The opinion
United States Court of Appeals
Fifth Circuit
F I L E D
REVISED JULY 31, 2006
July 11, 2006
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT Charles R. Fulbruge III
Clerk
No. 02-60912
MICHAEL T. CARACCI, ET AL.,
Petitioners - Appellants,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent - Appellee.
____________________________________________________________
STA-HOME HEALTH AGENCY OF CARTHAGE, INC.; STA-HOME
HEALTH AGENCY OF GREENWOOD, INC.; MICHAEL CARACCI;
VICTOR CARACCI; CHRISTINA C. MCQUILLEN; JOYCE P. CARACCI;
VINCENT E. CARACCI; STA-HOME HEALTH AGENCY OF JACKSON, INC.,
Petitioners - Appellants,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent - Appellee.
Appeal from the Decision of
the United States Tax Court
Before JOLLY and WIENER, Circuit Judges, and ROSENTHAL,
District Judge.*
PER CURIAM:
The Commissioner of Internal Revenue issued deficiency
notices requiring the taxpayers, three privately held home-
healthcare agencies and the family that owns and operates them,
to pay over $250 million in excise taxes under 26 U.S.C. §
4958. The Commissioner based the deficiency notices on an
internal valuation of assets and liabilities transferred when
the agencies converted from exempt to nonexempt status, finding
that the taxpayers received a “net excess benefit” in the
amount of $18.5 million. The taxpayers challenged the
deficiency notices in the Tax Court. During a two-year audit
and nearly two years of litigation, the Commissioner insisted
that the deficiency notices and underlying valuations were
correct. At the trial before the Tax Court, the Commissioner
for the first time conceded that the deficiency notices were
both excessive and erroneous. The Tax Court recognized that
the Commissioner’s deficiency notices were wrong. The Tax
Court also found that the valuation expert the Commissioner
presented at trial—the only support the Commissioner presented
*
District Judge for the Southern District of Texas, sitting by
designation.
2
for imposing excise taxes—also committed significant errors in
his analysis. The Tax Court nonetheless affirmed the
Commissioner’s decision to impose excise taxes, finding that
the fair market value of the assets transferred from the exempt
entities to the newly created nonexempt entities exceeded the
value of the liabilities and debts assumed as consideration by
over $5 million.
In this appeal, the Commissioner does not dispute that the
deficiency notices were erroneous. The Commissioner also
concedes that the Tax Court made a $1.78 million mistake in its
valuation analysis. The Commissioner nonetheless insists that
the Tax Court correctly found that the taxpayers received a
“net excess benefit” of over $5 million in the conversion from
exempt to nonexempt status and collectively owed $69,702,390
in excise taxes under I.R.C. § 4958(a) and (b).1
The taxpayers contend that the Tax Court made numerous
factual and legal errors in valuing the assets transferred in
the conversion from exempt to nonexempt status. We agree. As
explained below, the Tax Court erred as a matter of law in
affirming the Commissioner’s decision to impose excise taxes
1
The Tax Court entered separate orders as to each taxpayer; these
cases were consolidated in the Tax Court and remain so in this court.
3
after the Commissioner failed to meet his burden of proving
that the taxes were correctly assessed; erred as a matter of
law in selecting the method to value the assets and liabilities
transferred; and made clearly erroneous fact findings in
applying that valuation method. We reverse and render because
the record establishes as a matter of law that the taxpayers
did not receive any “net excess benefit” and therefore are not
liable for the excise taxes assessed.
I. Background
In 1976, Joyce Caracci, an experienced nurse, her husband,
Victor Caracci, and a third person started the Sta-Home Health
Agency, Inc. to provide home health care in a geographically
large and primarily rural part of Mississippi. A year later,
Joyce and Victor Caracci and the third individual formed two
other Sta-Home agencies, Sta-Home Health Agency, Inc., of
Forest, Mississippi and Sta-Home Health Agency, Inc., of
Grenada, Mississippi. The shareholders, directors, and
officers of the Sta-Home entities were Caracci family members
who also worked for the agencies.
The three Sta-Home entities were nonstock, tax-exempt
corporations formed under Mississippi law. To comply with the
Medicare regulations in place when the Caraccis began their
4
business, the agencies had to be tax-exempt under the Internal
Revenue Code § 501(c)(3) (26 U.S.C. § 501(c)(3)). In the
1980s, the law changed to permit agencies such as Sta-Home to
be formed as nonexempt corporations.
The Sta-Home agencies served the rural poor in a large
area in northeast Mississippi. The agencies were intended to
provide home healthcare as an alternative to what Joyce Caracci
believed from her long professional experience was unacceptable
institutional care available from nursing homes and other
facilities in the region. A large majority of the patients
Sta-Home served depended on Medicare and Medicaid. It is
undisputed that between 95 and 97 percent of Sta-Home’s income
consisted of Medicare and Medicaid reimbursements.
In 1995, Medicare reimbursed home-healthcare providers the
lesser of the actual reasonable cost or the customary charge,
up to a maximum per-visit “cost cap.” Medicare paid
retrospectively, sending a “periodic interim payment”—known as
a PIP—every two weeks. Home-healthcare agencies also submitted
quarterly and annual cost reports, which Medicare used to
adjust disparities between interim payments made and actual
costs reported by reimbursing the provider for any underpayment
or requiring the provider to remit any overpayment. Under the
5
Medicare reimbursement system, home-healthcare agencies like
Sta-Home effectively had no ability to realize profits.
Medicare did not even reimburse all of the costs expended, but
only costs it deemed “allowable.” If Sta-Home submitted a
claim for reimbursement that Medicare denied, the result for
Sta-Home was a negative cash outflow. On average, Medicare
disallowed .7 percent of Sta-Home’s submitted annual costs.
As a result, the greater the volume of Sta-Home’s business—the
more care Sta-Home provided patients and the more revenue it
received—the more money it lost.
Sta-Home generated increased revenue and commensurately
increased losses from 1992 through 1995. Financial statements
revealed that the Sta-Home corporations’ expenses exceeded its
revenues every year. Not only did Sta-Home sustain repeated
net operating losses, its capital deficit increased every year
from 1991 through 1995. At the end of fiscal year 1995, the
combined assets and stated liabilities of the three Sta-Home
exempt agencies was a negative $1.4 million.2
To ease this precarious financial situation, Sta-Home
required its newly hired employees to forgo pay for the first
2
The net income for each respective year from 1991 to 1995 was:
-$63,660; $27,757; -$45,554; -$258,729; and -$433,390. The total
deficit Sta-Home ran for the same period was: $583,526; $555,771;
$729,145; $901,535; and $1,408,248.
6
month of employment. Sta-Home paid this amount only when
employees left the company. Sta-Home also underpaid salaries
and wages during the year, using year-end “bonuses” to make up
unpaid compensation amounts. Sta-Home also deferred or accrued
contributions to employee benefit plans. These efforts to ease
cash-flow difficulties affected all Sta-Home’s employees,
including the Caracci family members.
During this period, Mississippi was the highest-ranking
state in the country in payments per Medicare recipient. As
noted, during 1995, over 95 percent of the services Sta-Home
provided went to Medicare beneficiaries. State law required
home-healthcare agencies in Mississippi to operate under a
Certificate of Need (CON). In 1983, Mississippi imposed a
moratorium on the issuance of new CONs, which prevented new
competitors from entering the industry unless they purchased
an existing CON. The combined Sta-Home entities had CONs in
nineteen Mississippi counties. The Sta-Home corporations
ranked first or second in market share in 14 of the 19 rural
Mississippi counties they served. “Sta-Home” was a recognized
name in home healthcare in Mississippi and enjoyed a strong
reputation among the state’s elderly. In 1993, Sta-Home was
the first freestanding agency to be accredited by the Joint
7
Commission on Accreditation of Healthcare Organizations, which
required achieving or exceeding certain regulatory standards,
including standards regulating the quality of patient care.
During 1994 and 1995, a change in the Medicare regulations
was proposed, under which certain healthcare entities accepting
Medicare payments would change from the retrospective PIP
system to a prospective payment system to be known as “PPS.”
Under PPS, healthcare providers would file a claim for each
service rendered and then wait for it to be processed and
paid.3 Concerned about the impact of this system on Sta-Home’s
already fragile cash flow, the Caraccis consulted an attorney,
Thomas Kirkland. He recommended converting Sta-Home into for-
profit corporations, which Medicare regulations had permitted
since the 1980s. The conversion to nonexempt status would
allow Sta-Home to borrow money that lenders were unwilling to
provide to exempt entities. Kirkland’s law firm had
represented many home-healthcare agencies in Mississippi, and
Kirkland was a recognized expert in the legal issues relating
to such agencies. He advised all his tax-exempt healthcare-
agency clients to convert to nonexempt status. Most of
3
Congress ultimately passed the system in 1997. Medicare fully
implemented the PPS system in 2001.
8
Kirkland’s clients followed his advice. The primary form of
conversion used was a transfer of assets from the old exempt
corporations to the newly formed nonexempt subchapter-S
corporations, in exchange for assuming the debts and
liabilities of the exempt corporations.
Sta-Home took a careful and conscientious approach to the
conversion. Not only did Sta-Home consult with an attorney
knowledgeable in the area, it also retained a tax attorney
whose accounting firm obtained two contemporaneous appraisals
of Sta-Home’s assets and liabilities. These appraisals showed
that Sta-Home’s liabilities exceeded the value of its tangible
and intangible assets. The appraisals specifically showed that
the value of the intangible assets—including the CONs—would not
result in a positive fair market value because the assets had
been consistently unprofitable. These appraisals were
consistent with the Caraccis’ conclusion that unless they did
something to provide more cash and capital, they would likely
not be able to continue to operate.
Before Sta-Home changed from tax-exempt to nonexempt
status, it investigated other alternatives to meet its need for
improved cash flow and access to capital in light of the
anticipated change from a PIP to a PPS Medicare reimbursement
9
system. Sta-Home looked for a hospital in its service area
that could purchase the agencies, to provide capital and
additional patient referrals. The search proved fruitless.
Sta-Home discovered that the potential purchasers were
uninterested; the most likely candidate had acquired a home-
healthcare agency the prior year. With no prospective or
potential buyer, Sta-Home decided to convert to nonexempt
status.
On July 11, 1995, Sta-Home’s board of directors authorized
the conversion of the tax-exempt entities into nonexempt
subchapter-S corporations. Sta-Home Health Agency, Inc. was
converted to Sta-Home Health Agency of Jackson, Inc.; Sta-Home
Health Agency, Inc., of Forrest, Mississippi was converted to
Sta-Home Health Agency of Carthage, Inc.; and Sta-Home Health
Agency, Inc., of Grenada, Mississippi was converted to Sta-Home
Health Agency of Greenwood, Inc. The exempt corporations
transferred their tangible and intangible assets to the for-
profit corporations in exchange for the assumption of, and
indemnification against, liabilities. The contemporaneous
appraisals performed in support of the conversion showed that
the consideration for the assets—the agreement to assume the
debts and liabilities—exceeded the value of the assets, which
10
had been unprofitable for the previous five years. It is
undisputed that after the conversion, the Sta-Home entities
continued to operate as before, providing the same services to
the same patients in the same manner, subject to the same
Medicare limits on profit.
In 1999, after an extended audit period, the Commissioner
issued deficiency notices to the Caracci family and the Sta-
Home agencies. The Commissioner determined that the value of
the assets transferred to the nonexempt Sta-Home corporations
exceeded the value of the liabilities and debts assumed by
approximately $18.5 million. Based solely on that valuation
analysis, the Commissioner concluded that the transfer provided
an “excess benefit” to the newly created nonexempt corporations
and the Caracci family, in violation of I.R.C. § 4958, which
imposes a 25 percent and a 200 percent penalty in the form of
excise taxes on “excess benefit transactions.” The deficiency
notices asserted that the taxpayers owed excise taxes totaling
$256,114,435.
The Commissioner based the deficiency notices on a brief
internal memorandum. This memorandum stated: “This
intermediate determination of value should not be considered
final until issuance of the final economic report.” The
11
deficiency notices were not based on a final economic report,
instead using the figures from the “intermediate determination
of value” in stating that the conversion from exempt to
nonexempt status resulted in a net excess benefit of
$18,543,694 and triggered excise taxes and penalties of over
$250 million. Sta-Home and the Caracci family filed timely
petitions in the United States Tax Court challenging the
determination of their tax liabilities.
In the Tax Court, the taxpayers pointed out that one
problem with the deficiency notices was that the valuations
made no adjustment for the liabilities that the nonexempt
corporations assumed as consideration for acquiring the assets
from the exempt corporations. The taxpayers moved for partial
summary judgment based on this problem in the deficiency
notices. The Commissioner responded that the notices were
correct, filing affidavits in opposition to the partial summary
judgment motion swearing to the validity of the deficiency
amounts and the consequent excise tax amounts. It was not
until the trial before the Tax Court that the Commissioner
acknowledged that the deficiency notices were wrong. On cross-
examination, the Commissioner’s own expert witness admitted
that the notices were “excessive,” “incorrect,” and
12
“erroneous.”
On May 22, 2002, the Tax Court affirmed the finding that
the conversion resulted in a “net excess benefit” triggering
excise taxes and penalties, but reduced the amount of the
benefit and the resulting amounts that Sta-Home and the Caracci
family owed. The Tax Court found that the value of the exempt
former Sta-Home entities’ debts and liabilities that the newly
formed nonexempt Sta-Home entities assumed was $13.5 million.
The parties do not challenge this valuation on appeal. The Tax
Court found that the newly formed nonexempt Sta-Home entities
received assets from the exempt former entities worth $20.8
million, exceeding the value of the assumed liabilities by $5.1
million. In so finding, the Tax Court rejected both the $20
million figure the Commissioner had asserted as the amount of
the net excess benefit in its deficiency notices and also
rejected the amount that the Commissioner’s expert presented.
Both Sta-Home and the Commissioner presented detailed
expert testimony on the fair market value of Sta-Home’s
tangible and intangible assets at the time of the conversion
from nonexempt to exempt status. The expert witnesses for both
the taxpayers and the Commissioner agreed that traditional
valuation methodology uses three approaches: (1) income; (2)
13
cost; and (3) market. An income approach assigns value based
on determining how much money an owner will derive from the
business in the future. A cost approach values a business by
determining how much it would cost to replace the entity’s
tangible and intangible assets.4 A market approach tries to
establish the market value of a company, usually by comparing
sales or transfers of similar companies. The experts disagreed
on how to value Sta-Home’s assets and what assumptions should
be used. The Tax Court agreed with neither expert, instead
selecting aspects from the Commissioner’s expert to piece
together its own valuation result.
Sta-Home’s expert, Allen D. Hahn, is a director at
Pricewatershouse Coopers Northeast Region Corporation Valuation
Consulting Group. He has written extensively on valuing home-
healthcare agencies. The Commissioner unsuccessfully attempted
to hire Hahn for this case, recognizing his expertise. To
prepare his analysis of the Sta-Home conversion, Hahn spent
4
Assets in accounting are items of worth to a company,
categorized as tangible (for example, property) and intangible (for
example, community goodwill). A company’s assets are equal to its
liabilities and ownership equity combined. Margaret A. Gibson, The
Intractable Debt/Equity Problem: A New Structure for Analyzing
Shareholder Advances, 81 NW. U. L. REV. 452, 482 n.216 (1987).
Liabilities (debt) and equity are the principal methods of financing
a company. Id. at 456–57. Under debt financing, a corporation
borrows funds; while under equity financing, a corporation raises
funds by issuing stock. Id.
14
eight weeks in Mississippi, studying the assets and liabilities
transferred in the conversion and analyzing the home-healthcare
industry in the area.
The Commissioner, unable to retain Hahn, hired Charles
Wilhoite. Although Wilhoite is a certified public accountant
and codirector of the Portland, Oregon office of Willamette
Management Associations, a business valuation firm, he had no
prior experience with the home-healthcare industry. Wilhoite
spent only two days in Mississippi to study the Sta-Home
entities in order to value their assets and liabilities and
spent one of those days in a hotel room tracking down lost
luggage. Lacking detailed or thorough knowledge about the
home-healthcare industry in general or in the part of
Mississippi where Sta-Home operated, and about Sta-Home itself,
Wilhoite instead relied on his general valuation knowledge and
experience and the information learned in the single day he
spent interviewing Sta-Home’s chief financial officer. In
short, neither the Commissioner nor his expert witness did the
work necessary to perform an asset-valuation analysis of the
Sta-Home entities throughout the extended audit period or
15
during the Tax Court litigation.5
Hahn’s analysis carefully took into account the economic
realities of home-healthcare agencies that depended almost
entirely on Medicare reimbursements rather than on private
payers, lost an average of .7 percent annually on their
operating costs, did not offer specialized services that could
generate profits, and had a capital deficit. Hahn used an
“adjusted balance sheet” method to value the Sta-Home assets,
adjusting the values identified on the companies’ balance sheet
to their fair market value equivalent.6 Hahn prepared both a
“base case” and a “best case” scenario, developing a range of
fair market values for Sta-Home’s assets ranging between $10.5
million and $11.5 million. Hahn specifically valued Sta-Home’s
intangible assets, attributing between $2.1 million and $3.4
million to the CONs and the workforce. Hahn found that the
Sta-Home entities’ total liabilities ranged between $12 million
and $12.5 million, concluding that these liabilities exceeded
5
The Commissioner faults Sta-Home for failing to provide access
to more information about the corporations, but this argument ignores
the discovery tools that the Commissioner had available and ignores
the fact that it is the Commissioner’s burden to show that the tax it
imposed was correct, not the taxpayers’ burden to show that the
Commissioner was wrong.
6
A company’s balance sheet documents the historical cost of its
assets, liabilities, and ownership equity. Shannon P. Pratt et al.,
Valuing Small Businesses and Professional Practices 366 (3d ed.
1998).
16
the value of Sta-Home assets by $.5 million to $2 million.
To check this asset valuation, Hahn also used a market
approach, comparing the Sta-Home transactions to thirteen
private transactions involving home-healthcare agencies engaged
in by publicly traded companies. Hahn cautioned that the
market approach was only a secondary indication of value
because transactions involving other home-healthcare providers
were too dissimilar to the Sta-Home transactions used to effect
the conversion from exempt to nonexempt entities to serve as
the basis for a stand-alone valuation. Hahn noted that
although Sta-Home provided only traditional home healthcare,
publicly traded companies often used home-healthcare agencies
as part of a broader mix of healthcare businesses. Sta-Home’s
heavy dependence on Medicare reimbursements also made it
difficult to compare with publicly traded companies offering
services to a mix that included a much larger number of private
payers and far fewer Medicare patients than Sta-Home. The
Commissioner’s expert conceded that home-healthcare agencies
serving private-pay patients can make a profit on those
services if they are run well; by contrast, healthcare agencies
cannot make a profit on serving Medicare patients. Hahn also
noted that sales of home-healthcare agencies that provided
17
sophisticated treatments could not be included as comparables
because these treatments attracted higher payments and
reimbursements than the services provided by Sta-Home.
Based on the adjusted balance sheet method and the
corroboration provided by the comparable market approach, Hahn
concluded that the liabilities the Sta-Home nonexempt entities
agreed to assume from the nonexempt entities exceeded the value
of the assets received by $600,000 to $2,350,000, resulting in
no net excess benefit and therefore no excise tax liability.
Hahn reached this result without applying a minority stock
discount, reasoning that the shares represented interests in
a loss corporation,7 and without a discount for lack of
marketability,8 concluding that the unattractive healthcare
market in Mississippi was already incorporated into his
adjusted balance sheet valuation.
The Commissioner’s expert, Wilhoite, lacked the specific
information about the Sta-Home entities necessary to value
7
When an individual has less than 50 percent ownership interest
in a company, it is deemed a “minority” ownership interest and
discounted to reflect the holder’s lack of control of the business.
Pratt, Valuing Small Businesses at 426–30.
8
“Marketability” is the ability to convert property to cash
quickly. When companies are not traded on the public market, they
are less marketable and therefore valued less. Pratt, Valuing Small
Businesses at 446–48.
18
their assets, particularly the intangible assets. Wilhoite
assumed that those intangible assets had significant value to
potential purchasers, despite Sta-Home’s history of losses,
because several home-healthcare agencies acquired in recent
transactions incurred losses just before those agencies were
purchased for large amounts.9 Wilhoite used market-based and
income-based approaches to assign values to all Sta-Home’s
assets in general, without valuing any of Sta-Home’s assets in
particular.
For both the market and income approaches, Wilhoite
determined the “market value of invested capital” (MVIC), which
represents the market value of ownership equity plus debt
invested in a company. The MVIC is commonly used in valuing
private companies because it minimizes differences in capital
structure between private and public corporations.10 Wilhoite
assumed that this method could be applied to value the Sta-Home
entities’ assets, despite the fact that method is designed to
value a company’s invested capital, not its assets, and the
9
As discussed below, this assumption violated the Commissioner’s
own valuation rules.
10
Public companies tend to have greater equity than do private
companies, which are often owned by small groups. See Hollis v.
Hill, 232 F.3d 460, 467 (5th Cir. 2000) (outlining the differences in
equity ownership between public and private companies).
19
Sta-Home agencies did not have invested capital.
Wilhoite calculated the MVIC for the Sta-Home entities by
extracting a “revenue pricing multiple” (RPM), a percentage
that when multiplied by a company’s annual revenues yield’s
that company’s MVIC. To derive the RPM, Wilhoite identified
two categories of “comparable” entities, one made up of
publicly traded companies and one made up of merged or acquired
entities. Wilhoite found the median RPM of publicly traded
companies operating home-healthcare agencies to be .61.
Because Sta-Home had been nonprofit, Wilhoite reduced that RPM
by 50 percent to reflect a lower return on invested capital.
When multiplied by Sta-Home’s 1995 revenues, this RPM led to
an MVIC of $13,563,000. Wilhoite ran the same analysis
comparing merged and acquired companies and arrived at an RPM
of .25 and an MVIC of $11,302,000.
Wilhoite’s income approach calculated the value to a
potential buyer that Wilhoite assumed would result from the
buyer’s ability to use a “cost-shifting” strategy.11 Wilhoite
determined that the annual value of cost-shifting, based on a
11
This attribute of Medicare business enables a buyer to shift
some of its overhead costs to Medicare’s cost reimbursement system.
If a home-healthcare agency sought less than the maximum
reimbursement allowed by Medicare, a buyer could shift its overhead
costs to the agency and Medicare would reimburse it to the extent
there was room under the cost cap.
20
historical “cost-cap gap”12 of .5 percent, was $1,408,168.
Wilhoite applied a capitalization rate of 12.8 percent and
calculated $11,001,000 as the present value of Sta-Home to a
potential buyer.
Wilhoite also assigned a weighted percentage to each of
the three values he derived. He assigned the largest weight
to the income approach, followed by the publicly traded
comparables market approach, followed by the merged or acquired
comparables market approach, yielding a weighted-average MVIC
of $11,604,000. Wilhoite then subtracted the amount of deficit
that a buyer of the Sta-Home companies would have to pay for
current liabilities and added the value of those current
liabilities. Based on the accounting rule that the asset side
and liability side of a company’s balance sheet must be equal,
Wilhoite reasoned that Sta-Home’s MVIC (long-term liabilities
and owners’ equity) plus current liabilities would be
equivalent to the value of the assets. Wilhoite valued Sta-
Home’s 1995 assets transferred from the nonexempt to the exempt
entities at $20,858,000, over $7 million more than the
$13,511,000 of liabilities assumed by the nonexempt entities.
12
The “cost-cap gap” is the difference between the reimbursement
amount sought by a home-healthcare provider and the maximum amount of
reimbursement permitted by Medicare.
21
The Tax Court rejected Wilhoite’s income method—the method
that Wilhoite viewed as deserving the greatest weight—stating
that the value of the cost-shifting strategy included “too many
imponderables.” Caracci v. Comm’r, 118 T.C. 379, 406 (2002).
The Commissioner does not challenge this rejection of its
expert’s method. The Tax Court adopted only one part of one
of Wilhoite’s market-value approaches, making adjustments and
filling in gaps to reach its own conclusion as to value.
The Tax Court adopted the part of the MVIC-Revenue
approach that used publicly traded companies as comparables.
In so doing, however, the Tax Court recognized that even the
publicly traded companies Wilhoite used as “comparables” were
in fact not comparable to the Sta-Home entities. Sta-Home
operated in a much less advantageous market than many of the
publicly traded companies, was much more heavily dependent on
Medicare reimbursements than these companies, and did not offer
the sophisticated and profitable therapies that many of these
companies did. Id. at 405-06. Elsewhere in the opinion, the
Tax Court recognized these important aspects of Sta-Home’s
operations and finances that distinguished it from the publicly
traded companies Wilhoite used as comparables. For example,
the Tax Court recognized Sta-Home’s dependency on Medicare
22
reimbursements for over 95 percent of its revenues and the fact
that Medicare disallowed .7 percent of Sta-Home’s costs
annually. But the Tax Court did not discuss these aspects in
analyzing whether the publicly traded healthcare companies were
sufficiently similar to Sta-Home to be “comparables,” as
Wilhoite’s MVIC-Revenue valuation method required. Instead,
although the Tax Court recognized that the publicly traded
companies Wilhoite selected as comparables were different from
Sta-Home in critical aspects, the Tax Court accounted for the
differences by simply reducing the multiplier from .3 to .25
percent. The Tax Court did not explain the basis for reducing
the multiplier by the amount it selected or why that reduction
accounted for the differences between the publicly held
companies and the Sta-Home agencies.
The Tax Court rejected Hahn’s primary adjusted balance
sheet valuation analysis and his secondary market-value
analysis. In rejecting Hahn’s secondary analysis, the Tax
Court failed to recognize that Hahn used it only to confirm his
primary valuation method, because Hahn himself recognized that
the publicly traded healthcare companies were not sufficiently
similar to the Sta-Home entities to serve as comparables in a
stand-alone valuation analysis. The Tax Court also rejected
23
Hahn’s adjusted balance sheet approach, believing that it
undervalued Sta-Home’s intangible assets. The Tax Court
justified its reliance on part of Wilhoite’s analysis and its
rejection of all of Hahn’s analysis and conclusion—despite the
fact that only Hahn had detailed information about how Sta-
Home’s operations and finances worked under the complex
Medicare regulations—by its belief that Sta-Home had “the
potential to generate income and thus demonstrate a substantial
fair market value.” Id. at 405. The primary reason the Tax
Court gave for this belief was that in 1995, the Sta-Home
entities had generated nearly $45 million in revenues but had
reported an operating loss that year, in part because the
entities deducted depreciation for their automobile fleet and
in part because they had declared employee bonuses, without
which 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.” Id.
On appeal, the Commissioner concedes that the Tax Court was
simply wrong in this statement, but insists that the error is
harmless.
Having rejected most of Wilhoite’s analysis and all of
Hahn’s, the Tax Court put together its own valuation analysis
24
with the little that remained of Wilhoite’s methodology. Using
an RPM of .25—its own modification of Wilhoite’s RPM of .3—the
Tax Court calculated an MVIC of $11.3 million. The court then
adjusted that amount by excluding four weeks of employees’
deferred compensation from the current liabilities that
Wilhoite had added to the MVIC and increasing current
liabilities to reflect a reserve for disallowed Medicare
claims.13 Adding current liabilities to the adjusted MVIC, the
Tax Court arrived at a fair market value of $18,675,000 for the
tangible and intangible assets that the new nonexempt Sta-Home
entities received from the old exempt Sta-Home entities. The
court subtracted the liabilities the old exempt Sta-Home
companies transferred to the newly created nonexempt
entities—$13,511,000—from the fair market value of the assets,
leaving an excess of $5,164,000. Because Sta-Home’s
transferred assets “far exceeded” the consideration paid by the
Sta-Home nonexempt corporations—the assumed debts and
liabilities—the Tax Court found a violation of I.R.C. § 4958
and ordered the taxpayers to pay $69,702,390 in excise taxes.
13
The court reasoned that these four weeks of deferred payment
were in fact long-term loans to the company for the duration of the
employees’ employment. The court classified the deferred salary as
part of Sta-Home’s invested capital (specifically as long-term
liabilities). Id. at 407.
25
This appeal followed.
II. Discussion
A. The Legal Standards
Section 4958 of the Internal Revenue Code prohibits
certain acts of self-dealing between private foundations and
company insiders. The statute imposes a 25 percent tax on
“excess benefit transactions,” defined as follows:
“[E]xcess benefit transaction” means any
transaction in which an economic benefit is
provided by an applicable tax-exempt
organization directly or indirectly to or
for 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.
I.R.C. § 4958(c)(1)(A). “Disqualified persons” include any
person in a position to exert “substantial influence” over the
organization’s affairs before the transaction, or any member
of such person’s family. Id. at § 4958(f)(1)(A)–(B).14 If
taxes imposed under the statute are not corrected within the
taxable period, an additional tax equal to 200 percent of the
excess benefit is assessed. Id. at § 4958(b).
Whether the transfer of Sta-Home’s assets qualifies as an
14
The parties do not dispute that the Sta-Home for-profit entities
and the Caracci family are “disqualified persons.”
26
“economic benefit” depends on the fair market value of the
companies’ assets and liabilities. Fair market value is the
price that a willing buyer would pay a willing seller, both
having reasonable knowledge of all relevant facts and neither
being under any compulsion to buy or sell. United States v.
Cartwright, 411 U.S. 546, 551 (1973); Dunn v. Comm’r, 301 F.3d
339 (5th Cir. 2002). The willing buyer and seller are
hypothetical persons rather than specific individuals or
entities, and their characteristics are not necessarily shared
by the actual seller or particular buyer. Estate of Bright v.
United States, 658 F.2d 999, 1005–06 (5th Cir. 1981). At the
same time, the valuation method must take into account, and
correspond to, the attributes of the entity whose assets are
being valued. Dunn, 301 F.3d at 356–57.
The Tax Court’s factual determinations are reviewed for
clear error and its conclusions of law are reviewed de novo.
Dunn, 301 F.3d at 348. The determination of fair market value
is a mixed question of fact and law; “the factual premises
[are] subject to review on a clearly erroneous standard, and
the legal conclusion[s are] subject to de novo review.” Id.
(quoting In re T-H New Orleans, Ltd. P’ship, 116 F.3d 790, 799
(5th Cir. 1997)). Although the mathematical computation of
27
fair market value is an issue of fact, the determination of the
appropriate valuation method is an issue of law. Dunn, 301
F.3d at 348 (citing Powers v. Comm’r, 312 U.S. 259, 260
(1941)).
B. Analysis
The conclusion is inescapable from the description of the
background of this case. There are so many legal and factual
errors—many of which the Commissioner acknowledges—infecting
this case from the outset that reversal must result.
The Commissioner began the cascade of errors by issuing
deficiency notices based on a brief, intermediate internal
analysis. That analysis stated on its face that it was
intermediate and that a final economic study had to be
performed. Ignoring this disclaimer, the Commissioner issued
valuation-based deficiency notices asserting § 4958 excise tax
penalties against the Sta-Home entities and the Caracci family
totaling $250,729,866 (plus interest) and income tax
deficiencies and penalties totaling $8,330,064 (plus interest),
and retroactively revoking the exempt status of the Sta-Home
exempt agencies. Internal IRS documents reveal that the IRS
issued the notices on the basis of an intermediate rather than
final economic study to prevent the Caraccis from correcting
28
what the IRS viewed as prohibited transactions, which would
have reduced the § 4958 “intermediate sanction” penalties. The
second reason the IRS issued these premature notices was its
concern over the statute of limitations. The IRS blamed the
taxpayers for that problem. One of the IRS employees working
on this case stated in an affidavit that the agency asked the
taxpayers to consent to extend the limitations period and
“informed [the taxpayers] that if the statute was not extended,
statutory notices would be issued based on the best available
information that [the IRS] had at that point,” despite the fact
that the IRS economist needed more time to analyze the case.
Even more disturbing, the record reveals that despite
recognizing the tentative and incomplete nature of the analysis
used as the basis for the deficiency notices, the Commissioner
defended the correctness of those notices for several years
into this litigation and only conceded that the notices
overstated the Commissioner’s tax claim when the trial began
in the Tax Court. In issuing the deficiency notices, the
Commissioner did not adjust the analysis by the amount of
liabilities the taxpayers assumed. As a result, the 1999
deficiency notices greatly overstated the excise tax liability.
Despite this error, the Commissioner insisted throughout a two-
29
year audit and nearly two years of litigation that the
deficiency notices were correct. It was not until March 5,
2001, in the opening statement before the Tax Court and in the
cross-examination of the Commissioner’s sole expert witness,
that the Commissioner acknowledged that the 1999 deficiency
notices were excessive and erroneous. This court has
recognized that when, as here, the Commissioner persists in
taking a position in litigation that is
so incongruous as to call his motivation
into question, . . . [i]t can only be seen
as one aimed at achieving maximum revenue
at any cost, . . . seeking to gain leverage
against the taxpayer in the hope of
garnering a split-the-difference
settlement—or, failing that, then a
compromise judgment—somewhere between the
value returned by the taxpayer . . . and
the unsupportedly excessive value
eventually proposed by the Commissioner.
Dunn, 301 F.3d at 349. In Dunn, the result that the
Commissioner obtained in the Tax Court was rejected. As in
Dunn, the result in this case cannot stand.
The legal effect of the Commissioner’s concession of error
in the Tax Court is clear. “In a Tax Court deficiency
proceeding, once the taxpayer has established that the
assessment is arbitrary and erroneous, the burden shifts to the
government to prove the correct amount of any taxes owed.”
30
Portillo v. Comm’r, 932 F.2d 1128, 1133 (5th Cir. 1991). The
Tax Court, however, did not place the burden of proof on the
Commissioner. Instead, the Tax Court stated that while the
parties disputed who bore the burden of proving “the central
issue in this case; namely, the value of the transferred
assets, . . . [w]e do not decide this dispute.” Caracci, 118
T.C. at 382 n.4. Instead, the Tax Court rejected most of the
only support the Commissioner provided for the net excess
benefit finding, the testimony of the Commissioner’s valuation
expert. At that point, the Commissioner failed to meet his
burden of proof. At that point, the Tax Court should have
found in the taxpayers’ favor. Its failure to do so was error,
as a matter of law.
In rejecting most, but not all, of the Commissioner’s
valuation expert’s opinions, the Tax Court made a number of
errors in the valuation method it selected and in the facts it
found in selecting and applying that method. The Tax Court’s
use of Wilhoite’s modified MVIC-Revenue method for valuing Sta-
Home’s assets, particularly its intangible assets, is wrong as
a matter of law. Wilhoite had no experience in appraising
healthcare companies and knew very little about the Sta-Home
entities or their assets and liabilities. Wilhoite did not
31
value Sta-Home’s specific assets, but instead used a variation
on an invested-capital valuation method to do a general and
indirect valuation of Sta-Home’s assets. The Tax Court adopted
a modified version of Wilhoite’s valuation approach, which is
designed to value invested capital—not assets—to value the
assets of a company that had no capital. The Tax Court did so
with no legal support for the use of such a method to value the
assets of these agencies, over the recognition of both Wilhoite
and Hahn that this method was inferior to, and less rigorous
than, an asset-valuation method. The Tax Court then compounded
this error by deriving the invested-capital multiple it applied
to the Sta-Home entities using the seven public companies
Wilhoite selected as “comparables.” Put simply, they were not.
The Tax Court considered the Commissioner’s expert
testimony against a record of stipulated or undisputed facts.
Those facts included that between 95 and 97 percent of Sta-
Home’s revenues came from Medicare, compared to a national
average of 38 percent, and that Medicare only reimbursed up to
actual costs and disallowed .7 percent of Sta-Home’s annual
costs, thereby ensuring that the Sta-Home entities would
continue to build liabilities, not assets, and could not
profit. The more patient care the Sta-Home entities provided,
32
the more revenues they generated, and the more their losses
grew. The parties did not dispute that the liabilities of the
Sta-Home exempt entities exceeded assets for every year from
1987 through 1995. The parties did not dispute that the Sta-
Home exempt agencies had $13.5 million in debts and liabilities
that the newly created nonexempt entities assumed. The parties
did not dispute that the Sta-Home exempt entities had sustained
progressively larger net operating losses and capital deficits
for the previous five years. The parties did not dispute that
there was no likely potential buyer for Sta-Home. Despite
these undisputed facts, the Tax Court’s valuation method used
an invested-capital valuation method that compared the Sta-Home
entities with solvent, publicly traded companies with
significant equity and a present ability to generate profits.
This aspect of Wilhoite’s analysis, accepted by the Tax Court,
excluded distressed companies from the “comparables.” Six of
the seven “comparable” companies were generating profits at the
time of Wilhoite’s comparison and the seventh had substantial
equity. Sta-Home had neither equity nor a record of profits.
The Commissioner’s expert erred when he stated to the Tax Court
that two of the “comparable” public companies had operating
losses; in fact, one of those companies was Sta-Home. The
33
Commissioner’s expert also erred in telling the Tax Court that
one of the public “comparables” had negative stockholder’s
equity; the only negative equity entry was Sta-Home. On cross-
examination, the Commissioner’s expert conceded that some of
the “comparables” provided infusion services, which are fee-
based and thus capable of turning a profit, and that some
“comparables” provided respiratory services, which are also fee
based. The Commissioner’s expert further conceded that other
“comparables” that provided residential medical services,
pediatric care, adult day care, and companion care services
either were fee-based or may have been; he did not know. The
Commissioner’s expert also admitted that many of the
“comparables” were far less Medicare-dependent than Sta-Home.
A “comparable” must be substantially similar to the entity
or asset that is at issue. Van Zelst v. Comm’r, 100 F.3d 1259,
1263 (7th Cir. 1996); Estate of Palmer v. Comm’r, 839 F.2d 420,
423 (8th Cir. 1988). As noted, none of the publicly traded
entities Wilhoite chose were similar to Sta-Home. They were
publicly traded. See Dunn, 301 F.3d at 350 (recognizing that
public companies generally cannot be compared with private
companies). They had capital. They were profitable. They
were not limited to offering basic, and unprofitable,
34
therapies. Most important, they did not depend on Medicare for
over 95 percent of their revenues, were not limited to recovery
of actual costs, and did not have a portion of their actual
costs disallowed every year. For these publicly traded
“comparables,” added revenue would logically create added
value. For Sta-Home, the overwhelming dependence on Medicare
reimbursements meant that added revenue meant added
unreimbursed costs, which in turn generated greater losses.
The Tax Court recognized some of these differences, but
assumed—without explanation—that the publicly traded entities
could still be used as “comparables” as long as the amount of
the multiple derived was adjusted. The Tax Court did not
explain how it arrived at the amount of the adjustment or how
that amount transformed fundamentally different financial
entities into “comparables.”
Using an adjusted version of the Wilhoite MVIC-Revenue
invested capital method, the Tax Court concluded that the value
of the assets the nonexempt Sta-Home entities received exceeded
the value of the $13.5 million in liabilities and debts they
assumed by $5.1 million. As the taxpayers point out, the Tax
Court concluded that a willing buyer would assume $13.5 million
in liabilities and pay $5.1 million to acquire the right to
35
lose money on an ongoing basis. The Tax Court explained why
it believed this apparently illogical conclusion made sense:
it found that Sta-Home had the potential to make a profit,
which demonstrated that its assets had substantial fair market
value. This finding was clearly erroneous.
The Tax Court based its finding that the Sta-Home entities
had the potential to make a profit on the finding that if Sta-
Home had not paid a year-end bonus to its staff in 1995, it
would have reported nontaxable income of approximately $1.78
million, “more than enough to eliminate the accumulated deficit
in net asset value.” Caracci, 118 T.C. at 405. The
Commissioner concedes that this statement is simply error. The
statement ignores the fact that under the Medicare system that
accounted for between 95 and 97 percent of Sta-Home’s revenues,
there is no reimbursement unless there is an actual expense
incurred. If Sta-Home had not paid the bonuses, the Medicare
reimbursements it received would have been reduced by an equal
amount, leaving the same level of company losses. The Tax
Court did not take into account this effect of the Medicare
reimbursement system on the Sta-Home entities, despite
acknowledging it earlier in the opinion. The Tax Court also
overlooked the reason for the bonuses and what they revealed
36
about the Sta-Home entities’ finances. These “bonuses” were
unpaid, deferred employee pay, rather than discretionary
bonuses. The deferred wages for existing employees, along with
deferred first-month wages for newly hired employees, were
mechanisms the taxpayers used to continue to operate despite
their perennial cash-flow problems, their lack of
profitability, their increasing operating losses, and their
increasing deficits. The Commissioner acknowledged before the
Tax Court that the salaries and bonuses were neither excessive
nor unreasonable. Moreover, the Caracci family members
withheld their own compensation in the same manner as
compensation for the other employees. In short, these
“bonuses” evidenced the unprofitable nature of the Sta-Home
entities, not the potential for profitability, as the Tax Court
erroneously stated.
The Tax Court also criticized Sta-Home—in the same section
of the opinion that discussed its profit potential—for taking
a large motor-vehicle depreciation deduction. The Tax Court
ignored the fact that a home-healthcare agency providing
services to a predominately rural population dispersed over a
geographically large area necessarily has a heavily used fleet
of vehicles. The Tax Court’s suggestion that the taxpayers
37
were improperly exploiting the depreciation ignored the fact
that it represented a very real cost that could not be annually
expensed because of the Tax Code’s specifications for the
depreciable life of such personal property. See generally
I.R.C. § 168. Indeed, stipulated facts in the record make it
clear that far from exploiting the tax consequences of their
corporate form, the Caracci family had been unable to take
advantage of the income tax exemption the agencies “enjoyed”
before 1995, because the agencies had consistently incurred net
operating losses.
The Tax Court stated that the Sta-Home agencies had not
profited from their business because of the entities’ previous
“tax-exempt” status. Caracci, 118 T.C. at 385-86. This
statement further reflects a misunderstanding of Sta-Home’s
business and the regulatory regime under which it operated.
The Sta-Home exempt agencies did not profit because they were
virtually entirely dependent on Medicare reimbursements and the
Medicare reimbursement system prohibits profit-taking,
regardless of an agency’s tax status. As the Tax Court
recognized elsewhere in its opinion, the Sta-Home entities
continued to operate in the same manner—at a loss—after
converting to nonexempt status.
38
The Commissioner concedes that the Tax Court’s statement
that the Sta-Home entities could have reported nontaxable
income of $1.78 million had it not declared a bonus in 1995 was
wrong. Yet the Commissioner insists on this appeal that the
error was harmless. The Tax Court opinion itself defeats this
argument. The Tax Court reasoned from the mistaken assumption
that the Sta-Home agencies could have generated positive net
income by eliminating the 1995 employee “bonus” to the mistaken
finding that the agencies had demonstrated a “substantial fair
market value.” Id. at 405. This mistaken statement was
immediately followed by the Tax Court’s decision to use an
invested-capital method to value Sta-Home’s assets and to use
profitable public companies as “comparables” to derive the MVIC
multiple as part of that method. If the Tax Court had not
found that the Sta-Home entities had the potential to generate
a positive net income and “thus demonstrate substantial fair
market value,” the Tax Court’s decisions to use an invested-
capital method for valuing assets and to use profitable public
companies as comparables for unprofitable privately held
agencies, would be not only erroneous but illogical. The Tax
Court’s $1.78 million error was anything but harmless.
The Tax Court’s erroneous finding that the Sta-Home
39
entities had shown a potential for profitability and thus
demonstrated that their assets had “substantial fair market
value” is also the only apparent explanation for the decision
to discredit the opinions provided by the taxpayers’ expert
witness, Hahn. As noted, in marked contrast to Wilhoite, Hahn
had spent months in Mississippi analyzing the Sta-Home agencies
and was a recognized authority on the home-healthcare industry.
In marked contrast to Wilhoite, Hahn did the work to value the
actual assets of the Sta-Home entities. Hahn used the
valuation method that both he and Wilhoite agreed was the
preferred and more rigorous approach to value assets. Neither
the Tax Court nor the Commissioner disputed Hahn’s tangible
asset valuations, which attributed values between $8.4 and $8.7
million. The Tax Court rejected Hahn’s intangible asset
valuations, which attributed approximately $2.7 million to the
workforce, including the certificates and licenses, because
Hahn’s conclusion that the value of the assets the nonexempt
entities received from the exempt entities was less than the
$13.5 million in liabilities they assumed was inconsistent with
the Tax Court’s (erroneous) finding that the Sta-Home entities
had “demonstrated substantial fair market value.”
The Tax Court’s mistaken belief that Sta-Home’s intangible
40
assets had substantial fair market value led it to ignore its
own long-recognized position that unprofitable intangible
assets do not contribute to fair market value unless those
assets produce net income or earnings. Revenue Rule 59-60
requires the IRS to assign zero value to unprofitable
intangible assets. See Rev. Rul. 59-60, 1959-1 C.B. 237 (“The
presence of goodwill and its value, therefore, rests upon the
excess of net earnings over and above a fair return on the net
tangible assets.”). The Tax Court (and reviewing courts) have
recognized this. See Fox River Paper Corp. v. United States,
65 F. Supp. 605, 607 (E.D. Wis. 1946), aff’d 165 F.2d 639 (7th
Cir. 1948); Rosen v. Comm’r, 62 T.C. 11 (1974), aff’d 515 F.2d
507 (3d Cir. 1975). The Tax Court clearly erred and violated
its own prior rulings in failing to recognize that the Sta-Home
exempt agencies’ unprofitable intangible assets—including the
workforce, the licenses, the CONs, the Medicare-dependent
client base, and the aging and largely uncollectible accounts
receivable—had little or negative market value.
Hahn established the value of the Sta-Home exempt
agencies’ tangible assets at a range between $8,421,977 and
$8,787,492. Neither the Commissioner nor the Tax Court
challenged this figure. The parties agreed that the for-profit
41
entities assumed roughly $13.5 million in liabilities. The Tax
Court concluded that the Sta-Home exempt agencies’ total asset
value was $18,675,000, meaning that the agencies’ intangible
asset value had to be approximately $10,000,000. The parties
agree that the Tax Court clearly erred in including the $1.78
million in “bonus” money as an intangible asset. Setting this
error aside, there is no basis to assign over $8 million to the
Sta-Home exempt agencies’ remaining intangible assets, the
largest of which—its patients—would only enable the agencies
to lose money for the indefinite future. The CON was similarly
of little or no value as an intangible asset because it
provided Sta-Home access to the same Medicare-dependent group
of patients; neither Sta-Home (or another buyer) could raise
prices on the services provided to these patients to generate
revenue because Medicare precluded profit. Even if the Tax
Court assigned a significant value to the Sta-Home exempt
agencies’ other intangible assets, such as its trained
workforce (which would need to be paid, representing further
liabilities as well as future profits), and goodwill, the Tax
Court would have had to find these remaining intangible assets
were worth approximately $5 million to conclude that the
taxpayers realized any net excess benefit from the transaction,
42
assuming that the Sta-Home nonexempt agencies assumed $13.5
million in liabilities from the exempt entities and that the
exempt entities assumed approximately $8.5 million in tangible
assets from the exempt agencies. There is no legal or factual
basis for assigning a $5 million value to these intangible
assets.
This case began and ends with the Commissioner’s refusal
to recognize the legal effect of its own errors. The
Commissioner issued erroneous and excessive deficiency notices,
yet persisted in defending them for nearly two years of
litigation before the Tax Court. After the Commissioner
admitted his erroneous deficiency notices, he failed to meet
his burden of proving that the excise taxes he sought to
collect were correct. The Commissioner presented an expert who
used an inappropriate valuation method and lacked basic factual
information essential to the asset valuation he was called on
to provide. The Tax Court erred as a matter of law when it
failed to find for the taxpayers after it rejected much of the
Commissioner’s expert’s opinion and instead proceeded to use
bits and pieces from that opinion to value the Sta-Home assets
transferred to the newly created nonexempt entities. The Tax
Court erred as a matter of law in the valuation method it
43
selected. In the process of arriving at and applying that
method, and in struggling to make that method make sense, the
Tax Court made a number of clearly erroneous factual findings.
These errors led the Tax Court to reject the taxpayers’ expert,
whose adjusted balance sheet valuation method provided the only
rational and justifiable valuation available in the record, and
to find that a willing buyer would have paid $18.6 million for
the Sta-Home exempt agencies despite their unprofitability.
These errors require this court to reverse and render.
IV. Conclusion
The Commissioner failed to perform a legitimate asset
valuation analysis throughout the audit, discovery, and
litigation of this case. The Tax Court erred as a matter of
law in failing to hold the Commissioner to his burden of proof
and in selecting an inappropriate and incorrect method to value
the assets of the Sta-Home entities and made clearly erroneous
factual findings in applying this valuation method. The Tax
Court’s errors do not require remand because the record makes
it clear that the Commissioner cannot meet his burden of proof
under 26 U.S.C. § 6213, Portillo, and Dunn. The Tax Court’s
decision is reversed and judgment is rendered in favor of the
taxpayers.
44
REVERSED AND RENDERED
45