because of the predominance of
Medicare in the payor mix of most home health agencies, a
conventional cashflow or earnings approach to valuation would
produce “a very different result from other, more appropriate
approaches.” This is so because home health agencies, with a
preponderance of Medicare-eligible patients, earn little if any
profit.7
Hahn instead relied principally upon an “Adjusted Balance
Sheet” methodology, a form of the cost approach. That
methodology restates a company’s accounting balance sheet to its
fair market value equivalent. Hahn explained that this approach
involves the identification and valuation of tangible and
intangible assets and liabilities, whether or not they appear on
the subject company’s accounting balance sheet.
Hahn started with the unaudited balance sheets prepared by
petitioners’ accounting firm in 1995. He concluded that several
of the Sta-Home tax-exempt entities’ asset accounts required
revaluation. He noted that there were several “unrecorded
7
The evidence includes an article written by Hahn wherein
he reports that his firm’s database reflects that “more than 75
percent of home health agency acquisitions involved agencies that
recorded losses.” Hahn, “Payment Reform Will Shift Home Health
Agency Valuation Parameters”, Healthcare Financial Management
(Dec. 1998).
- 27 -
material assets and liabilities” in addition to the assets and
liabilities on the balance sheets. In terms of the assets, he
indicated that economic intangible assets should be adjusted to
fair market value. He also included some liabilities that were
not recorded on the unaudited balance sheet, such as a balance
due to Medicare from the Jackson and Grenada facilities for the
fiscal year 1993. He further made allowance for pending events
which, he opined, suggested the possibility of future claims
against the companies, such as a reserve for future downward
reimbursement adjustments by Medicare.
Hahn observed that the passage of time had obscured the
then-current value of the companies because the analysis was
prepared 5 years after the actual transaction. Accordingly, Hahn
prepared both a “base case” and a “best case” scenario to develop
a range of fair market values. He concluded that the fair market
value of the Sta-Home tax-exempt entities’ total tangible and
intangible assets was between $10.5 million and $11.5 million.
He noted that the entities’ total recorded and contingent
liabilities were between $12 million and $12.5 million. His
result indicates that the combined liabilities of the Sta-Home
tax-exempt entities exceeded the value of their assets by $.5
million to $2 million.
The following tables set forth Hahn’s “base case” and “best
case” adjusted balance sheets. The first figure column lists the
- 28 -
unaudited balance sheets for the fiscal year ended September 30,
1995. The next column (PwC Valuation Adjustments) shows changes
made by Hahn. The last column shows Hahn’s estimate of the fair
market value of each category after making his changes.
Valuation of Sta-Home Agency, Inc. - Combined
Adjusted Balance Sheet Approach
Valuation Performed as of 9/30/95
Best Case Scenario
Compiled PwC Fair Market Value
FYE Valuation FYE
9/30/95 Adjustments 9/30/95
Cash $1,271,031 -- $1,271,031
Accounts receivable 9,115,026 ($857,786) 8,257,240
Allowance for contractual adjustments (4,205,058) 274,701 (3,930,357)
Allowance for bad debts -- (264,444) (264,444)
Est. third-party payor settlements--Medicare 2,269,063 (295,473) 1,973,590
Allowance for unsuccessful claims -- (543,803) (543,803)
Accounts receivable-–employees 51,518 -- 51,518
Accounts receivable--other 96,820 -- 96,820
Prepaid expenses 656,465 -- 656,465
Total current assets 9,254,865 -- 7,568,060
Property, plant & equipment 2,850,538 -- 2,850,538
Accumulated depreciation (1,456,464) -- (1,456,464)
Total PP&E 1,394,074 -- 1,394,074
Deposits 9,033 -- 9,033
Long-term accounts receivable–-other 78,435 (59,610) 18,825
Total other assets 87,468 -- 27,858
Workforce-in-place -- 2,100,000 2,100,000
Cost-shifting capacity -- 667,467 667,467
Total intangible assets -- -- 2,767,467
--
Total assets 10,736,407 11,757,459
Current portion of long-term debt 369,967 -- 369,967
Accounts payable 750,199 -- 750,199
Accounts payable–-other 165,808 -- 165,808
Accrued payroll 5,009,968 -- 5,009,968
Accrued payroll taxes 1,141,431 -- 1,141,431
Other accrued expenses 4,206,978 -- 4,206,978
Due to Medicare -- 201,000 201,000
Total current liabilities 11,644,351 -- 11,845,351
Notes payable, long-term portion 500,304 -- 500,304
Total liabilities 12,144,655 -- 12,345,655
Liabilities in excess of assets (1,408,248) -- (588,196)
Valuation of Sta-Home Agency, Inc. - Combined APPENDIX C
Adjusted Balance Sheet Approach
Valuation Performed as of 9/30/95
Base Case Scenario
Compiled PwC Fair Market Value
FYE Valuation FYE
- 29 -
9/30/95 Adjustments 9/30/95
Cash $1,271,031 -- $1,271,031
Accounts receivable 9,115,026 ($1,072,232) 8,042,794
Allowance for contractual adjustments (4,205,058) 274,701 (3,861,682)
Allowance for bad debts (142,885) (142,885)
Est. third-party payor settlements--Medicare 2,269,063 (295,473) 1,973,590
Allowance for unsuccessful claims (1,087,606) (1,087,606)
Accounts receivable--employees 51,518 -- 51,518
Accounts receivable--other 96,820 -- 96,820
Prepaid expenses 656,465 -- 656,465
Total current assets 9,254,865 -- 7,000,045
Property, plant & equipment 2,850,538 -- 2,850,538
Accumulated depreciation (1,456,464) -- (1,456,464)
Total PP&E 1,394,074 -- 1,394,074
Deposits 9,033 -- 9,033
Long-term accounts receivable-–other 78,435 (59,610) 18,825
Total other assets 87,468 -- 27,858
Workforce-in-place -- 2,100,000 2,100,000
Total intangible assets -- -- 2,100,000
Total assets 10,736,407 -- 10,521,977
Current portion of long-term debt 369,967 -- 369,967
Accounts payable 750,199 -- 750,199
Accounts payable--other 165,808 -- 165,808
Accrued payroll 5,009,968 -- 5,009,968
Accrued payroll taxes 1,141,431 -- 1,141,431
Other accrued expenses 4,206,978 -- 4,206,978
Due to Medicare -- 201,000 201,000
Total current liabilities 11,644,351 -- 11,845,351
Notes payable, long-term portion 500,304 -- 500,304
Unaudited cost reports -- (517,909) 517,909
Total liabilities 12,144,655 (718,909) 12,863,564
Liabilities in excess of assets (1,408,249) (933,338) (2,341,587)
To corroborate his findings of net asset value, Hahn used a
market-transaction approach. This approach involved valuing the
Sta-Home tax-exempt entities on the basis of market values of
comparable companies that had been sold. To Hahn, the comparable
approach was only a secondary indication of value, because sales
of other individual home health care agencies appeared to be too
“idiosyncratic” to provide a principled basis for valuation. In
any event, Hahn noted that approximately 50 applications to
change ownership had been filed by home health care agencies in
- 30 -
Mississippi during the 11-year period ended in 1995. Little
information was available as to these ownership changes, and Hahn
found only two guideline transfers.
Hahn further noted that the Sta-Home tax-exempt entities
were focused almost entirely upon traditional home health care
and depended almost entirely upon Medicare payments. Publicly
traded companies, by contrast, usually utilized traditional home
health care agencies as part of a broader mix of health care
business. Hahn concluded, therefore, that a comparison to
publicly traded companies would not be appropriate to value the
Sta-Home tax-exempt entities, and he instead utilized “readily
available” information on 13 comparable sales derived from
privately held transactions engaged in by those publicly traded
companies. From these privately held transactions, Hahn excluded
sales of privately held home health agencies that provided
sophisticated “infusion or respiratory therapy” because those
could attract reimbursement at a higher rate than those available
to the more traditional home health care agencies such as Sta-
Home.
Principally upon the basis of his adjusted balance sheet and
comparable market computations, Hahn reached an ultimate
conclusion that the Sta-Home tax-exempt entities’ liabilities
exceeded their total tangible and intangible assets by $600,000
to $2,350,000.
- 31 -
Finally, Hahn turned his attention to making adjustments to
the Sta-Home for-profit entities’ stock for “control premiums”
and lack of marketability. He hypothecated that no additional
premium for control of the Sta-Home tax-exempt entities was
appropriate because the sale of 100 percent of the Sta-Home tax-
exempt entities was contemplated (therefore, all of the value of
the companies would be included in the transaction price). He
also concluded that any adjustment to reflect the fact that
Mississippi presented an unattractive market for the sale of the
Sta-Home tax-exempt entities had been incorporated into his
adjusted balance sheet valuation.
With respect to the value of the stock held by the
individual shareholders, Hahn noted that no one individual could
control the Sta-Home tax-exempt entities. While he believed that
this usually would require that a minority discount be reflected
in the value of the shares held by the noncontrolling
shareholders, he concluded that a minority discount was not
appropriate here because the shares represented equity interests
in a loss corporation. He noted, however, that at the time of
the asset transfer the appropriate control premium and market
discount in the home health care industry were approximately 36
percent and 26 percent, respectively.
D. Expert Testimony for Respondent
- 32 -
Charles A. Wilhoite (Wilhoite) presented expert testimony on
behalf of respondent. Wilhoite, a certified public accountant,
is a principal of Willamette Management Associates and codirector
of that firm’s office in Portland, Oregon. He has performed a
number of assignments involving the analysis and appraisal of
professional practices, with a heavy concentration in the health
care field. He has been involved with assignments requiring the
valuation of intangible assets, including CONs, customer
relationships, goodwill, and workforces.
Petitioners argue that Wilhoite’s testimony should be
stricken because, they claim, his qualifications as an expert and
his methodology are insufficient to meet the standards set forth
in Daubert v. Merrill Dow Pharm., Inc., 509 U.S. 579 (1993).
These contentions are nonsensical and border on the frivolous.
Gross v. Commissioner, T.C. Memo. 1999-254, affd. 272 F.3d 333(6th Cir. 2001). We have no reason to question our recognition
of Wilhoite as an expert on the fair market valuation of health
industry and related businesses; i.e., the business of the
Sta-Home tax-exempt entities. Nor are we unsatisfied as to the
reliability of his methodology, including ascertaining the fair
market values of invested capital for comparable entities. BTR
Dunlop Holding, Inc. v. Commissioner, T.C. Memo. 1999-377.
Turning to Wilhoite’s testimony, Wilhoite, like Hahn,
considered the three principal means of valuing a company’s
- 33 -
assets; i.e., the income, cost, and market approaches. Wilhoite
rejected the cost approach as a means of valuing the Sta-Home
tax-exempt entities. He noted that the value of the Sta-Home
tax-exempt entities’ intangible assets was especially important
because the entities were service-based business with a
relatively low investment in tangible assets. He noted that the
Sta-Home tax-exempt entities’ intangible assets included
operating licenses, Medicare certifications, patient lists,
referral relationships, a trained and assembled workforce,
proprietary policies and procedures and trade name, and a going
concern value. He noted that the CONs had been subject to a
moratorium for the 12 years prior to the valuation date. He
noted that “health issues” prevented him from learning details
about the Sta-Home tax-exempt entities’ intangible assets from
the Sta-Home tax-exempt entities’ management and that much of
that information was simply not available.
He explained that several of the home health care agencies
acquired in recent transactions had incurred losses immediately
before their sale. He observed, however, that the purchasers of
those agencies still had paid considerable amounts to acquire
them. To Wilhoite, this factor indicated that the intangible
assets even of companies that showed losses were worth
considerable sums to potential acquirers. Moreover, it indicated
to Wilhoite that an examination of similar acquisitions would
- 34 -
result in an indication of a value which included the value of
intangible assets.
Wilhoite decided that a better valuation would come from
employing the market approach; i.e., examining transfers of
ownership of comparable home health care agencies. His market
approach utilized two types of transfers. One involved the
valuation of comparable publicly traded home health care
agencies. The other valued the consideration paid for merged or
acquired companies. In addition to the two-pronged market
approach, Wilhoite also utilized an income method, wherein he
calculated the value of the Sta-Home tax-exempt entities’ cost-
savings attribute to a potential buyer.
As a basis for his valuations under both the market and
income approaches, Wilhoite ascertained the market value of
invested capital (MVIC) for the Sta-Home tax-exempt entities.
The MVIC represents the market value of a company’s capital
structure–-all of its ownership equity and all of its interest-
bearing debt. The MVIC method is commonly used in the valuation
of closely held companies. Its use operates to minimize
differences in capital structure between a closely held company
and publicly traded companies which are used as comparables. See
Pratt et al., Valuing Small Business and Professional Practices
548 (3d ed. 1998).
- 35 -
Wilhoite turned first to the market approach, examining the
value of publicly traded companies that operated home health care
agencies. For each of these, he ascertained a “revenue pricing
multiple”; i.e., a percentage that when multiplied by the annual
revenues of a home health care agency would reflect the MVIC of
that agency. The MVIC of the comparable companies reflected a
median revenue multiple of .61. Because Sta-Home tax-exempt
entities were nonprofit companies, however, their returns on
invested capital were considerably lower. Wilhoite selected a
multiple of .3, noting that this multiple represented a discount
of 50 percent from the median guideline company multiple. He
then multiplied .3 times the Sta-Home tax-exempt entities’ 1995
revenues of $45,209,000 to arrive at an MVIC for the Sta-Home
tax-exempt entities of $13,563,000.
Wilhoite next turned his attention to the guideline merged
and acquired company method. He examined figures available from
publications such as the “Home Health Care M&A Report” published
by Irving Levin Associates, Inc. He pointed out that two of the
comparable merged or acquired companies were very close in
revenues to the Sta-Home tax-exempt entities; of those two, the
MVIC of Patient-Care, Inc., represented a revenue multiple of
.40, and the MVIC of Magellan Health Services, Inc., reflected a
revenue multiple of 1.08. With respect to a comparable company
that operated at a loss, namely, Nurse-Care, Inc., Wilhoite noted
- 36 -
that when acquired, it had reported revenues of $15.3 million but
overall losses of 1.9 percent. Nurse-Care, Inc., sold for an
MVIC revenue multiple of .21. Taking these factors into
consideration, Wilhoite selected a revenue multiple of .25 times
the last year’s revenue. This amount was approximately 20
percent higher than that of Nurse-Care, Inc., but 50 percent
lower than the guideline for the median merged or acquired
companies. Having applied the .25 multiple to the Sta-Home tax-
exempt entities’ last 12-month revenue of $45,209,000, Wilhoite
arrived at an MVIC of $11,302,000.
Wilhoite then turned to the income approach. He ascertained
that the Sta-Home tax-exempt entities could generate meaningful
income for a purchaser that was positioned to use the cost-
shifting strategy. An officer of Sta-Home tax-exempt entities
had indicated to Wilhoite that the entities had historically
received reimbursed costs in an amount that was 5 percent below
the limit they were allowed. Wilhoite ascertained that the
annual value of such a saving in 1995 was $1,408,168. To
ascertain the present value of a stream of such payments,
Wilhoite ascertained an appropriate multiplier by examining the
weighted average cost of capital for Sta-Home tax-exempt
entities, less the anticipated increases generated by long-term
growth. Wilhoite arrived at a capitalization rate of 12.8
percent. This capitalization rate yielded a value for the Sta-
- 37 -
Home tax-exempt entities, on the basis of use of the cost gap, of
$11,001,000.
To conclude his study, Wilhoite assigned a weighted
percentage to each of the three values he had derived under the
two market approaches and the single income approach. He gave
the most weight to the income approach, somewhat less weight to
the publicly traded comparable approach, and the least weight to
the merged or acquired comparable approach. His weighted average
was $11,604,000 for the MVIC. Wilhoite then took into account
the fact that, although they were ongoing businesses, the Sta-
Home tax-exempt entities had nevertheless generated a net working
capital deficit; i.e., the current liabilities exceeded the
current assets by more than $2 million. While sufficient current
assets would usually be present in an ordinary operating business
to pay for current liabilities, this was not the case for the
Sta-Home tax-exempt entities. A purchaser would quickly have to
come up with additional moneys to pay the bills. Wilhoite viewed
the necessity for such a “working capital infusion” as a factor
that would lower the value of the calculated MVIC. Thus, from
the $11,604,000 value for the MVIC, he subtracted the $2,020,000
deficit that a buyer of the Sta-Home tax-exempt entities would
have to provide following an acquisition of the companies.
To the resulting figure for the now-discounted MVIC,
Wilhoite added the companies’ current liabilities. He did so
- 38 -
because accounting rules require the asset side and the liability
side of a company’s balance sheet to be equal. His calculated
MVIC, which comprised long-term liabilities and owners’ equity,
did not include current liabilities. Wilhoite reasoned that, by
adding the known current liabilities to the MVIC, he would
complete the liability side of the balance sheet. The asset
sheet would thus be an amount that equaled the liabilities so
computed. He compared the inclusion of current liabilities as a
means of ascertaining value by showing that petitioners had done
essentially the same operation. Their position was that the
companies’ value was equal to the total liabilities, both long-
term and short-term debt. The difference between Wilhoite’s view
and that of petitioners is that Wilhoite concluded, on the basis
of his MVIC analysis, that the companies had some value, which
was expressed on the liabilities side as owners’ equity.
Petitioners, however, maintained that there was no owners’ equity
and, hence, they did not include it in the balance sheet. His
explanation stated:
Basic accounting requires that the total asset value of
an entity (i.e., the “left-hand side” of the balance
sheet) is equal to the sum of the total liabilities and
equity, or net asset value, of an entity (i.e., the
“right-hand side” of the balance sheet). * * * [The
Sta-Home for-profit entities] and the Caraccis reported
acquired all of the assets of the tax-exempt agencies
by assuming all of the liabilities of the tax-exempt
agencies. Because the Caraccis assumed no equity value
existed, and because basic accounting requires that the
- 39 -
“left-hand side” of the balance sheet equal the “right-
hand side”, our independently determined estimate of
the fair market value of Sta-Home’s invested capital
(i.e., interest-bearing debt and equity, reduced by the
estimated working capital infusion) combined with
reported current liabilities, provides the total
“right-hand side” of the balance sheet.
The result is as follows:
Indicated MVIC $11,604,000
Less working capital infusion 2,020,000
Plus current liabilities 11,274,000
Indicated asset value 20,858,000
E. Our Valuation of the Sta-Home Tax-Exempt Entities
The traditional determinants of fair market value persist
even when valuing a nonprofit, tax-exempt company. There are
differences, however, in the amount of weight usually given to
the earnings and profits of regular business organizations and
those of tax-exempt entities. Earnings and profits are obviously
less meaningful in the case of nonprofit organizations. Here,
Medicare funded 95 percent of the Sta-Home tax-exempt entities’
operations. As applicable herein, the Medicare program was not
designed to produce corporate profits nor to contribute to the
capital growth of health care organizations. It was designed to
reimburse providers of home health care services for their costs,
including administrative salaries and overhead. The system
nevertheless permitted the operators of such agencies to generate
executive-level salaries and benefits for themselves. It also
permitted them to accumulate substantial assets in their
businesses without paying income taxes on any of their earnings.
- 40 -
Petitioners urge that “common sense” requires a decision in
their favor. They argue that they incurred losses, not gains, on
the transactions leading to formation of the Sta-Home for-profit
entities. They point to balance sheets which show that the
liabilities they assumed exceeded the value of the assets they
acquired.
We disagree with petitioners’ so-called common sense
rationale. To the contrary, we think it obvious that a company’s
negative book value does not require a finding that the company
had a fair market value of less than zero. Nor does the fact
that a company operates at a loss mean that its intangible assets
have no value. Those assets are still capable of generating
revenue, thus proving they have value. Even petitioners’ tax
adviser, Pettis, testified to that effect.
Moreover, the Sta-Home tax-exempt entities’ assets generated
revenues of approximately $45 million in the year they were
transferred to the Sta-Home for-profit entities. The Sta-Home
tax-exempt entities reported a modest income from operations,
but, after deducting interest and depreciation (mostly for their
fleet of automobiles), they reported a loss of $506,713.
Although in 1995 they also reported an increase for the third
consecutive year in the negative net asset value to a new total
of $1,408,248, the evidence shows that their fourth employee
bonus in that year amounted to some $2,314,086. Had they not
- 41 -
declared that bonus, they would have reported nontaxable income
of approximately $1,785,000, or, in other words, more than enough
to eliminate the accumulated deficit in net asset value.
The Sta-Home tax-exempt entities’ expert also reported that
their total payroll for 1995 was $34,600,000, or about 80.5
percent of operating expenses, and that this amount of employee
compensation was “generous”. A common range of compensation for
other home health care agencies was between 70 and 75 percent.
Had petitioners not declared the last bonus, their compensation
expense would have been $34,085,914, or 75.4 percent of operating
expenses. This amount would have exceeded the industry average
and still enabled the companies to eliminate their accumulated
deficit and show a modest profit. Thus, even though the Sta-Home
tax-exempt entities reported a history of losses, they at least
had the potential to generate income and thus demonstrate a
substantial fair market value.
We believe that the best evidence of the value of the Sta-
Home tax-exempt entities arises from the use of the comparable
value method employed by both experts. We also are persuaded
that the fair market value is best determined by relying upon the
rationale of Wilhoite. His use of the MVIC approach to compare
the privately held Sta-Home tax-exempt entities to similar
publicly traded businesses is especially appropriate here. That
approach harmonizes the differences between debt and equity usage
- 42 -
by publicly traded companies and privately held entities. It
also considers the total investment, which, as discussed infra,
is especially important for the Sta-Home tax-exempt entities.
We do not agree, however, that Wilhoite ascertained an
accurate price-to-revenue multiple for ascertaining the Sta-Home
tax-exempt entities’ MVIC. His .3 multiplier was approximately
half that applicable to the median of the publicly traded
comparables. His discount reflects petitioners’ demonstration
that many of these publicly traded companies functioned in areas
where combinations of businesses, including managed care
operations, produced more favorable prospects than were generally
available in Mississippi. Wilhoite’s discount does not, however,
sufficiently take into account the absence from the Sta-Home
services of some of the more sophisticated, and remunerative,
home health care techniques, such as infusion and respiratory
therapies. These techniques were utilized by many of the
comparison companies. We therefore believe that the price-to-
revenue multiple for publicly traded companies should be no
higher than the .25 that he applied to the merged and acquired
comparable companies.
We also fail to find Wilhoite’s valuation particularly
meaningful solely on the basis of the capitalization of Sta-Home
tax-exempt entities’ intangible known as the “cost gap”.
Wilhoite has correctly noted that the cost gap has substantial
- 43 -
potential value to a hospital purchaser, and, in fact, Hahn has
written extensively about the value of this cost-shifting
attribute. We feel, however, that Wilhoite has included too many
imponderables in his calculation. For example, we do not believe
that the entire value of the Sta-Home tax-exempt entities is
appropriately bound up in the marketability of a single
intangible asset–-the cost gap. Nor do we believe that it is
justified to conclude that the cost gap would produce economic
benefits indefinitely, especially in view of the official
scrutiny it had received before, and during, 1995. Finally, we
observe that Wilhoite has assumed that the cost gap would equal
95 percent of the allowable cost ceiling (i.e., be 5 percent less
than the ceiling). This percentage appears to have been accurate
for earlier years, but the most recent cost gap was only 2.86
percent below the cost ceiling. The way for a potential buyer to
increase the cost-gap percentage would be to reduce costs
further. We do not think, however, that a buyer of the Sta-Home
tax-exempt entities would necessarily decrease expenses to move
the cost gap asset from its most recent 2.86-percent level back
to historic 5-percent level and then continue this cost gap
indefinitely. On balance, we believe that the most weight is
properly given to Wilhoite’s estimate of the MVIC for the Sta-
Home tax-exempt entities, using a price-to-revenue multiple of
.25. This results in an MVIC of $11.3 million.
- 44 -
Petitioners have raised a number of issues concerning the
Sta-Home tax-exempt entities’ MVIC, and we believe that one of
their points has merit. Their principal contention arises from
their concession that the Sta-Home tax-exempt entities’ capital
structure was “different”. They explained that the entities’
practice of requiring employees to forgo paychecks for the first
6 weeks created a pool of approximately $6.1 million. Although
they identified this amount as a current liability in the form of
accrued payroll and accrued payroll taxes, this permanent pool
actually functioned as a source of permanent capital. To prove
their point, they show that their reported current liabilities
for 1995 were 108 percent of invested capital, an amount several
times greater than that of comparable companies. In effect, they
argue, their employees had made a collective long-term loan to
the company. We agree. In operation, much of the $6.1 million
which had been held back from the employees’ payroll and payroll
taxes functioned as a source of long-term financing.
Not all of the withheld payroll, however, is properly
considered long-term financing. Petitioners’ accountant, Hart,
testified that the Sta-Home tax-exempt entities originally had a
“two-week payroll” which was extended to 4 weeks, and then to 6
weeks, as a source of working capital. Hahn’s report states that
Medicare pays home health care agencies no less frequently than
every 2 weeks based on estimated costs. To aid their cashflow
- 45 -
situation, the Sta-Home entities paid their employees 6 weeks in
arrears. Thus, an employee was required to wait 6 weeks before
getting his or her first paycheck, for 2 weeks’ work. In the
meantime, however, Medicare reimbursed the companies for the
amount of accrued wages every 2 weeks. The entities thus
received 6 weeks’ worth of wages per employee before being
required to pay out 2 weeks’ worth. The deferral of actual
payment meant, in effect, that each employee made a loan of 4
weeks’ wages to the company, and the “loan” would not be repaid
until the employee left his or her employment. When one employee
left, another was presumably hired, and the new employee would be
required to forgo 4 weeks’ salary, thus keeping the total amount
of deferrals relatively stable. By 1995, this practice had
generated a “float” of approximately $4.1 million that the
entities possessed and were not required to repay until some
unspecified time in the future. It appears that 2 weeks’ worth
of payroll and payroll taxes is properly characterized as short-
term liabilities. We conclude that the amounts of payroll that
were withheld for longer than 2 weeks were not, in this case,
properly characterized as current liabilities. For purposes of
this valuation, they should be considered part of the invested
capital. Accordingly, of the $6,150,000 withheld, two-thirds (or
4 weeks’ worth) should be excluded from the current liabilities
that Wilhoite added to the MVIC. Wilhoite based his calculation
- 46 -
of MVIC upon an informed estimate of the value of invested
capital (i.e., long-term debt plus owner’s equity) that would
produce the known revenues. For 1995, his calculations showed
that invested capital of $11.3 million would produce the reported
$45,209,000 in revenue that the Sta-Home tax-exempt entities
generated. Some part of this MVIC is readily discernible; it
includes $500,000 of long-term debt. Additionally, as we have
explained, it also includes the $4.1 million of deferred wages
that functioned as long-term debt for the companies. As earlier
observed, however, a buyer would have to include as part of the
purchase price not only the value of the invested capital, the
MVIC, but also the current liabilities that the purchased company
would have to pay. Wilhoite accordingly added current
liabilities of $11,475,000 from the Sta-Home tax-exempt entities’
balance sheets to his calculated MVIC of $11.3 million. That
amount of current liabilities, however, includes $4.1 million of
withheld wages that operate as long-term debt and thus form part
of the MVIC. To avoid duplicating this $4.1 million figure in
arriving at a fair market value for the companies, we believe
that it should be excluded from current liabilities. (Removing
$4.1 million from current liabilities, however, also restores the
$2,020,000 working capital shortfall resulting from the failure
of current assets to match current liabilities. Accordingly,
there is no longer a need to reduce the asset value by the amount
- 47 -
of the capital infusion.) Finally, we also believe that current
liabilities should be increased by $201,000, as suggested by
Hahn, to reflect a reserve for disallowed claims on its Medicare
cost reports. This increases the current liabilities to
$11,475,000, before deducting the amount of withheld payroll that
is to be considered part of the MVIC.
When we take these modifications into account, we arrive at
a fair market value of $18,675,000:
Indicated MVIC $11,300,000
Plus current liabilities 11,475,000
Less withheld payroll (4,100,000)
Indicated asset value 18,675,000
We are unimpressed and unpersuaded by Hahn’s conclusions as
to the fair market value of the Sta-Home tax-exempt entities, and
we have decided not to accept them. His reasoning that the Sta-
Home tax-exempt entities had a fair market value of less than
zero is unconvincing, and, in fact, appears to be more an
advocacy of petitioners’ litigating position than a candid fair
market appraisal. We think a willing buyer would be puzzled and
confused by his conclusions. Neither Hahn’s “adjusted balance
sheet” approach nor his backup market approach justify the
finding of a negative net worth.
First, in one substantial respect, even Hahn’s “best case”
adjusted balance sheet is seriously deficient. Hahn’s report
states: “Most buyers concentrate on the intangible assets of a
home health agency.” His conclusions, however, fail to account
- 48 -
for much of the substantial value of the Sta-Home tax-exempt
entities’ intangible assets. Hahn ascertained a value for two
intangible assets. He first developed a value for the Sta-Home
tax-exempt entities’ workforce in place of $2.1 million to $3.4
million. He used the $2.1 million value in both the “base case”
and “best case” scenarios. He fails to justify using the lower
value in the “best case” scenario. Petitioners have assembled a
workforce of approximately 1,000. A very substantial proportion
of them are highly trained professionals, including registered
nurses and other trained medical personnel. The Sta-Home tax-
exempt entities employed 25 percent of the full-time and 17
percent of the part-time home health care staff in the State of
Mississippi. If Hahn has developed an approximate value of $3.4
million, we see no reason not to employ this estimate in the
“best case” scenario. Indeed, we suspect that the value of the
workforce is higher, but on this record, we cannot reasonably
estimate how much.
With respect to another intangible asset, Hahn’s “best case”
scenario ascribed a value of $667,000 to the “cost gap” attribute
that the Sta-Home tax-exempt entities presented for a qualifying
buyer. His valuation is based on the assumption that the value
of this attribute would end after 1 year. This value is too low.
The cost gaps were available under the then-current reimbursement
program. They would cease to exist under a PPS. Although there
- 49 -
had been discussions of a PPS for several years, Congress had
passed no such legislation at the time of the transfer, and there
is no evidence that the prospect of such legislation had a
negative effect upon the value of home health care agencies. In
fact, one of Hahn’s articles, published in the Spring of 1998,
demonstrates a “furious pace of home health transfers” from 1994
through 1997. The article contains a chart showing that the
number of home health agency transfers did not begin to decrease
until the second quarter of 1997. A “best case” scenario would,
we think, indicate at least a 2-year value for the cost gap
asset. By using a 2-year figure in Hahn’s computations, we
arrive at a value of more than $1 million for the cost-shifting
attribute.
Hahn’s valuation of the intangible assets also fails to
address the value of the CONs held by the Sta-Home tax-exempt
entities. These certificates effectively closed the home health
care market to competition during a period of high growth for the
industry. Michael Caracci acknowledged his efforts to lobby the
Mississippi legislature in the interests of keeping the CON
moratorium in place, thus preserving the monopoly of the Sta-Home
tax-exempt entities and others who had received CONs before the
moratorium. His efforts indicate that the CONs possessed by the
Sta-Home tax-exempt entities would be worth considerable amounts
to a willing buyer, but Hahn did not ascribe any value to them.
- 50 -
We conclude that the absence of a candid valuation for the
Sta-Home tax-exempt entities’ intangible assets explains the
considerable gap between the adjusted balance sheet value
ascertained by Hahn and the $18,675,000 value we have decided
today.8
We also reject Hahn’s assertion that his alternate “market”
approach to valuation guideline supports his adjusted balance
sheet approach. Initially, we find that his selection of
guideline companies is at least adequate. Most of them value
“traditional” visiting nurse companies, such as petitioners, and
thus Hahn avoids the problem of including home health care
agencies that offer more technical home health care services. He
has also included both publicly traded and privately held
companies in his survey, and he has included both companies that
have positive income and companies that reported losses. His
guideline companies also include those with a positive net worth
and companies that indicate a negative equity capital.
8
Hahn’s “best case” scenario indicates that the value of
the intangible assets represents 17.68 percent of the total
assets. In one of his recent articles, he presents a chart
showing the goodwill value of seven publicly traded home health
care companies. The lowest of these indicates a goodwill value
to total asset ratio of 22 percent, and the others indicate
values at 31 percent, 39 percent, 47 percent, 52 percent, and two
others at 56 percent. Hahn et al., “Home health Agency
Valuation: Opportunity Amid Chaos”, Intrinsic Value (Spring
1998).
- 51 -
We are unable, however, to accept Hahn’s conclusions of fair
market value on the basis of his market approach. Hahn has
derived two “Implied Valuation Multiples”. The first is a
ranking based upon the ratio of selected comparable companies’
sale prices to their most current revenues. The second is a
ranking of the companies’ sale prices to their total book
assets.9 The median sale prices were .68 times annual revenues
and 1.9 times total book assets. Here, however, in his “best
case” scenario, he has ascertained that the Sta-Home tax-exempt
entities would sell at a price only .22 times annual revenues
and, further, that they would sell at a price only 1.1 times
their total book assets. Hahn’s “best case” scenario ranks the
Sta-Home tax-exempt entities next to last in both categories. In
contrast, none of the comparable companies ranks as low in both
categories. Clausen Health Services, for example, sold at a
multiple of .22 times revenues, a ratio close to that ascribed to
the Sta-Home tax-exempt entities. Clausen’s sale price, however,
also represented a price-to-asset ratio of 1.64, ranking seventh
among the comparables. If the Sta-Home tax-exempt entities sold
at this multiple, the indicated fair market value would be
9
It is important to keep in mind that Hahn’s valuation
multiples generated a figure that represented the total asset
value of a company, while Wilhoite’s multiples generated the
value of its invested capital, or MVIC. Thus, application of the
same valuation multiple, say .25, will generally yield different
fair market values, depending upon which method is used.
- 52 -
$17,670,040.10 Another example shows that House Call, Inc., sold
at a price 1.08 times its total assets, a ratio close to the 1.10
that Hahn has ascribed to the Sta-Home tax-exempt entities.
House Call, Inc.’s sale price, however, also indicates that it
sold at a multiple of .74 times revenues, ranking second of the
13 comparables. If the Sta-Home tax-exempt entities were sold at
this ratio, the indicated sales price would be approximately $33
million. Moreover, in an article published in the spring of
1997, Hahn indicated that for the prior 2 years, a standard
market benchmark for valuing traditional visiting nursing
agencies, such as the Sta-Home tax-exempt entities, was a price-
to-revenue multiple of .55. Hahn & Spieler, “Valuation of Home
Health Care Companies,” Intrinsic Value (Spring 1997). We fail
to understand why the Sta-Home tax-exempt entities had a much
lower multiple of .26. We recognize that the Sta-Home tax-exempt
entities operated at a loss for the prior year, but so did 8 of
the 13 comparable companies. We further recognize that the
Sta-Home tax-exempt entities’ equity capital was a negative
amount, but so was that of 7 of the 13 comparable companies.
These characteristics reflect the accepted conclusion that exempt
entities operating under the Medicare reimbursement system stood
10
The book value used for the Sta-Home tax-exempt entities’
total asset value excludes any value for intangible assets. It
is unclear whether Clausen’s book value for total assets includes
intangibles.
- 53 -
little chance of turning a profit. In fact, Hahn’s 1997 article
states that “Analysis of recent VNA [i.e. traditional visiting
nursing agency] transactions indicates that companies with
operating losses have transacted at multiples of revenue similar
to agencies with operating profits.” Id. at 3.
Accordingly, we conclude that the sale price we have decided
more accurately reflects the fair market value of the Sta-Home
tax-exempt entities than does that of Hahn. We note that our
valuation of $18,675,000 indicates that the Sta-Home tax-exempt
entities would sell at a price-to-revenue multiple of .42, lower
than the .68 median applicable to Hahn’s comparable home health
care agencies. Our finding also indicates that the ratio of
price to book value would be 1.75, which again is less than the
1.90 median for the same comparable companies.
In reaching this value, we have also considered, but
rejected, petitioners’ arguments that conditions in Mississippi
require a finding that the assets of the Sta-Home tax-exempt
entities were worth less than the liabilities assumed.
Petitioners argue strenuously that the Sta-Home tax-exempt
entities’ operation in Mississippi, a relatively poor and rural
State, dramatically reduces their fair market value. Petitioners
do not mention, however, that the Federal per-patient Medicare
payment was higher for Mississippi than for any other State. We
- 54 -
think that this factor substantially offsets the demographic
challenges of operating home health care agencies in Mississippi.
Petitioners also maintain that there was no market in
Mississippi for acquisition of the Sta-Home tax-exempt entities.
The record in this case, however, indicates that there were many
such sales, including the purchase of Mississippi home health
care agencies by out-of-State hospitals. We are not convinced
that reasonable exploration by a willing seller would have failed
to turn up a willing buyer, whether in Mississippi or elsewhere.
F. Excess Value
Having found the fair market value of the Sta-Home tax-
exempt entities, we turn to decide the value in excess of the
assumed liabilities. We are satisfied that the Sta-Home for-
profit entities intended to, and did, assume all of the
liabilities of the predecessor businesses. The evidence includes
an audited balance sheet, prepared for purposes of this case,
which indicates that the total liabilities as of September 30,
1995, were $13,310,860. To this amount we think there is
properly added $201,000, as ascertained by Hahn, representing a
reserve account for cost claims disallowed by Medicare. Total
liabilities assumed were therefore $13,511,000. Subtracting the
total liabilities from the fair market value we have decided,
results in an excess of $5,164,000:
Fair market value $18,675,000
Assumed liabilities (13,511,000)
- 55 -
Excess 5,164,000
III. Excise Taxes Under Section 4958
Section 4958, the provisions of which are set forth in the
appendix to this report, was added to the Internal Revenue Code
by the Taxpayer Bill of Rights 2, Pub. L. 104-168, sec. 1311(a),
110 Stat. 1452, 1475 (1996).11 Section 4958 is patterned after
section 4941, which applies to acts of self-dealing between
private foundations and disqualified persons. Section 4958
applies to public charities and social welfare organizations
which are exempt from Federal income taxes.12
Section 4958 was enacted to impose penalty excise taxes as
“intermediate” sanctions in cases where organizations exempt from
tax under section 503(c) engage in “excess benefit transactions.”
H. Rept. 104-506, at 56 (1996), 1996-3 C.B. 49, 104. An excess
11
No regulations apply to the transactions at issue. The
Treasury Department published proposed regulations under sec.
4958 on Aug. 4, 1998, secs. 53.4958-1 through 53.4958-7, Proposed
Excise Tax Regs., 63 Fed. Reg. 41486 (Aug. 4, 1998), which were
revised and replaced by temporary regulations effective Jan. 10,
2001, secs. 53.4958-1T through 53.4958-8T, Temporary Excise Tax
Regs., 66 Fed. Reg. 2144 (Jan. 10, 2001). On Jan. 23, 2002, the
Treasury Department removed the temporary regulations and
published final regulations effective Jan. 23, 2002. Secs.
53.4958-0 through 53.4958-8, Excise Tax Regs., T.D. 8978, 2002-7
I.R.B. 500.
12
Sec. 4958 is generally effective for transactions
occurring after Sept. 13, 1995. At trial, the parties directed
considerable attention to the effective date of the transfers at
issue. On brief, however, petitioners did not argue that the
transfers were effective on or before Sept. 13, 1995, and we deem
that argument to have been abandoned.
- 56 -
benefit transaction is one in which a tax-exempt organization
provides an economic benefit to one or more of the organization’s
insiders, called “disqualified persons”, if the fair market value
of the benefit exceeds the value of what the organization
receives in return. Sec. 4958(c)(1)(A); H. Rept. 104-506, supra
at 56, 1996-3 C.B. at 104. Disqualified persons include not only
those who are able to exercise substantial influence over the
tax-exempt organization, but also their family members and
entities in which those individuals have 35 percent of the voting
power. Disqualified persons are subject to the excise penalties,
whether the excess benefit transactions are accomplished
“directly or indirectly”. Sec. 4958(c).
Before the enactment of section 4958, if an organization
within its purview did not comply with the rules regarding tax
exemption, the Commissioner’s only recourse was to revoke the
organization’s exemption. The Treasury Department realized that
such a response might be inappropriate when the exempt
organization did not conform to all the applicable rules but was
nevertheless capable of functioning for a charitable purpose.
See U.S. Department of the Treasury’s Proposals to Improve
Compliance by Tax-Exempt Organizations: Hearing Before the
Subcommittee on Oversight of the House Comm. On Ways and Means,
103d Cong., 2d Sess. 17 (1994). At the urging of the Treasury
- 57 -
Department, Congress enacted section 4958. See H. Rept. 104-506,
supra at 56, 1996-3 C.B. at 104.
A disqualified person who receives an excess benefit from an
excess benefit transaction is liable for an initial excise tax
equal to 25 percent of the excess benefit. Sec. 4958(a)(1). If
the initial tax is imposed and the transaction is not corrected
within the taxable period, then the disqualified person is liable
for an additional tax of 200 percent of the excess benefit. Sec.
4958(b).
Here, the fair market value of the Sta-Home tax-exempt
entities’ transferred assets far exceeded the consideration paid
by the Sta-Home for-profit entities. Thus, the asset transfers
were excess benefit transactions which directly benefited the
transferees (i.e., the Sta-Home for-profit entities) and
indirectly benefited the Sta-Home for-profit entities’
shareholders (i.e., the Caracci family members). Petitioners do
not seriously dispute that they are disqualified persons with
respect to the Sta-Home tax-exempt entities. Joyce P. Caracci,
Michael Caracci, and Christina C. McQuillen, as directors and
officers of each of the three Sta-Home tax-exempt entities, are
disqualified persons because they were in positions to exercise
substantial influence over the entities’ affairs. Sec.
4958(f)(1)(A). Victor Caracci and Vincent Caracci are
disqualified persons because of their familial relationships to
- 58 -
Joyce P. Caracci, Michael Caracci, and Christina C. McQuillen.
Sec. 4958(f)(1)(B). Sta-Home Health Agency of Carthage, Inc.,
Sta-Home Health Agency of Greenwood, Inc., and Sta-Home Health
Agency of Jackson, Inc., are disqualified persons because they
are entities that are 35-percent controlled by disqualified
persons; in fact, members of the Caracci family own 100 percent
of the Sta-Home for-profit entities’ voting stock. Sec.
4958(f)(1)(C). Accordingly, petitioners are subject to excess
benefit taxes under section 4958.
Because we have decided the value of the Sta-Home tax-exempt
entities’ assets on the basis of a revenue multiple, it is
appropriate to ascribe the excess benefit to each of the Sta-Home
for-profit entities in proportion to the amounts the 1995
revenues of their respective predecessors bore to the total
revenue. This produces the following results:
Entity Percentage Benefit
Sta-Home Health Agency 42.1 $2,173,682
of Carthage, Inc.
Sta-Home Health Agency 30.1 1,554,105
of Greenwood, Inc.
Sta-Home Health Agency 27.8 1,435,353
of Jackson, Inc.
Because each of the three entities acquired or assumed its
predecessor’s assets and liabilities, as opposed to acquiring its
predecessor’s stock, we see no basis to apply a minority discount
to the value of the excess benefits each has received. Nor for
that reason is an application of a minority discount appropriate
- 59 -
as to the excise taxes imposed upon the individual shareholders
of the Sta-Home for-profit entities.
We conclude that each of the disqualified person/petitioners
is jointly and severally liable for the initial and additional
taxes under section 4958(a)(1) and (b) as to the excess benefits.
The effect of our holding is that the individual petitioners are
jointly and severally liable for the total excess benefit of
$5,164,000 from the three Sta-Home entities, while the Sta-Home
for profit entities are liable for taxes as specified in the
above table. In so concluding, we decline at this time
petitioners’ invitation to abate the initial and additional
excise taxes pursuant to section 4961 (second-tier tax abatement)
and section 4962(a) (first-tier tax abatement). Because the
excess benefit transactions have never been corrected for
purposes of section 4958(f)(6), petitioners’ invitation is, at
best, premature. Petitioners have not as of yet met the
prerequisite for the requested abatement; i.e., a timely
correction. In this regard, however, we note that sections
4961(a) and 4963(e)(1) generally allow for the abatement of a
section 4958 excise tax if the excess benefit transaction giving
rise thereto is corrected within 90 days after our decision
sustaining the tax becomes final. Cf. Morrissey v. Commissioner,
T.C. Memo. 1998-443. Because the issue of whether petitioners
- 60 -
will or would qualify for an abatement is not yet ripe for
decision, we express no opinion on this issue.
IV. Revocation of Tax-Exempt Status
Section 501(c)(3) requires, among other things, that an
organization be operated exclusively for one or more specified
exempt purposes. An organization is not operated exclusively for
one or more exempt purposes unless it serves a public rather than
a private interest and its net earnings do not inure to the
benefit of any shareholder or individual. Sec. 1.501(c)(3)-1,
Income Tax Regs.
The presence of a single substantial nonexempt purpose can
destroy the exemption regardless of the number or importance of
exempt purposes. Better Bus. Bureau v. United States, 326 U.S.
279, 283 (1945); Am. Campaign Acad. v. Commissioner, 92 T.C.
1053, 1065 (1989). When an organization operates for the benefit
of private interests, such as designated individuals, the creator
or his family, or persons directly or indirectly controlled by
such private interests, the organization by definition does not
operate exclusively for exempt purposes. Prohibited benefits may
include an advantage, profit, fruit, privilege, gain, or
interest. Am. Campaign Acad. v. Commissioner, supra at 1065-
1066. We have held that when a section 501(c)(3) tax-exempt
entity sells its assets for less than fair market value to a for-
profit corporation whose shareholders are directors of the tax-
- 61 -
exempt entity, the sale constitutes inurement and revocation may
be appropriate. Anclote Psychiatric Ctr., Inc. v. Commissioner,
T.C. Memo. 1998-273.
With the enactment of section 4958, however, the issue
whether the tax-exempt status of the Sta-Home tax-exempt entities
should be revoked must now be considered in the context of the
“intermediate sanction” provisions. As noted above, the
intermediate sanction regime was enacted in order to provide a
less drastic deterrent to the misuse of a charity than revocation
of that charity’s exempt status. The legislative history
explains that “the intermediate sanctions for ‘excess benefit
transactions’ may be imposed by the IRS in lieu of (or in
addition to) revocation of an organization’s tax-exempt status.”
H. Rept. 104-506, supra at 59, 1996-3 C.B. at 107. A footnote to
this statement explains: “In general, the intermediate sanctions
are the sole sanction imposed in those cases in which the excess
benefit does not rise to a level where it calls into question
whether, on the whole, the organization functions as a charitable
or other tax-exempt organization”. Id. n.15, 1996-3 C.B. at 107.
Although the imposition of section 4958 excise taxes as a result
of an excess benefit transaction does not preclude revocation of
the organization’s tax-exempt status, the legislative history
indicates that both a revocation and the imposition of
intermediate sanctions will be an unusual case.
- 62 -
We do not believe that this is such an unusual case. The
dormant state of the Sta-Home tax-exempt entities precludes
calling into question whether, on the whole, they are functioning
tax-exempt entities. Moreover, we perceive three reasons why it
is not appropriate to remove their tax-exempt status at this
time. First, the excess benefit represented the fair market
value of the Sta-Home tax-exempt entities’ assets less the
liabilities assumed by the Sta-Home for-profit entities. Given
that we have already sustained the imposition of intermediate
sanctions as to this excess value, we do not believe it
appropriate under the facts herein to conclude that the single
transaction (as to each entity) underlying the excess value also
requires our revocation of each entity’s tax-exempt status.
Second, the Sta-Home tax-exempt entities have not since the
transfers been operated contrary to their tax-exempt purpose.
Third, we find some credence in petitioners’ suggestion that
maintenance of the tax exemption may enable them to utilize the
correction provisions made available in sections 4961 through
4963. While the issue is not ripe for us to decide at this time,
we note that a permissible correction may require that the
Sta-Home for-profit entities transfer the assets back to the
Sta-Home tax-exempt entities. If we were to remove the Sta-Home
tax-exempt entities’ tax-exempt status at this stage, however,
- 63 -
those entities would no longer be tax-exempt entities available
to receive the assets.
The legislative history quoted above indicates that “the
term ‘correction’ means undoing the excess benefit to the extent
possible and taking any additional measures necessary to place
the organization in a financial position not worse than that in
which it would be if the disqualified person were dealing under
the highest fiduciary standards.” H. Rept. 104-506, supra at 59,
1996-3 C.B. at 107. Petitioners suggest that preserving the tax-
exempt status of the now-dormant tax-exempt Sta-Home entities may
leave petitioners with a means of correction by placing the
entities back into a “financial position not worse than it would
be” if the disqualified persons had observed the proper
standards. While, as noted above, we do not address the issue of
timely corrections, we believe that leaving the exemptions intact
is consistent with both the legislative history underlying
section 4958 and the provisions for abatement in sections 4961
through 4963.
V. Income Taxes
Michael Caracci, Vincent Caracci, and Christina McQuillen
(collectively, the Caracci children) had no ownership interest in
the Sta-Home tax-exempt entities. The Caracci children also did
not contribute any property to the Sta-Home for-profit entities
in exchange for the stock that they received in those entities
- 64 -
upon their formation. Respondent determined that the Caracci
children realized gross income by virtue of the fact that the
Sta-Home for-profit entities, in connection with their
organization, received the assets of the Sta-Home tax-exempt
entities. Respondent argues in brief that the assets of the Sta-
Home tax-exempt entities were constructively transferred to the
Caracci children who, in turn, contributed those assets to the
Sta-Home for-profit entities. Respondent argues in brief that
the constructive transfer is an accession to wealth that is
includable in the Caracci children’s gross income under section
61.
We disagree with respondent that the asset transfer resulted
in gross income to the Caracci children. Although section 61
provides broadly that gross income includes all income “from
whatever source derived”, section 102(a) generally exempts from
that provision the value of any property received by gift. When
property is transferred for less than adequate and full
consideration in money or money’s worth, the amount by which the
value of the property exceeds the value of the consideration is
deemed a gift. Sec. 2512(b); Commissioner v. Wemyss, 324 U.S.
303 (1945); Georgia Ketterman Trust v. Commissioner, 86 T.C. 91,
96 (1986); Estate of Higgins v. Commissioner, T.C. Memo. 1991-47.
In the corporate setting, such a transfer may be a gift by the
donor to the individual shareholders of the corporation to the
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extent of their proportionate interests in the corporation.
Kincaid v. United States, 682 F.2d 1220, 1224 (5th Cir. 1982);
Chanin v. United States, 183 Ct. Cl. 840, 393 F.2d 972 (1968);
Estate of Hitchon v. Commissioner, 45 T.C. 96, 103-104 (1965);
Tilton v. Commissioner, 88 T.C. 590, 597 (1987); Estate of
Trenchard v. Commissioner, T.C. Memo. 1995-121; sec. 25.2511-
1(h)(1), Gift Tax Regs. When the shareholders of a recipient
corporation are members of the donor’s family, that fact is
strongly indicative of a gift. See Kincaid v. United States,
supra; Tilton v. Commissioner, supra; Estate of Hitchon v.
Commissioner, supra; Estate of Trenchard v. Commissioner, supra;
Estate of Higgins v. Commissioner, supra.
Here, Victor and Joyce Caracci set up transactions pursuant
to which their three children each received stock in the Sta-Home
for-profit entities that, in connection therewith, had a total
net asset value of more than $5 million. The Caracci children,
the natural heirs of Victor and Joyce Caracci, paid nothing for
that stock, nor did they contribute property for it. The
transfers were effectively gifts to the Caracci children.
The fact that the children were also employees of the new
corporations does not transform their receipt of 65 percent of
the corporate stock into compensation subject to income tax. We
are aware that section 102(c) provides that the transfer of
property to an employee is generally deemed to be compensation,
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rather than a gift. We believe, however, that a transfer of
property to an employee who is a member of the employer’s family
is more properly considered a gift when the transfer is not made
in recognition of the employee’s work but is made in connection
with the family relationship.
The transfer of most of the assets involved in this case is
clearly attributable to the familial relationship between the
Caracci parents and their children. It contrasts strongly to
situations cited by respondent involving compensation, such as
Strandquist v. Commissioner, T.C. Memo. 1970-84 (president of car
sales company taxable on value of new cars he received in excess
of value of used cars he turned in). Nor is this a situation
involving disguised rentals paid to a lessor-shareholder, as in
Haag v. Commissioner, 334 F. 2d 351, 355 (8th Cir. 1964), affg.
40 T.C. 488 (1963). Nor is it, in substance, a distribution with
respect to the stock of a controlling shareholder for his
personal benefit, as in Kenner v. Commissioner, T.C. Memo. 1974-
273 (doctor who owned tax-exempt hospital corporation taxed on
relatively small amounts it transferred to corporation that
operated his ranch in Arizona). Here, during the year in issue,
none of the home health care assets was distributed to any of the
children, and none of the children sold the stock or otherwise
benefited personally from the transfer of the home health care
assets to the for-profit entities.
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On the evidence before us, we conclude that the transfers of
the home health care assets to the for-profit entities
constituted gifts to the Caracci children, and not the
realization of taxable income by them. They are not subject to
income taxes on those transfers.
In view of the foregoing,
Decisions will be entered for
petitioners in docket Nos.
14711-99X, 17336-99X, and
17339-99X, and will be entered
under Rule 155 in the remaining
dockets.
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APPENDIX
SEC. 4958. TAXES ON EXCESS BENEFIT TRANSACTIONS
(a) Initial Taxes.--
(1) On the disqualified person.--There
is hereby imposed on each excess benefit
transaction a tax equal to 25 percent of the
excess benefit. The tax imposed by this
paragraph shall be paid by any disqualified
person referred to in subsection (f)(1) with
respect to such transaction.
(2) On the management.--In any case in
which a tax is imposed by paragraph (1),
there is hereby imposed on the participation
of any organization manager in the excess
benefit transaction, knowing that it is such
a transaction, a tax equal to 10 percent of
the excess benefit, unless such participation
is not willful and is due to reasonable
cause. The tax imposed by this paragraph
shall be paid by any organization manager who
participated in the excess benefit
transaction.
(b) Additional Tax on the Disqualified Person.–-In
any case in which an initial tax is imposed by
subsection (a)(1) on an excess benefit transaction and
the excess benefit involved in such transaction is not
corrected within the taxable period, there is hereby
imposed a tax equal to 200 percent of the excess
benefit involved. The tax imposed by this subsection
shall be paid by any disqualified person referred to in
subsection (f)(1) with respect to such transaction.
(c) Excess Benefit Transaction; Excess
Benefit.-–For purposes of this section--
(1) Excess benefit transaction.--
(A) In general.--The term
“excess benefit transaction” means
any transaction in which an
economic benefit is provided by an
applicable tax-exempt organization
directly or indirectly to or for
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the use of any disqualified person
if the value of the economic
benefit provided exceeds the value
of the consideration (including the
performance of services) received
for providing such benefit. For
purposes of the preceding sentence,
an economic benefit shall not be
treated as consideration for the
performance of services unless such
organization clearly indicated its
intent to so treat such benefit.
(B) Excess benefit.--The term
“excess benefit” means the excess
referred to in subparagraph (A).
(2) Authority to include certain other
private inurement.--To the extent provided in
regulations prescribed by the Secretary, the
term “excess benefit transaction” includes
any transaction in which the amount of any
economic benefit provided to or for the use
of a disqualified person is determined in
whole or in part by the revenues of 1 or more
activities of the organization but only if
such transaction results in inurement not
permitted under paragraph (3) or (4) of
section 501(c), as the case may be. In the
case of any such transaction, the excess
benefit shall be the amount of the inurement
not so permitted.
(d) Special Rules.--For purposes of this section--
(1) Joint and several liability.--If
more than 1 person is liable for any tax
imposed by subsection (a) or subsection (b),
all such persons shall be jointly and
severally liable for such tax.
(2) Limit for management.--With respect
to any 1 excess benefit transaction, the
maximum amount of the tax imposed by
subsection (a)(2) shall not exceed $10,000.
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(e) Applicable Tax-Exempt Organization.--For
purposes of this subchapter, the term “applicable tax-
exempt organization” means--
(1) any organization which (without
regard to any excess benefit) would be
described in paragraph (3) or (4) of section
501(c) and exempt from tax under section
501(a), and
(2) any organization which was described
in paragraph (1) at any time during the 5-
year period ending on the date of the
transaction.
Such term shall not include a private foundation (as
defined in section 509(a)).
(f) Other Definitions.--For purposes of this
section--
(1) Disqualified person.--The term
“disqualified person” means, with respect to
any transaction--
(A) any person who was, at any
time during the 5-year period
ending on the date of such
transaction, in a position to
exercise substantial influence over
the affairs of the organization,
(B) a member of the family of
an individual described in
subparagraph (A), and
(C) a 35-percent controlled
entity.
(2) Organization manager.--The term
“organization manager” means, with respect to
any applicable tax-exempt organization, any
officer, director, or trustee of such
organization (or any individual having powers
or responsibilities similar to those of
officers, directors, or trustees of the
organization).
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(3) 35-percent controlled entity.--
(A) In general.--The term “35-
percent controlled entity” means--
(i) a corporation in
which persons described
in subparagraph (A) or
(B) of paragraph (1) own
more than 35 percent of
the total combined voting
power,
(ii) a partnership
in which such persons own
more than 35 percent of
the profits interest, and
(iii) a trust or
estate in which such
persons own more than 35
percent of the beneficial
interest.
(B) Constructive ownership
rules.--Rules similar to the rules
of paragraphs (3) and (4) of
section 4946(a) shall apply for
purposes of this paragraph.
(4) Family members.--The members of an
individual’s family shall be determined under
section 4946(d); except that such members
also shall include the brothers and sisters
(whether by the whole or half blood) of the
individual and their spouses.
(5) Taxable period.--The term “taxable
period” means, with respect to any excess
benefit transaction, the period beginning
with the date on which the transaction occurs
and ending on the earliest of--
(A) the date of mailing a
notice of deficiency under section
6212 with respect to the tax
imposed by subsection (a)(1), or
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(B) the date on which the tax
imposed by subsection (a)(1) is
assessed.
(6) Correction.--The terms “correction”
and “correct” mean, with respect to any
excess benefit transaction, undoing the
excess benefit to the extent possible, and
taking any additional measures necessary to
place the organization in a financial
position not worse than that in which it
would be if the disqualified person were
dealing under the highest fiduciary
standards.