UNITED STATES TAX COURT
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T.C. Memo. 2008-45
UNITED STATES TAX COURT
CHARLES A. AND MARIAN L. DERBY, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 10930-02, 10931-02,
10932-02, 10933-02,
10934-02, 10935-02,
10936-02, 10937-02,
10939-02, 10941-02,
10942-02, 10943-02,
10945-02.
1
Filed February 28, 2008.
Cases of the following petitioners are consolidated
herewith: Peter E. and Geraldine Droubay, docket No. 10931-02;
James W. and Marilee G. Eusebio, docket No. 10932-02; Michael R.
and Ann J. Harris, docket No. 10933-02; Michael A. and Linda S.
Hirsch, docket No. 10934-02; John F. Hoefer and Elise R. SmithHoefer, docket No. 10935-02; Daniel J. and Sean C. Kennedy,
docket No. 10936-02; Harris D. and Barbara F. Levin, docket No.
10937-02; Gerald R. MacLean and Joan L. Smith-MacLean, docket No.
10939-02; Estate of Hugh A. Patterson, Deceased, Elizabeth K.
Patterson, Executrix, and Elizabeth K. Patterson, docket No.
10941-02; Robert S. Silva and Susan C. Silva, a.k.a. Susan K.
Silva, docket No. 10942-02; Women's Health Associates, Leon
Schimmel, Tax Matters Partner, docket No. 10943-02; and Richard
H. White and Paula A. Watts-White, docket No. 10945-02.
- 2 Steven J. Mopsick and Betty J. Williams, for petitioners.
Christian A. Speck and Kathryn K. Vetter, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GALE, Judge:
Respondent determined deficiencies in
petitioners' Federal income taxes for the 1994 taxable year as
follows:
Docket No.
10930-02
10931-02
10932-02
10933-02
10934-02
10935-02
10936-02
10937-02
10939-02
10941-02
10942-02
10943-02
10945-02
Petitioner1
Derby
Droubay
Eusebio
Harris
Hirsch
Smith-Hoefer
Kennedy
Levin
Smith-MacLean
Patterson
Silva
Women's Health Assocs.
Watts-White
Deficiency
$16,739
24,950
14,237
9,724
8,008
33,237
13,917
41,320
12,170
23,091
26,976
2
162,926
13,341
1
Although petitioners filed joint returns, for
convenience we use the surnames of the spouses whose
medical practice transfers are at issue in these cases.
2
Adjustment to the charitable contribution deduction
claimed by the partnership. The resulting deficiencies
to the partners, Dr. Leon Schimmel and Dr. Carol Lynne
Conrad-Forrest, are not at issue in these cases.
In his answers, respondent affirmatively alleges that the
individual petitioners are liable for accuracy-related penalties
for gross valuation misstatements equal to 40 percent of the
- 3 deficiencies pursuant to section 6662(a)2 and (h).
Alternatively, respondent alleges that those petitioners are
liable for penalties for substantial valuation misstatements
equal to 20 percent of the deficiencies pursuant to section
6662(a), (b)(3), and (e)(1)(A).
The issues common to all petitioners are whether:
(1)
Petitioners are entitled to the charitable contribution
deductions claimed under section 170(a)(1) for the transfer to a
tax-exempt medical foundation of intangible assets associated
with each petitioner physician's medical practice, and (2) the
individual petitioners are liable for the 40-percent accuracyrelated penalty for gross valuation misstatements pursuant to
section 6662(a) and (h) or, alternatively, for the 20-percent
penalty for substantial valuation misstatements pursuant to
section 6662(a), (b)(3), and (e)(1)(A).3
In addition, the
following issues involve certain of petitioners as indicated,
whether:
(1) Petitioners Daniel J. and Jean C. Kennedy (the
Kennedys) underreported Dr. Kennedy's 1994 gross receipts by
$3,760 on Schedule C, Profit or Loss From Business, and (2)
2
Unless otherwise noted, all section references are to the
Internal Revenue Code of 1986 as in effect for the year in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
3
The deficiencies also reflect adjustments that are
derivative of the principal adjustments, are not directly
disputed by petitioners, and will be resolved by our resolution
of the principal adjustments. We do not further discuss those
derivative adjustments.
- 4 petitioners Charles A. and Marian L. Derby (the Derbys)
underreported the 1994 income from Dr. Derby's S corporation by
$3,665.
FINDINGS OF FACT4
Some facts are stipulated and are so found.
The stipulation
of facts, with accompanying exhibits, is incorporated herein by
this reference.
I.
Petitioners
When they filed their petitions in these consolidated cases,
petitioners Charles A. and Marian L. Derby, Peter E. and
Geraldine Droubay, James W. and Marilee G. Eusebio, Michael A.
and Linda S. Hirsch, John F. Hoefer and Elise R. Smith-Hoefer,
Daniel J. and Sean C. Kennedy, Harris D. and Barbara F. Levin,
Gerald R. MacLean and Joan L. Smith-MacLean, Hugh A. and
Elizabeth K. Patterson, Robert S. and Susan C. Silva, and Richard
H. White and Paula A. Watts-White, resided in California;
petitioners Michael R. and Ann J. Harris resided in Oregon.
During the taxable year ended December 31, 1994, Women's Health
Associates (WHA) was a partnership as defined by section
6231(a)(1).
4
Its principal place of business was in California.
To the extent that petitioners have failed to set forth
objections to respondent's proposed findings of fact, or vice
versa, we conclude that these proposed findings of fact are
correct except to the extent that the nonobjecting party's
proposed findings of fact are clearly inconsistent therewith.
See Jonson v. Commissioner, 118 T.C. 106, 108 n.4 (2002), affd.
353 F.3d 1181 (10th Cir. 2003).
- 5 WHA had two partners, Drs. Leon Schimmel (Dr. Schimmel) and Carol
Lynne Conrad-Forrest (Dr. Conrad-Forrest), both of whom practiced
obstetrics/gynecology.
of WHA.
Dr. Schimmel was the tax matters partner
At the time the petition for WHA was filed, Dr. Schimmel
resided in California.
Petitioners were primary care physicians5 (with three
exceptions:
an orthopedic surgeon, an otolaryngologist, and a
psychiatrist) that had been practicing in individual and small
group practices (as sole proprietorships, S corporation
shareholders, or partners) in the Davis, California, area for
periods ranging from 1 to 21 years in 1994.
II.
Background
A.
Healthcare Industry
Through the early 1980s, medicine was generally practiced in
the Davis, California, area under a "fee-for-service" model, in
which physicians were paid fees when services were provided to
patients.
Patients with health insurance paid fixed premiums to
a health insurer, and the insurer would in turn contract directly
with physicians to establish a fee schedule for services provided
to its insureds.
5
Though collecting premiums, the insurer paid
Each individual petitioner physician filed a joint return
with his or her spouse, and the spouses are petitioners in these
cases by virtue of having filed joint returns. We shall refer to
the individual petitioner physicians as "petitioners". For
convenience, we shall also generally refer to the two partners of
WHA, Dr. Schimmel and Dr. Conrad-Forrest, as petitioners.
- 6 the physicians only when its insureds received medical services.
Consequently, the insurer bore the risk that a given patient
would require medical care costing more than the premiums that
patient had paid.
In the fee-for-service environment, many doctors, including
petitioners, owned their own practices (alone or with partners)
and managed them independently, including hiring support staff,
purchasing equipment, and overseeing billing and collection.
In the mid-1980s, the phenomenon of managed care, in the
form of health maintenance organizations (HMOs), began to take
hold in the provision of medical services, especially in
California.
Under managed care, HMOs, a form of health insurer,
would collect premiums from patients, but rather than pay
physicians for services as rendered, HMOs would instead pay to a
primary care physician a fixed monthly capitation fee to manage
the care of each patient who selected that physician.
Thus,
under the HMO model of managed care, the risk of having a patient
whose medical care costs exceeded the premiums paid was in
general shifted from insurers to physicians and other health care
providers.
The penetration of the HMO model was low at first, but it
became much more prevalent over time.
HMOs generally would not
contract directly with individual physicians; instead, they would
enter into agreements only with larger groups.
Physicians in the
- 7 Davis area became aware in 1985 that the University of California
at Davis (UC-Davis), the largest employer in the region, was
considering offering HMO style coverage as a health insurance
option for its employees.
In response, a group of Davis area
independent physicians, including several of petitioners, began
to meet monthly to consider options for dealing with any
significant penetration of the HMO model into the Davis area
patient population.
B.
Formation of IPA
One option for physicians desiring to serve patients with
HMO coverage was membership in an independent practice
association (IPA).
An IPA is a collection of independent
physicians formed (typically as a corporate entity) to serve as
an intermediary between its member physicians and HMOs.
IPAs
negotiate contracts directly with HMOs, administer claims,
collect capitation fees for the HMO patients who select a
physician member, and pay over those fees to the physician
members.
The penetration of the HMO model into the Davis area
continued after 1985.
In 1987, several of petitioners and other
local doctors, principally primary care physicians, formed an
IPA, the Davis Area Medical Group, Inc., later renamed United
Health Medical Group, Inc. (UHMG).6
6
UHMG negotiated contracts
By 1994, each petitioner had become a member of UHMG,
(continued...)
- 8 with HMOs, collected capitation fees paid under those contracts,
and distributed them to member physicians.
UHMG contracted with
a third-party administrator to perform the latter two functions
for a fee of 15 percent of receipts.
UHMG performed no other
consolidated functions for its member physicians, such as other
billing, patient record keeping, appointments, employment of
staff, etc.
Its member physicians continued to operate
independent practices and to directly bill fee-for-service and
preferred provider organization (PPO)7 patients.
III.
Decision To Affiliate
A.
Necessity of Affiliation
By approximately late 1992 or early 1993, several factors
prompted petitioners to consider affiliating with a larger health
care organization.
The penetration of the HMO model into the
Davis area had become substantial.
The principal employer in the
Davis area, UC-Davis, faced with burgeoning costs in providing
conventional fee-for-service health insurance coverage, arranged
to have HMOs among the health insurance options for its employees
6
(...continued)
although UHMG's approximately 70 shareholder/members also
included physicians who did not participate in the transactions
at issue.
7
A PPO is an organization created by an insurer consisting
of physicians and/or other health care providers who individually
contract with the insurer to provide medical services to its
insureds for reimbursement at a discount. The insureds have an
incentive to use the insurer's "preferred providers" because the
out-of-pocket costs of doing so are reduced.
- 9 starting in 1994.
Because the out-of-pocket costs to the UC-
Davis employees of HMO coverage were considerably less than feefor-service coverage, petitioners believed UC-Davis's change
would result in a substantial additional migration to HMOs in the
area.
In fact, a significant fee-for-service insurer, Blue
Shield of California, faced with declining enrollments, dropped
out of providing coverage to UC-Davis employees for 1994.
This
left only a few very expensive fee-for-service insurance options
for UC-Davis employees; virtually all employees switched to HMO
or other managed care coverage.
By 1993, Sacramento, which is
approximately 15 miles from Davis, had the highest penetration of
HMO care in the United States.
In California, the shift towards managed care was
accompanied by a significant consolidation of health care
providers and insurers into larger organizations, or integrated
delivery systems.
Both HMOs and hospitals had begun to acquire
physicians' practices as a means of expanding their patient base.
Primary care physicians were attractive acquisition targets,
given their patient rosters, especially organized groups of such
physicians.
The UHMG physicians, including petitioners, had in
addition developed a reputation as especially cost-efficient
practitioners; that is, they were perceived by insurers and
others in the field as having shorter-than-average hospital
- 10 stays,8 fewer-than-average Caesarian sections, etc.
The UHMG
physicians were therefore courted by several HMO and hospital
organizations in the area as acquisition targets.
In petitioners' view, the IPA model, which they had adopted
in forming UHMG, did not prove to be an especially effective
means of preserving the economic viability of their medical
practice in a managed care environment, where the risk of having
sicker-than-average patients was shifted from insurers to health
care providers.
That was so because, while the IPA arrangement
provided a mechanism whereby petitioners could treat patients
with HMO coverage, the IPA arrangement did not create a capital
pool, or result in sufficient size, to allow for the management,
or effective spreading, of the foregoing new risk.
Instead,
petitioners believed, effective management of the risk would
require that they affiliate with a larger organization.
They
also believed that such an affiliation would bring them greater
leverage in negotiating capitation rates with HMOs and other
insurers.
A final impetus towards affiliation was the
anticipation, by petitioners and other members of the medical
community, that managed care would spread and consolidation of
healthcare providers would increase as a result of a major effort
8
UHMG physicians had pioneered the use of a "hospitalist",
i.e., the full-time assignment of a physician from their group to
a hospital to oversee the care of hospitalized patients of other
UHMG physicians, rather than having each physician individually
care for his or her hospitalized patients.
- 11 to restructure the provision of health care in the United States
in 1994 by the Federal Government, including the creation of some
form of national health insurance.
Against this backdrop, petitioners concluded that practicing
medicine as independent or small group practitioners using an IPA
would no longer be economically viable for them.
Instead, they
decided, it would be advisable to affiliate with a larger health
care organization such as an HMO or a hospital.
Affiliation with
a larger organization provided a more secure means to practice
medicine in a managed care environment, in petitioners' view, as
it would provide them with a larger patient base for spreading
the risk of loss being transferred to them by health insurers,
greater capital resources for the same purpose, the benefits of
greater bargaining leverage in negotiating managed care
contracts, and greater efficiencies and economies of scale in
providing care.
To facilitate the affiliation, it was also decided that
certain of the UHMG member physicians, including petitioners,
should form a medical group.9
Unlike an IPA, a medical group
involved the consolidation of the member physicians' medical
practices, so that patient revenues were pooled, expenses were
shared, and salaries were paid to member physicians.
9
The newly
Not all members of the UHMG IPA were asked to join the new
medical group, for various reasons, including that his or her
medical specialty, or personality and/or practice style, was not
perceived to be a good fit.
- 12 formed medical group would then affiliate with a larger
organization seeking to acquire group practices.
A "steering
committee" of six UHMG physicians was formed for purposes of
exploring an affiliation.
Letters announcing the physicians'
interest in forming a medical group and affiliating with a larger
organization were sent to five potential acquirers:
U.C.-Davis
Medical Center, Foundation Health Corp., Woodland Clinic,
Mercy
Healthcare of Sacramento, and Sutter Health, all of which were
seeking to acquire or affiliate with medical practices.
B.
Rejection of Foundation Health Corp. Affiliation
The steering committee met and negotiated with
representatives of the foregoing entities and recommended that
the group affiliate with Foundation Health Corp. (Foundation).
Foundation was an HMO operated for profit and publicly traded; it
had embarked on a course of becoming a "Kaiser model" HMO; i.e.,
one that acquired medical practices as a means of expanding its
patient base or "market share" in California.
Foundation had
offered what steering committee members believed was the most
generous financial consideration, including substantial cash
payments for the intangible assets, or goodwill, associated with
the UHMG physicians' practices.
Foundation considered the UHMG
physicians more valuable to it as a medical group (rather than
individual practices) because its experience had shown that
existing working arrangements between physicians, such as call
- 13 schedules, reduced the management effort required of Foundation
in organizing independent physicians to work together.
When the steering committee presented its recommendation
(which had not been unanimous) to the group, it was soundly
rejected.
The remaining UHMG physicians, including several of
petitioners, were vehemently opposed to any affiliation with
Foundation.
Most had had unpleasant experiences with
Foundation's unwillingness to approve certain drugs and
procedures they had recommended for patients.
Foundation
employed "formularies", which were approved lists of drugs the
departure from which when prescribing for patients required
substantial justification by the physician.
This and other
Foundation practices, which many of petitioners attributed to
Foundation's for-profit, business-driven orientation, caused
petitioners to fear a significant loss of professional autonomy
were they to practice medicine as employees of Foundation.
IV.
Acquisition by Sutter Health
A.
Selection of Sutter Health
The discussions with Foundation were terminated, and after
some consideration of the remaining potential acquirers,
petitioners and the other UHMG doctors decided to pursue an
affiliation with Sutter Health.10
10
Sutter Health was the parent
Woodland Clinic had offered very little in the steering
committee's view, as negotiations revealed that it was merely
interested in the UHMG physicians' joining its organization
(continued...)
- 14 corporation of a regional health care system comprising a wide
range of inpatient and outpatient clinics as well as acute care
hospitals located in Northern California.
Sutter Health had a
section 501(c)(3) subsidiary, Sutter Medical Foundation (SMF),
that operated group medical practices that were integrated with
Sutter Health's affiliated hospitals in an integrated delivery
system.
SMF operated its group medical practices through
professional service agreements with groups of local physicians.
Sutter Health hoped to expand into the Davis area in 1994 by
acquiring a local medical group to integrate with its hospitals
in the area.
To accomplish this, Sutter Health envisioned having
SMF purchase the assets of local physicians and enter into a
professional services agreement with those physicians organized
as a medical group.
Acquiring a physician group was important to
Sutter Health, as it represented an immediate roster of patients
for its clinics and acute care hospitals.11
Many of the UHMG physicians had privileges at the existing
Sutter Health hospital in Davis and had been involved in the
10
(...continued)
individually. Moreover, Woodland typically required physicians
it employed to sign noncompete agreements, and petitioners were
unwilling to agree to such restrictions. The committee
terminated discussions with U.C.-Davis and Mercy Healthcare for
reasons not fully disclosed in the record; at least one UHMG
physician believed U.C.-Davis Medical Center was too large and
"bureaucratic".
11
SMF was not interested in contracting with physicians
individually.
- 15 design of a new, state-of-the-art Sutter Davis Hospital scheduled
to open in September 1994.
B.
Negotiations
Negotiations between SMF and physician representatives of
UHMG began in 1993 and continued through most of 1994.
The
discussions covering the consideration that petitioners would
receive for their medical practices were protracted and sometimes
acrimonious.
Unlike Foundation, Sutter Health was unwilling to
pay anything for the intangible assets, or goodwill, that might
be associated with petitioners' medical practices.
was unwilling to do so for two reasons:
Sutter Health
First, and principally,
because Sutter Health's management believed that doing so might
constitute a crime under the Medicare and Medicaid antikickback
statute, 42 U.S.C. sec. 1320a-7b(b), prohibiting payments for
referrals of patients eligible for Medicare or Medicaid;12 and,
12
Sutter Health's nonprofit, tax-exempt subsidiaries,
including SMF, provided substantial goods and services for which
payment was made under Medicare and Medicaid. The Associate
General Counsel of the U.S. Department of Health and Human
Services had written a letter on Dec. 22, 1992, in response to a
request from the Internal Revenue Service Office of the Associate
Chief Counsel for Employee Benefits and Exempt Organizations for
the Department's views concerning the application of the Medicare
and Medicaid antikickback statute, 42 U.S.C. sec. 1320a-7b(b), in
the case of transactions involving the acquisition of physician
practices by tax-exempt hospitals and other health care
providers. The letter, widely circulated in the nonprofit health
care sector, had expressed the view that payments made in
connection with the acquisition of physician practices that were
in excess of the fair market value of the "hard assets" of the
practice, including payments for goodwill, patient lists, or
patient records, might be considered payments for patient
(continued...)
- 16 second, because Sutter Health's management believed, on the basis
of their projections of the financial performance of the UHMG
physicians' group after acquisition, that any additional payment
for intangibles would have rendered the deal financially
nonviable for Sutter Health.
Sutter Health's management
anticipated that petitioners and the other UHMG physicians could
be persuaded to affiliate with Sutter Health through additional
incentives, such as being given a management role, through
participation in various management committees of SMF and Sutter
Health.
Many of petitioners were greatly concerned that they not be
required to sign any noncompete agreement in connection with
their affiliation with a larger health care organization.
It was
vitally important to them to be able to terminate their
affiliation in the event they judged it unsatisfactory and resume
the practice of medicine in the Davis, California, area without
having to relocate.
Many were familiar with the tribulations of
physicians in the area who had affiliated with the Woodland
Clinic, which required affiliating physicians to sign noncompete
agreements.
Petitioners were aware that when certain Woodland
Clinic physicians sought to terminate their relationships with
the clinic, they became embroiled in protracted litigation over
12
(...continued)
referrals in violation of the antikickback statute. Violations
of the statute could result in criminal penalties and/or
exclusion from participation in Medicare and Medicaid programs.
- 17 the noncompete agreements.
Petitioners were determined to avoid
that possibility.
At some point in the negotiations, petitioners and the other
UHMG physicians decided to pursue exclusively an affiliation with
Sutter Health.
Thereafter they retained an attorney, Peter
Grant, to advise them with respect to the transaction with SMF.
Mr. Grant, whose fees were paid by SMF, was experienced in
matters affecting health care organizations, including
acquisitions of physician practices.
Mr. Grant recommended that,
in light of Sutter Health's unwillingness to pay cash for
goodwill or similar intangible assets associated with the
physicians' practices, petitioners should consider donating their
practice intangibles to SMF and claiming charitable contribution
deductions for their values.
Mr. Grant recommended that petitioners structure the
transfers of the intangibles as donations because that technique
had been used in connection with an acquisition of a group
medical practice by a nonprofit medical foundation (Friendly
Hills Healthcare Foundation), for which Mr. Grant had served as
an adviser.
Mr. Grant had received a written determination in
the form of a determination letter granting section 501(c)(3)
tax-exempt status to Friendly Hills Healthcare Foundation, where
it had been represented that the medical group physicians would
make donations of an aggregate portion of the transferred assets
- 18 (including intangible assets) to the foundation and claim
charitable contribution deductions for proportionate amounts of
the aggregate donation (Friendly Hills determination letter).
In
addition, Mr. Grant was familiar with the annual Exempt
Organizations Continuing Professional Education Technical
Instruction Program manuals, including the manual for 1994, which
expressly contemplated a "charitable donation" as one method by
which a nonprofit corporation might acquire assets from an
existing group medical practice in connection with its
acquisition of the practice.13
C.
Acquisition Transaction
1.
In General
To effect Sutter Health's acquisition of the medical
practices of the UHMG physicians, including petitioners, who
wished to affiliate with it, a number of steps were taken, as
discussed below.
First, Sutter Health and the affiliating physicians arranged
for an appraisal of the "business enterprise value" of the to-beformed medical group, as well as a separate appraisal of the
tangible assets that would be transferred to SMF as part of the
acquisition.
In April 1994, Sutter Health retained an investment
banking firm, Houlihan Lokey Howard & Zukin (Houlihan), to
13
See "Exempt Organizations Continuing Professional
Education Technical Instruction Program for FY 1994", Dept. of
Treasury, Internal Revenue Service, Training 4277-045, at 215-217
(7-93).
- 19 perform an analysis of the "Davis Medical Group * * * , a group
medical practice (currently being formed) comprised of thirtyfive primary care physicians" and to render an opinion regarding
"the fair market value of the aggregate assets of * * * [the
Davis Medical Group] exclusive of any benefit or element of value
conferred upon Sutter [Health] as a consequence of its current or
proposed relationship with * * * [Davis Medical Group], and with
consideration of proposed posttransaction compensation and
benefits to the physician group."
Houlihan also agreed to
"allocate the appraised value of * * * [Davis Medical Group] to
each of its physician/shareholders" using a method to be agreed
upon in consultation with the UHMG steering committee, but the
agreed-upon method "[had to] be acceptable" to Houlihan.
The
retainer agreement further provided that Houlihan would arrange
for an appraisal of the hard assets by a qualified third party,
for a separate fee.
Second, shortly after Houlihan was retained, a corporation
was formed to serve as the entity for the medical group to be
formed by certain of the UHMG physicians, including petitioners,
for purposes of the acquisition of their medical practices by
SMF.
On April 19, 1994, the Community Health Associates
Multispecialty Medical Group, Inc. (d.b.a. Sutter West Medical
Group), was incorporated as a California professional medical
corporation (SWMG).
- 20 2.
Professional Services Agreement (PSA)
SWMG thereupon entered into a Professional Services
Agreement (PSA) with SMF on August 12, 1994, to become effective
on November 1, 1994, subject to the conditions precedent that at
least 25 primary care physicians associated with the UHMG IPA
would become shareholder-employees of SWMG and sell their medical
practices to SMF under prescribed asset purchase agreements.
PSA had a 2-year term, subject to renewal.
The
Pursuant to the PSA,
SWMG agreed to provide professional services through its member
physicians exclusively to the patients of SMF's group practice
program in a prescribed service area, generally the Davis,
California, region, so as to become part of a comprehensive
health care delivery system involving SMG, SWMG, and Sutter
Health's hospitals and other health care facilities.
The
physicians rendering the professional services on behalf of SWMG
were to be under contract with SWMG pursuant to agreements
complying with the terms of the PSA, which included the proviso
that the physicians would provide professional services solely to
SMF (through SWMG), with an exception for reasonable amounts of
unpaid volunteer work.
SMF agreed to provide and maintain clinic
locations and equipment, all necessary nonphysician personnel,
professional liability insurance coverage, and accounting and
billing services, as well as maintenance of patient records.
Under the PSA, all patients seen by the SWMG shareholder
- 21 physicians were deemed to be the patients of SMF's group practice
program, and all income from the rendering of professional
services to these patients was to accrue to SMF.
The PSA contained a noncompete provision, under which SWMG
and its physician shareholder/employees were prohibited from
participating in the ownership, management, operation, or control
of any business or person providing health care services within
the service area covered by the agreement.
However, specifically
exempted from this prohibition was any SWMG physician who left
the employment of SWMG.
Pursuant to the PSA, SWMG would receive compensation for its
provision of professional services equal to a percentage of net14
revenues from patients, as follows:
57.75 percent15 of fee-for-
service revenue; 47 to 53 percent of capitation revenue,
depending on average monthly levels; and a sliding scale from 90
14
For this purpose, "net" revenue consisted, in the case of
fee-for-service revenues, of gross revenues less an estimated
percentage to account for contractual discounts and bad debts
and, in the case of capitation revenue, of gross revenue less
amounts equal to the cost of third-party administration, cost of
ancillary services, and other miscellaneous costs. "Net"
revenues for this purpose were not offset by SMF's expenses of
providing clinic locations, nonphysician personnel, or
administrative services such as billing or maintaining patient
records.
15
The parties amended the PSA, wherein the fee-for-service
percentage was initially set at 54.5 percent, to reflect the
percentage noted above on Dec. 1, 1994, retroactive to Nov. 1,
1994.
- 22 to 60 percent for the first $800,000 of "risk pool revenue",16
with a 55 percent17 share of amounts above $800,000.
SWMG agreed
to compensate its physician members, including petitioners, from
the foregoing share of revenues.
In addition, the PSA provided a
guaranty, or floor, on the annual compensation that SWMG (and
through SWMG, its member physicians) would receive, generally
equal to 98 percent of the total designated annual compensation
amounts for SWMG's member physicians.
(The designated annual
compensation amounts were set individually for each member, and
ranged (for full-time practitioners) from a high of $348,859 for
petitioner Elise R. Smith-Hoefer to a low of $110,076 for
petitioner James W. Eusebio.)
Finally, the PSA provided for the
payment of a "Physician Access Bonus" described as follows:
"A
critical element necessary to maintain an integrated health
system is physician access.
To provide an incentive to SWMG to
form and sustain a group, SMF will pay SWMG a Physician Access
Bonus."
The PSA nowhere provided, or required that the
employment agreement between SWMG and each SWMG physician
provide, that SWMG physicians maintain "open" practices; i.e.,
accept new patients notwithstanding existing patient loads.
Provisions governing the assignment of patients to SWMG
16
17
The record does not define "risk pool revenue".
As with capitation revenues, the share of risk pool
revenues noted above was the product of a subsequent amendment,
having been initially set at a flat 50 percent.
- 23 physicians were contained in the employment agreements between
SWMG and each SWMG physician, discussed below.
The "Physician Access Bonus" was $35,000 for each of SWMG's
full-time physicians, plus a prorated portion of $35,000 for each
of up to five part-time physicians.
Forty-four percent of the
amount so calculated was payable 2.5 months after the November 1,
1994, effective date of the PSA (January 15, 1995), with the
balance payable in two 28-percent installments on the first and
second anniversaries of the PSA's effective date.
When the PSA
was renegotiated for the period after its initial 2-year term,
there was no comparable provision for a "Physician Access Bonus".
SMF did not pay physician access bonuses in connection with its
acquisition of any other physician practices.
The PSA also secured for SWMG a role in the governance of
SMF.
Pursuant to the PSA, SWMG was entitled to designate one of
its member physicians to serve as a voting member of SMF's board
of directors during the first year of the agreement, and one to
serve as a nonvoting member for the term of the agreement.18
SWMG
was also entitled to designate representatives on various
management and planning committees of SMF and Sutter Health.
In
addition, as one of SMF's contracting medical groups, SWMG was
entitled to nominate three of the seven members of SMF's Area
18
SMF also agreed to "facilitate discussions" between SWMG
and Sutter Health to evaluate and restructure provisions
regarding permanent physician members of SMF's board of
directors.
- 24 Governance Council, the function of which was to oversee the dayto-day operations of the group medical practices in SWMG's
service area and to provide advice to SMF's board of directors
with respect to all policy matters affecting that service area.
Finally, SMF agreed under the PSA to include the SWMG member
physicians' clinic locations among its clinic locations and to
refrain from making changes in clinic locations during the term
of the agreement without the approval of SWMG.
3.
Physician Employment Agreements (PEAs) and Asset
Purchase Agreements (APAs)
The concluding steps of the affiliation of the UHMG
physicians with Sutter Health were effected during the latter
half of October 1994 and consisted of the purchase of a share of
SWMG's stock by each affiliating physician (including
petitioners) coupled with his or her execution, effective
November 1, 1994, of a Physician Employment Agreement (PEA) with
SWMG and an Asset Purchase Agreement (APA) with SMF.
SMF's
obligation to purchase, and each affiliating physician's
obligation to sell, his or her medical practice pursuant to an
APA was preconditioned upon the physician's having become a
shareholder and employee of SWMG, and the PSA between SWMG and
SMF having become effective.
As noted, a precondition to the PSA's becoming effective was
the requirement that at least 25 of the UHMG physicians become
shareholders of SWMG.
This had occurred by the end of October
- 25 1994, by which time 36 UHMG physicians had done so.
Accordingly,
the SWMG shareholder physicians sold their practices pursuant to
the APAs and became employees of SWMG pursuant to the PEAs, on
November 1, 1994.
The PEAs between SWMG and the affiliating physicians,
including petitioners, were substantially identical except for
the compensation and benefit amounts to be paid to the physicians
under the agreements, and were effective November 1, 1994, for a
term of 1 year, renewable annually.
Each petitioner agreed to
practice medicine full time and exclusively for SWMG (except for
reasonable amounts of unpaid volunteer work) and to provide
medical services solely to SMF and its group practice patients.
SWMG was given "the exclusive right to allocate patients among
its employees with due regard to the source of the patients, the
patient's preference with respect to choice of physicians, the
specialty and skills of its employees, and their workload";
however, SMF was given "final authority over acceptance or
refusal of any patient".
The PEAs provided that persons treated
by physicians pursuant to the agreement were patients of SMF and
that SMF was solely entitled to all fees for the services
rendered by the physicians.
Upon the termination of a
physician's employment under the PEA, the physician was not
entitled to take or use any confidential or proprietary
- 26 information of SWMG, including "patient lists" and "patient
medical records".
The PEAs provided in addition that
the Physician shall not use any information obtained in
the course of his or her employment with * * * [SWMG]
for the purpose of notifying patients of * * * [SWMG]
of the termination of his or her employment, or of his
or her willingness to provide medical services;
provided, however, the departing Physician may give
written notice to the Departing Physician's patients
named in the Departing Physician's patient list
furnished to SMF on or before the [November 1, 1994]
Effective Date [of the PEA], announcing the Departing
Physician's separation from * * * SWMG and his or her
new practice location, and offering the patient an
opportunity to choose whether his or her patient
records should remain with SMF or be transferred to the
Departing Physician.
We shall hereinafter refer to the foregoing patient notification
right, together with the PSA's exemption from its noncompete
provision for SWMG physicians who ceased employment with SWMG, as
the free-to-compete provision.
Each affiliating UHMG physician (or partnership), including
petitioners, agreed to sell his/her (or its) medical practice
assets to SMF pursuant to an APA.
Although each seller entered
into a separate APA with SMF, the APAs were virtually identical.19
Pursuant to article 1 of those agreements, SMF agreed to purchase
from each seller "all of the fixtures and personal property of
every kind and description, whether tangible or intangible and
wherever located, * * * used in the operation of [the seller's]
business."
19
Those assets included the seller's fixed assets
The APAs were prepared from master agreements that were
customized for each seller.
- 27 (equipment, furniture, fixtures), inventory and supplies, records
(excluding patient records), licenses and permits to the extent
transferrable under applicable law, and any intangibles which
were part of the seller's medical practice.
Each seller retained
his/her (or its) cash and accounts receivable.
Each seller was
given "an equal and joint ownership interest" with SMF "in all
patient lists and patient medical records used in [the seller's
business]".
SMF agreed to assume contractual and lease
liabilities.
Article 1.04 of each APA provided:
Seller and Buyer believe that the purchase price
of the Assets is less than their fair market value.
The difference between the purchase price and the fair
market value of the Assets is referred to as the
"contribution". At the closing, Seller will
irrevocably and unconditionally donate the Contribution
to Buyer to be used in furtherance of its charitable
purposes. If Seller chooses to claim a charitable
contribution deduction for the Contribution, then,
subject to the following conditions, Buyer, upon the
written request of Seller, agrees to acknowledge
receipt of the contributed property by executing Part
IV (Donee Acknowledgment) of a properly completed IRS
Form 8283 (Noncash Charitable Contribution) supplied by
Seller: (a) Seller must obtain from a duly qualified
independent third-party appraiser an appraisal (the
"Appraisal") of the value of the Seller's Business that
complies with the standards of Rev. Rul. 59-60,
including its later modification and amplifications;
(b) the Appraisal must be made as of a date no more
than sixty (60) days prior to the Closing Date (as
defined in Section 7.01); (c) the claimed fair market
value of Seller's charitable contribution must not
exceed the Contribution, as determined by the
Appraisal.
- 28 The APA further provided that each seller was required "to
use Seller's best efforts * * * to preserve Seller's present
business relationship with suppliers, patients and others having
business relationships with Seller" and "to cooperate with * * *
[SMF's] attempts to retain the services of the employees of
Seller's Business following the Closing to the extent that * * *
[SMF] decides to attempt to employ any such employees."
4.
Houlihan and Narvco Appraisals
Houlihan issued its appraisal (Houlihan appraisal) on April
7, 1995.20
The Houlihan appraisal described SWMG as "a newly
formed group of thirty-eight physicians who have practiced in the
City of Davis for many years."
Using a discounted cashflow
approach, the Houlihan appraisal concluded that, "as of November
1, 1994 and currently, the fair market value of the fixed and
intangible assets, excluding working capital, of * * * [SWMG] is
reasonably stated as $4 million."
The tangible assets of the affiliating physicians' practices
were valued separately by Narvco Enterprises, Inc. (Narvco).
The
standard used by Narvco in valuing the tangible assets, namely,
"value in use", was directed by SMF and the SWMG physicians after
they had agreed that it was appropriate.
20
Under the APAs, each
Respondent contends, and we agree, that the Houlihan
appraisal is hearsay. It was not offered as an expert report
under Rule 143(f). Nonetheless, it was the appraisal relied on
by petitioners in the 1994 returns, and it is relevant for
various nonhearsay purposes.
- 29 SWMG physician received payment for the tangible assets of his or
her medical practice equal to the appraised value determined by
Narvco.
The aggregate amount paid by SMF for the tangible assets
of the SWMG physicians' practices was $1,156,733.
5.
Allocation of Value of Intangibles
SWMG entered into a further retainer agreement with Houlihan
on June 14, 1995, pursuant to which Houlihan would provide an
opinion "with respect to the appropriateness of the allocation of
the intangible value [of SWMG] among the individual shareholders
of SWMG pursuant to * * * the Asset Purchase Agreement [APA]
between SWMG and Sutter Health."
record.
No such opinion is in the
Earlier, in an October 11, 1994, letter, Houlihan had
advised Dr. Silva (chairman of the SWMG steering committee) that
an allocation could be made upon one, or a combination, of the
following three methods:
On the basis of each physician's
contribution to revenue, on the basis of each physician's
contribution to income, or on the basis of each physician's
roster of active patients.
The formula for allocating each SWMG physician's
proportionate share of the estimated intangible value of SWMG was
devised, however, not by Houlihan but by one of petitioners;
namely, Dr. Levin.
Dr. Levin described his allocation, to be
used by each SWMG physician for purposes of calculating his or
her charitable contribution deduction arising from the "bargain
- 30 sale" of his or her medical practice to SMF, in a July 11, 1995,
letter.
Dr. Levin calculated that the aggregate value of the
intangible assets that had been "contributed" by the SWMG
physicians to SMF was equal to the "business enterprise
valuation" of SWMG as determined by Houlihan ($4 million), less
the aggregate value of the amount paid by SMF to the SWMG
physicians for the fixed assets of their practices, as determined
by Narvco ($1,156,733), less the aggregate accounts receivable
estimated to be collectible by the SWMG physicians as of November
1, 1994 (the transfer date) ($1,210,890).
The residual
($1,632,377) was assumed to represent "the value of the
intangible donation to * * * [SMF]."
This aggregate value was
then allocated among the 29 SWMG physicians who sold their
medical practices to SMF, pursuant to a formula devised by Dr.
Levin.
That formula allocated (i) 50 percent of the aggregate
value on the basis of each physician's share of gross revenues
generated in the year preceding the transfer to SMF; (ii) 25
percent on the basis of each physician's "years in the
community", with up to a maximum of 5 years being counted; and
(iii) 25 percent on the basis of each physician's share of the
aggregate fixed assets transferred to SMF by the SWMG physicians.
V.
Petitioners' and SMF's 1994 Returns
On their 1994 returns, petitioners claimed charitable
contribution deductions for the transfer to SMF of the intangible
- 31 assets associated with their medical practices in amounts
consistent with Dr. Levin's allocations, as follows:
Docket No.
Petitioner
10930-02
10931-02
10932-02
10933-02
10934-02
10935-02
10936-02
10937-02
10939-02
10941-02
10942-02
10943-02
10945-02
Derby
Droubay
Eusebio
Harris
Hirsch
Smith-Hoefer
Kennedy
Levin
Smith-MacLean
Patterson
Silva
Women's Health Assoc.
Watts-White
Deduction
Claimed
1
$65,006
73,592
35,978
38,839
28,619
81,769
2
40,884
104,255
47,427
83,405
76,045
3
162,926
40,475
1
Because the charitable contribution deduction claimed
on Schedule A, Itemized Deductions, of the Derbys' 1994
return ($8,913 in cash contributions plus the $65,006
noncash portion at issue in this case) exceeded 50
percent of adjusted gross income, the Derbys' 1994
charitable contribution deduction was limited to
$60,212. Respondent denied a deduction for "any amount
in excess of $8913" and increased the Derbys' income by
$51,409, although it appears that the deduction
disallowance should not have exceeded $51,299 (the
difference between $60,212 and $8,913).
2
3
Claimed on an amended return.
This is the aggregate amount of the charitable contribution
deduction related to the SMF transaction that the
partnership allocated to the two partners (Dr. Schimmel
($77,277); and Dr. Conrad-Forest ($85,699)) on the
partnership return. The Forms 8283 provided for each
partner list a charitable contribution deduction of $96,896
for each. There is no evidence in the record that accounts
for the discrepancy.
- 32 Attached to each petitioner's 1994 return was a Form 8283,
Noncash Charitable Contributions, in support of the charitable
contribution deduction claimed for the transfer of intangible
assets to SMF.
Part III, Certification of Appraiser, of Section
B of the Form 8283 was executed by Houlihan and dated April 7,
1995, the date of the Houlihan appraisal.
Part IV, Donee
Acknowledgment, of Section B of the Form 8283 was executed on
behalf of SMF by Karl Silberstein, "VP", and dated July 18, 1995.
On its 1994 return, Form 990, Return of Organization Exempt
From Income Tax, SMF did not report as contributions received any
donations of intangible assets or goodwill from petitioners or
any other SWMG physician.
VI.
Dutcher Appraisal
After respondent commenced an examination of petitioners'
1994 returns, petitioners' counsel in this case retained another
appraiser, Ernest E. Dutcher, managing member of National
Business Appraisers, L.L.C., to "independently determine the
market value of the intangible assets of SWMG as of * * *
November 1, 1994, assuming a sale to a qualified buyer who could
either be a for-profit entity or a 501(c)(3) corporation."
Mr.
Dutcher's appraisal (Dutcher appraisal) postulated that the value
of the aggregate intangibles of the SWMG physicians was equal to
- 33 SWMG's "business enterprise value" less SWMG's (i)"implied
working capital" and (ii) fixed assets.21
Mr. Dutcher derived the business enterprise value of SWMG by
taking the weighted average of what he computed to be SWMG's
value based on an income method (50 percent), an asset method (40
percent), and a market method (10 percent).
The income value was
based upon a discounted future distributable earnings approach
whereby an estimate of SWMG physicians' aggregate revenues for
199422 was projected forward, and the future after-tax
distributable earnings then discounted to present value,
producing a business enterprise value on November 1, 1994, of
$4,112,500.
In calculating what SWMG's future distributable
earnings would be, Mr. Dutcher assumed that the expense of
physician compensation would equal the national median for the
21
The Dutcher appraisal treated the fixed assets of SWMG as
equal to the fixed assets of the medical practices of each of the
SWMG physicians (or partnership) who transferred his or her (or
its) practice to SMF.
22
SWMG did not exist as an operating entity until Nov. 1,
1994. Mr. Dutcher treated as SWMG's 1994 revenues the estimated
1994 aggregate revenues of the 29 UHMG physicians who transferred
their practices to SMF, plus the 1994 revenues of 5 of the 7
"hired" physicians in SWMG who did not have ownership interests
in a medical practice when the affiliation with SMF consummated.
- 34 "Western Region"23 for a weighted average of the medical
specialties comprising SWMG, or 45.18 percent.
The asset value was based upon a capitalization of excess
earnings approach.
In making his computations under the excess
earnings approach, Mr. Dutcher used the Narvco appraised value of
the tangible assets of the medical practices of the UHMG
physicians who transferred their practices to SMG (namely,
$1,156,733), as the value of SWMG's fixed assets.
Mr. Dutcher's
estimate of the business enterprise value of SWMG computed under
the excess earnings approach was $4,061,400.
Finally, Mr. Dutcher used a market approach whereby he
derived a business enterprise value for SWMG based on a
comparison with price/earnings ratios of publicly traded health
care companies, with a 23.1-percent discount for SWMG's smaller
size, a 35-percent premium reflecting control, and a discount for
lack of marketability of 10 percent, resulting in an indicated
value of $4,076,400.
Weighting the three values in the manner
previously noted produced a business enterprise value of
$4,088,450.
As noted, Mr. Dutcher treated the value of SWMG's intangible
assets as SWMG's business enterprise value ($4,088,450), less (i)
23
Mr. Dutcher's figures were taken from a "Physician
Compensation Survey", based on data from a report by the Center
for Research in Ambulatory Health Care Administration, "Physician
Compensation and Production Survey: 1994 Report Based on 1993
Data".
- 35 "implied working capital" (estimated as 4 percent of net revenue,
in accordance with industry standards, or $416,46224) and (ii)
fixed assets (Narvco's $1,156,733 appraised value), producing an
estimated value for SWMG's intangible assets of $2,515,255.
Mr.
Dutcher further opined that SWMG's intangible value represented a
"bundle" of intangible assets, including "assembled workforce,
patient records, provider contracts, trademarks and tradename,
and practice goodwill".25
For purpose of allocating the $2,515,255 value for SWMG's
intangible assets to the 29 SWMG physicians, Mr. Dutcher simply
adopted the same formula devised by Dr. Levin.
The Dutcher
appraisal offered no analysis of the appropriateness of Dr.
Levin's formula.
The business enterprise value of SWMG as estimated in the
Houlihan and Dutcher appraisals differed by only 2 percent
24
In Mr. Dutcher's view, substituting an amount for
"implied working capital", based on industry standards, instead
of measuring actual current assets and liabilities, provided a
more accurate measure of the business enterprise value of a going
concern, since the level of current assets and liabilities
fluctuates greatly.
25
In Mr. Dutcher's view, the goodwill of a medical or other
professional practice consists of "practice goodwill", which is
associated with the entity, and "professional goodwill", which is
associated with the individual. According to Mr. Dutcher, the
practice goodwill of a medical practice generally consists of
such items of value as patient records, provider contracts,
assembled workforce, trademarks and tradenames, and going concern
value. Professional goodwill, in his view, "results from the
charisma, knowledge, skill, and reputation of a specific
practitioner", is not transferable, and has no economic value.
- 36 ($4,000,000 and $4,088,450, respectively).
However, the
aggregate value of SWMG's intangible assets estimated by the
Dutcher appraisal ($2,515,255) differed markedly from the amount
postulated by Dr. Levin through the use of his formula
($1,632,377).
Since the Dutcher appraisal and Dr. Levin's
formula both started with substantially the same figure for
SWMG's business enterprise value, and both subtracted an
identical figure for fixed assets ($1,156,733), the marked
difference in their outcomes is attributable to the fact that Dr.
Levin believed that the SWMG physicians' accounts receivable
($1,210,890 as of November 1, 1994) also needed to be subtracted
(and that no adjustment needed to be made for working capital),
whereas the Dutcher appraisal postulated that all current assets
and liabilities (i.e., including accounts receivable) were best
accounted for by subtracting an amount for implied working
capital, which was estimated as $416,462.
The difference between
the Dutcher appraisal's working capital figure and Dr. Levin's
accounts receivable figure, when added to the approximately 2percent difference in the Dutcher and Houlihan estimates of
SWMG's business enterprise value, accounts for the discrepancy in
the estimates of SWMG's aggregate intangible value by Dr. Levin
and the Dutcher appraisal.
In his appraisal, Mr. Dutcher also asserted that "it is my
opinion the physician compensation offered SWMG shareholders by
- 37 Sutter had no market value beyond the value of their professional
medical services".
The Dutcher appraisal contains no further
discussion or analysis purporting to support this proposition.
The Dutcher appraisal does, however, contain a "Physician
Compensation Survey", which sets forth the national median ratios
(for the "Western Region") of physician compensation to net
revenues for listed medical specialties.
Using a weighted
average of those published ratios, the Dutcher appraisal's
Physician Compensation Survey shows that the weighted average of
the national median ratios of "compensation to revenue" for the
specialties mix of the SWMG physicians was 45.18 percent.
As
previously noted, the PSA entered into between SWMG and SMF
provided for compensation to SWMG equal to 57.75 percent of feefor-service revenue, 47 to 53 percent of capitation revenue, and
at least 55 percent of risk pool revenue.
VII.
Issues Related to Specific Petitioners
A.
The Kennedys
On Schedule C of the Kennedys' 1994 return, they reported
$195,709 of gross receipts from Dr. Kennedy's medical practice.
The notice of deficiency issued to the Kennedys increased
reported Schedule C gross receipts by $3,760 to $199,469.
B.
The Derbys
On Schedule E, Supplemental Income and Loss, Part II, Income
or Loss From Partnerships and S Corporations, of the Derbys' 1994
- 38 return, they reported $4,209 of nonpassive income from Schedule
K-1, Shareholder's Share of Income, Credits, Deductions, etc.,
attached to the 1994 Form 1120S, U.S. Income Tax Return for an S
Corporation, filed by Dr. Derby's wholly owned professional
corporation, Charles A. Derby, M.D., Inc.
The referenced
Schedule K-1 states that Dr. Derby's share of his S corporation's
1994 ordinary income from business activities was $7,874.
The
notice of deficiency issued to the Derbys increased their 1994
income by $3,665, the difference between the foregoing figures on
the Schedules K-1 and E.
OPINION
I.
Petitioners' Entitlement to Charitable Contribution
Deductions for Their Transfers of Intangible Assets to SMF
A.
Transfer Without Adequate Consideration
Petitioners contend that as part of the transfer of their
medical practices to SMF they each made a charitable contribution
to that entity of the intangible assets of the practices.
Respondent determined that the deductions petitioners claimed on
account of the charitable contributions are not allowable, and we
must decide the extent, if any, to which they may be deducted.
Petitioners bear the burden of proving their entitlement to those
deductions.
See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial
- 39 Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); see also Rule
142(a)(1).26
Section 170(a) generally allows a taxpayer a deduction for
any charitable contribution, as defined in section 170(c), made
during the taxable year.
Section 170(c) defines the term
"charitable contribution" as "a contribution or gift" to or for
the use of certain specified organizations.
Respondent has not
disputed that SMF was a qualified recipient of a charitable
contribution as required by section 170(c).
If a charitable contribution is made in property other than
money, the amount of the contribution is generally the fair
market value of the property at the time of the contribution.
Sec. 1.170A-1(c)(1), Income Tax Regs.
"[F]air market value" for
this purpose "is the price at which the property would change
hands between a willing buyer and a willing seller, neither being
under any compulsion to buy or sell and both having reasonable
knowledge of relevant facts."
Regs.
Sec. 1.170A-1(c)(2), Income Tax
A charitable contribution is allowable as a deduction only
if verified under regulations prescribed by the Secretary, sec.
170(a)(1), including certain substantiation requirements provided
in section 1.170A-13(c)(2), Income Tax Regs.
In addition, no
deduction for any contribution in excess of $250 is allowed
26
Petitioners concede that sec. 7491(a) does not apply in
this proceeding.
- 40 unless the taxpayer substantiates it by a contemporaneous written
acknowledgment by the donee organization.
Sec. 170(f)(8).
The question of what constitutes a "contribution or gift"
for purposes of section 170 has been the subject of considerable
caselaw.
Some 5 years before the transaction at issue in this
case, the Supreme Court provided the following guidance:
The legislative history of the "contribution or
gift" limitation [of section 170], though sparse,
reveals that Congress intended to differentiate between
unrequited payments to qualified recipients and
payments made to such recipients in return for goods or
services. Only the former were deemed deductible. The
House and Senate Reports on the 1954 tax bill, for
example, both define "gifts" as payments "made with no
expectation of a financial return commensurate with the
amount of the gift." * * * Using payments to hospitals
as an example, both Reports state that the gift
characterization should not apply to "a payment by an
individual to a hospital in consideration of a binding
obligation to provide medical treatment for the
individual's employees. It would apply only if there
were no expectation of any quid pro quo from the
hospital." * * * [Hernandez v. Commissioner, 490 U.S.
680, 690 (1989); citations omitted.]
Thus, "A payment of money [or transfer of property] generally
cannot constitute a charitable contribution if the contributor
expects a substantial benefit in return."
United States v. Am.
Bar Endowment, 477 U.S. 105, 116 (1986); see also Transamerica
Corp. v. United States, 902 F.2d 1540, 1543 (Fed. Cir. 1990);
Singer Co. v. United States, 196 Ct. Cl. 90, 449 F.2d 413 (1971)
(sewing machine manufacturer not entitled to charitable
contribution deduction for sale of sewing machines to public
schools at discount, given the expectation that students' use
- 41 would result in future increases in sales); Murphy v.
Commissioner, 54 T.C. 249, 254 (1970) (no charitable contribution
deduction for payment to effect adoption of child).
The Supreme Court has further instructed that in
ascertaining whether a given payment or property transfer was
made with the expectation of any return benefit or quid pro quo,
we are to examine the external, structural features of the
transaction, which obviates the need for imprecise inquiries into
the motivations of individual taxpayers.
Commissioner, supra at 690-691.
Hernandez v.
In Hernandez, where the Supreme
Court found a lack of donative intent in the taxpayers' payments
to the Church of Scientology for certain "auditing" and training
sessions, the external features cited by the Court included the
church's establishment of fixed price schedules for the sessions,
calibrated to length and level of sophistication; the provision
of refunds if session services went unperformed; and the
categorical prohibition on providing the sessions for free.
These external features revealed the "inherently reciprocal
nature of the exchange" involving the payments and the services
provided by the church.
A taxpayer who receives or expects to
receive a benefit in return for a purported contribution may
nonetheless be allowed a deduction if the money or property
transferred clearly exceeds the benefit received and the excess
is given with the intent to make a gift.
- 42 Where the size of the payment is clearly out of
proportion to the benefit received, it would not serve
the purposes of §170 to deny a deduction altogether. A
taxpayer may therefore claim a deduction for the
difference between a payment to a charitable
organization and the market value of the benefit
received in return, on the theory that the payment has
the "dual character" of a purchase and a contribution.
See, e.g., Rev. Rul. 67-246, 1967-2 Cum. Bull. 104
(price of ticket to charity ball deductible to extent it
exceeds market value of admission) * * * . [United
States v. Am. Bar Endowment, supra at 117.]
A taxpayer claiming a charitable contribution deduction under the
"dual character" theory, however, "must at a minimum demonstrate
that he purposely contributed money or property in excess of the
value of any benefit he received in return."
Id. at 118; see also
Sklar v. Commissioner, 282 F.3d 610, 621-622 (9th Cir. 2002),
affg. T.C. Memo. 2000-118.
Petitioners argue that they transferred their medical
practices to SMF, a section 501(c)(3) organization, in a
transaction in which they agreed to accept a cash payment equal to
the value of the tangible assets of their respective practices and
no consideration for the intangible assets, because a payment for
goodwill would have violated Federal law.
Because they received
no consideration for the intangible assets, they made a
contribution thereof with the requisite donative intent,
petitioners contend.
In petitioners' view, the value of that
contribution is equal to each petitioner's allocable share of the
fair market value of the intangible assets of the medical group,
SWMG, formed when the transfers were made (as estimated by expert
- 43 appraisal).
The allocation to each petitioner of a share of the
value of the intangible assets of the newly-formed medical group,
though performed by a nonexpert (Dr. Levin, one of petitioners),
was reasonable, petitioners argue, and was ratified by expert
opinion.
In addition, petitioners argue, the Commissioner
indicated in a determination letter and in certain training
manuals that a charitable contribution deduction was available in
similar circumstances for the transfer of medical practice
intangible assets in connection with the acquisition of a group
medical practice by a section 501(c)(3) organization.
Consequently, petitioners contend, respondent has a duty of
consistency with the foregoing in his litigating position in this
case.
Respondent disputes all of petitioners' arguments.
Respondent contends that petitioners have failed to show that the
value of the assets they transferred to SMF, including any
intangible assets of their medical practices, exceeded the values
of the consideration each received in exchange therefor.
Consequently, respondent argues, petitioners have failed to
satisfy the test outlined in United States v. Am. Bar Endowment,
supra.
Respondent further argues, relying on United States v. Am.
Bar Endowment, supra, and Hernandez v. Commissioner, supra, that
petitioners lacked donative intent in light of the substantial
benefits that they expected to, and did in fact, receive in return
- 44 for the transfers of their medical practice intangibles.
Respondent also takes issue with numerous aspects of the valuation
of the intangible assets purportedly transferred by petitioners to
SMF.
Finally, respondent argues that petitioners have failed to
satisfy the substantiation requirements of section 1.170A-13,
Income Tax Regs., and section 170(f)(8).
We agree that petitioners have failed to satisfy the
requirements for a charitable contribution deduction.
While
petitioners seek to characterize the transaction between
themselves and SMF as the sale of the tangible assets of their
medical practices for cash equal to their value, coupled with the
transfer of their medical practice intangibles to SMF for no
consideration, that characterization ignores a significant
additional element of consideration they received; namely, future
employment with SMF on carefully delineated terms.
The agreements
securing the terms of petitioners' future employment (i.e., the
PSA between SWMG and SMF, and the PEAs between SWMG and each SWMG
physician) were integral to and legally interdependent with the
agreements under which petitioners transferred their medical
practice assets to SMF (i.e, the APAs).
agreements was contingent upon the other.
Each of the foregoing
Thus, the transfer of
petitioners' intangible assets to SMF was part of an integrated
transaction in which petitioners also agreed to provide future
services (through SWMG) and transfer tangible assets to SMF in
- 45 exchange for SMF's agreement to pay them cash and to employ them
(through SWMG27) pursuant to specified terms.
The transaction had an "inherently reciprocal nature".
Hernandez v. Commissioner, 490 U.S. at 692.
The record
demonstrates that Sutter Health clearly wanted the SWMG
physicians' intangible assets, a significant portion of which
consisted in their patient roster and the expectation of continued
patronage from those patients.28
Sutter was engaged in a strategy
of expansion into the Davis area by means of acquiring existing
medical practices to become part of an integrated delivery system
with its hospitals.
Sutter also had a nearly completed hospital
in Davis for which it needed to ensure an adequate patient base.
Another portion of petitioners' goodwill, their established
reputation as efficient, cost-effective practitioners, increased
their desirability to Sutter.
The negotiations over the terms of
the acquisition transactions were protracted and sometimes
27
Under the integrated and legally interdependent
agreements, petitioners were obligated to form SWMG and to enter
into contracts to provide their medical services exclusively to
SWMG under stated terms, and SMF was obligated to contract with
SWMG for the medical services provided by petitioners and the
other SWMG physicians. The obligation of SMF to purchase, and
petitioners' obligation to sell, the tangible and intangible
assets of their medical practices was contingent on the
foregoing.
28
We note that the PSA provided that once the transaction
was consummated, all patients treated by the SWMG physicians were
deemed to be the patients of SMF (subject to the physicians'
rights to reclaim patients under the "free to compete"
provision). In addition, the APA obligated the SWMG physicians
to use their best efforts to retain existing patients.
- 46 acrimonious, according to the testimony of participants.
It is
clear from this testimony that the SWMG physicians negotiated
aggressively for the best terms they could get.
The intensity of
the negotiations is reflected in the written agreements, which
were amended late in the discussions to increase the percentages
of net revenue that were to be paid to the SWMG physicians for
given categories of revenue.
Significantly, an official of SMF
who participated in the negotiations testified that SMF not only
"could not" pay anything for the SWMG physicians' intangibles but
"would not", explaining that SMF's refusal to pay any cash for the
intangibles was based both on the possible legal proscriptions and
on SMF's unwillingness to pay anything for the intangibles
because, according to SMF's financial projections, to do so would
render the transaction financially infeasible for SMF.
In sum,
the SWMG physicians extracted from SMF all that SMF believed it
could provide if the affiliation with the physicians were to
remain economically viable.
The consideration received in the transaction by petitioners
and the other SWMG physicians included:
(1) Employment, with
compensation to their medical group set at a minimum of 47 to
57.75 percent of net revenues with a guaranteed floor, (2) a
$35,000 "Physician Access Bonus" for each physician, (3) rights to
participate in the management of SMF; (4) greater professional
autonomy than was perceived to be available from other potential
- 47 acquirers of their medical practices; and (5) rather than a
noncompete agreement, the "free to compete" provision, which
secured for each petitioner the express right, upon his or her
termination of employment with SWMG/SMF, to have his or her
patients as of the date of affiliation with SMF notified of the
departure and given the option of having the patient's medical
records transferred to the departing physician.
In addition, when
petitioners' circumstances before the transaction are considered,
a second tier of benefits they secured in the transaction with SMF
becomes apparent.
First, petitioners solved their core economic
problem arising from the advent of managed care; namely, the risk
of loss from having patients requiring extraordinary care.
After
the transaction, by virtue of the minimum compensation guaranties,
this risk was largely transferred to SMF, which could better
manage it given SMF's greater patient population and resources.
Second, as a result of their affiliation with a relatively large
health care organization, petitioners secured the benefits of
greater leverage in negotiating contracts with HMO's and greater
efficiencies in providing care, with any resulting enhancement in
revenues inuring to their benefit by virtue of SWMG's compensation
being determined as a percentage of net revenues.
In sum, by
transferring their practices to SMF in the transaction at issue,
petitioners ensured for themselves the continued ability to
maintain or improve their accustomed level of earnings from the
- 48 practice of medicine-– something they had concluded was not likely
to be possible had they continued to maintain solo or small group
practices.
The linchpin of petitioners' claim of entitlement to a
charitable contribution deduction is their argument that none of
the foregoing consideration was received in exchange for the
intangible assets of their medical practices, which consisted
essentially of goodwill or going concern value.
Petitioners
contend that they received no consideration for their goodwill
from SMF because any payment for goodwill by SMF was proscribed by
law.
Clearly none of the consideration from SMF was denominated
as a direct payment for the intangible assets of petitioners'
medical practices.
However, given the integrated nature of the
transaction, Sutter Health's desire to obtain petitioners' patient
roster and other goodwill, and the intensity of the negotiations,
we are persuaded that petitioners' intangible assets functioned as
leverage in the negotiations and that their transfer to SMF
resulted in an increase in the total consideration petitioners
received in the transaction.
Thus, the claim that petitioners
received no consideration for their intangible assets is
contradicted by the substantive evidence.29
29
We are aware that the parties to the transaction went to
some lengths in the APAs to memorialize that each SWMG physician
as seller and SMF as buyer "believed" that the purchase price for
the medical practice assets was less than their fair market value
and that the seller was therefore donating to the buyer the
(continued...)
- 49 Since petitioners received consideration for their
intangibles, their charitable contribution deductions fail unless
they can show, pursuant to the theory approved in United States v.
Am. Bar Endowment, 477 U.S. 105 (1986), that the transfer of their
intangibles to SMF had a "dual character" as both a transfer for
consideration30 and a contribution.
To do so, however, petitioners
"must at a minimum demonstrate that * * * [they] purposely
contributed money or property in excess of the value of any
benefit * * * [they] received in return."
Id. at 118; see also
Sklar v. Commissioner, 282 F.3d at 620-622.
Petitioners have not shown that the value of what they
transferred to SMF exceeded the value of the benefits they
received in return.
As noted above, those benefits included, in
29
(...continued)
excess of fair market value over the (purported) purchase price.
In our view, this provision is a self-serving attempt to support
the claim for a charitable deduction contribution. As discussed
hereinafter, the SWMG physicians received many other kinds of
consideration in connection with the integrated transaction. The
effort in the APAs to allocate any consideration away from the
intangible assets was self-serving for the SWMG physicians and a
matter of indifference for SMF. Notably, notwithstanding the
APAs' characterization of a contribution of intangible assets,
SMF did not report the receipt of any such contributions on its
Form 990 for 1994.
30
United States v. Am. Bar Endowment, 477 U.S. 105 (1986),
and the revenue ruling therein approved by the Supreme Court
(Rev. Rul. 67-246, 1967-2 C.B. 104) both involved transfers of
cash for goods or services that purportedly had dual characters
as purchases and contributions. The same principle applies,
however, to a transfer of property for consideration, see, e.g.,
Transamerica Corp. v. United States, 902 F.2d 1540, 1543-1546
(Fed. Cir. 1990), such as the transfer of the assets of
petitioners' medical practices at issue.
- 50 the first instance, employment that was compensated with shares of
revenue (47 to 57.75 percent) that significantly exceeded the
median share of revenue (45.18 percent) devoted to physician
compensation in petitioners' specialties; a $35,000 "Physician
Access Bonus" for each SWMG physician, including petitioners;31 an
absence of restrictions on establishing a competing medical
practice in the event of cessation of employment with SMF; and
greater economic security in the managed care environment.
31
Other
Petitioners strenuously argue that the "Physician Access
Bonuses" were consideration for the SWMG physicians' agreement to
maintain "open" practices; i.e., to accept new patients
notwithstanding existing patient loads. Accordingly, petitioners
contend, the "Physician Access Bonuses" could not have served as
consideration for the SWMG physicians' transfer of their medical
practice intangibles.
Petitioners' argument is unpersuasive. As with petitioners'
broader claim that no consideration was paid for their intangible
assets, the argument depends upon segregating elements of
consideration that were part of an integrated, and intensely
negotiated, agreement. The extensive and otherwise detailed
written agreements governing the transaction with SMF do not
mention any open practice requirement. Even if the transaction
documents had expressly allocated the $35,000 bonuses to the
physicians' agreements to maintain open practices, we would
remain unpersuaded, because there is no evidence in the record
that a $35,000 payment was customary for a physician-employee's
agreement to maintain an open practice. In fact, one SMF
official who testified conceded that no such bonuses had been
paid to other physician groups that affiliated with SMF, and the
Dutcher appraisal does not address the bonuses. Tellingly, when
the PSA was renegotiated to cover the period after its initial 2year term, there was no comparable provision for "Physician
Access Bonuses" to secure the SWMG physicians' open practice
commitments. After respondent noted this apparent inconsistency
on brief, petitioners offered no explanation to account for it.
Consequently, we find that the $35,000 "Physician Access Bonuses"
are not fully allocable to open practice agreements and instead
were part of the consideration package received by the SWMG
physicians in exchange for the transfer of their medical
practices.
- 51 benefits received included greater professional autonomy than was
perceived to be available from competing acquirers and a role in
management.
Petitioners rely on the Dutcher appraisal to establish that
they contributed property worth more that any benefits received in
return.32
Petitioners' position is that they transferred property
with a value in excess of what they received back from SMF because
the Dutcher appraisal estimated the value of their intangible
assets at $2,515,255,33 whereas they received back from SMF only a
$1,156,733 payment in the aggregate.
There are a number of
problems in the Dutcher appraisal's estimate of the fair market
value of SWMG's intangible assets and each petitioner's allocable
share thereof.34
However, even if it is assumed for argument's sake
32
Although petitioners used the Houlihan appraisal, coupled
with Dr. Levin's allocation formula, for purposes of claiming on
their returns the deductions at issue, they abandoned the
Houlihan appraisal for purposes of trial and rely instead on the
Dutcher appraisal, prepared for them after respondent commenced
examinations of the returns.
33
The Dutcher appraisal treats as the value of each
petitioner's intangible assets an allocable share of the value of
the intangible assets of SWMG, a medical group petitioners formed
simultaneously with the consummation of the transaction with SMF,
as required by the terms of the transaction. Respondent argues
that because SWMG did not exist before the transaction,
petitioners could not have transferred any portion of SWMG's
intangible value to SMF as part of the transaction. We find it
unnecessary to resolve this issue for purposes of deciding
whether petitioners are entitled to the charitable contribution
deductions claimed.
34
Some of the more salient problems with the Dutcher
appraisal include:
(continued...)
- 52 -
34
(...continued)
(1) There is no allocation of any value to the professional
goodwill of the SWMG physicians. Mr. Dutcher distinguishes, in
the case of the goodwill of a professional practice, between
"practice" goodwill and "professional" goodwill, the former
attributable to characteristics of the practice entity such as
patient records, provider contracts, and workforce in place; and
the latter attributable to the personal attributes of the
individual practitioner, such as charisma, skill, and reputation.
Mr. Dutcher further acknowledges that professional goodwill is
not transferable. The intangible asset value attributed by Mr.
Dutcher to SWMG was derived to a substantial degree from the
discounted present value of the distributable earnings stream
that would be generated by the SWMG physicians in the 5 years
after the affiliation with SMF. (That is, Mr. Dutcher treated
the value of SWMG's intangible assets as equal to the present
value of its future distributable earnings, less implied working
capital and tangible assets.) Yet those distributable earnings
were undoubtedly generated in part by patients who continued to
see a physician because of that physician's charisma, skill,
and/or reputation--his or her professional goodwill. Several
petitioners testified that they understood the goodwill that they
transferred to SMF to consist of the foregoing elements. We
believe that some portion of the earnings from which Mr. Dutcher
derived his intangible value estimate were generated as a result
of professional goodwill. However, Mr. Dutcher made no
adjustment to his intangible value estimate to account for any
portion attributable to the professional goodwill that he
concedes is nontransferable. To that extent, his estimate of
value of the intangible assets transferred by the SWMG physicians
to SMF is inflated and unreliable.
(2) There is no adjustment for the fact that the SWMG
physicians were not required to execute noncompete agreements.
Mr. Dutcher treated each SWMG physician as transferring an
allocable share of SWMG's intangibles, including goodwill, which
was not treated as diminished in any way by the physicians' not
having executed noncompete agreements with respect to SWMG or
SMF. However, in Norwalk v. Commissioner, T.C. Memo. 1998-279,
we found that there is no transferable or salable goodwill where
a company's business depends on its employees' personal
relationships with clients and the employees have not provided
covenants not to compete. We acknowledged, distinguishing
Schilbach v. Commissioner, T.C. Memo. 1991-556, that some of the
goodwill of a medical practice is inherent in the operating
(continued...)
- 53 that each petitioner transferred intangible assets with some value
to SMF, petitioners would still have failed to show that the value
of what they transferred exceeded the value of what they received
in return.
As previously outlined, the consideration petitioners
34
(...continued)
entity. Norwalk v. Commissioner, supra. We also believe that,
under the willing buyer/willing seller standard of fair market
value enunciated in Rev. Proc. 59-60, 1959-1 C.B. 237, to which
Mr. Dutcher purportedly adhered, a willing buyer of SWMG on the
transaction date would have insisted on a significant discount
with respect to the value of the entity's intangible assets,
precisely on account of the absence of noncompete agreements from
the SWMG physicians. Indeed, the SWMG physicians not only did
not execute noncompete agreements; they had the benefit of the
"free to compete" provision in the PSA which facilitated their
reclaiming their patients in the event they decided to cease
working for SWMG/SMF. Mr. Dutcher's failure to account for the
risk to his estimated 5-year stream of earnings posed by SWMG
physicians' departing with their patients is contrary to wellestablished valuation principles and common sense, and results in
an inflated value for the SWMG physicians' goodwill.
(3) The Dutcher appraisal adopts the formula devised by Dr.
Levin, a nonexpert, for allocating the purported value of SWMG's
intangible assets among the SWMG physicians, without providing
any reasons or analysis to support or justify that choice. See
Mid-State Fertilizer Co. v. Exch. Natl. Bank, 877 F.2d 1333, 1340
(7th Cir. 1989); Estate of Jann v. Commissioner, T.C. Memo. 1990333. To the extent petitioners may not be relying on the Dutcher
appraisal to support the allocation formula used, the allocation
underlying the claimed charitable contribution deductions is not
the product of expert appraisal and should be rejected on that
account.
(4) The Dutcher appraisal takes no account of the $35,000
"Physician Access Bonus" payable to each SWMG physician over the
initial 2 years of the affiliation. Ignoring these payments when
computing distributable earnings that SWMG would generate results
in a overstatement of those earnings and a corresponding
overstatement of the value of SWMG's intangible assets (since,
under Mr. Dutcher's analysis, intangible asset value equals
present value of future distributable earnings, less tangible
assets and implied working capital).
- 54 received was not confined to the cash payment for their tangible
assets.
They in addition received a package of valuable benefits
(above-median compensation, $35,000 "Physician Access Bonuses",
working conditions they preferred, etc.) that were not merely
incidental or akin to the benefits that inure to the general
public as a result of a charitable transfer.
See, e.g., Ottawa
Silica Co. v. United States, 699 F.2d 1124 (Fed. Cir. 1983);
Singer Co. v. United States, 196 Ct. Cl. 90, 449 F.2d 413 (1971).
Concededly, some elements of the consideration petitioners
received may have been difficult to quantify, but this does not
mean these benefits can be disregarded in determining whether a
quid pro quo existed that defeats donative intent.
See, e.g.,
Transamerica Corp. v. United States, 902 F.2d 1540 (Fed. Cir.
1990) (donor-taxpayer's receipt back from donee of commercial
access rights to donated motion picture film negatives defeats
charitable deduction for value of negatives transferred); Singer
Co. v. United States, supra (benefit of possible increase in
future customers defeats charitable deduction for the value of
discounts given to public schools purchasing taxpayer's sewing
machines).
Petitioners argue that any consideration they purportedly
received in the transaction representing the "value of their postcontribution employment relationship" with SMF must be disregarded
because "that value is already taken into consideration in the
- 55 valuation process."
In petitioners' view, because the Dutcher
appraisal computed the value of petitioners' intangible assets as
being essentially the discounted present value of SWMG's "future
distributable earnings" (less the value of tangible assets and an
amount for implied working capital), and those future earnings
were net of physician compensation expense and all other
operational expenses, the amount claimed as a contribution for
intangible assets should not be offset by physician salaries or
any other benefit petitioners received in connection with their
providing services to SMF.
The "value of the physicians' future
salaries is already netted out of the value of the contribution",
petitioners argue.
We disagree.
First, we do not believe the Dutcher appraisal
fully accounts for petitioners' compensation from SMF.
Presumably
because SWMG was newly formed and there existed no historical data
on its physician compensation expense, Mr. Dutcher assumed when
computing future distributable earnings that SWMG's physician
compensation expense (computed as a percentage of revenue) would
be equal to the median physician compensation expense for the
medical specialties comprising SWMG, or 45.18 percent of revenue.
In fact, SMF agreed to pay compensation to the SWMG physicians of
at least 47 to 55.75 percent of revenue.
Moreover, because Mr.
Dutcher treated SWMG's physician compensation expense as equal to
the 45.18 percent median, his computation of physician
- 56 compensation expense takes no account whatsoever of the $35,000
"Physician Access Bonus" that each SWMG physician received.
More
fundamentally, the Dutcher appraisal takes no account of the
various contractual rights and other intangible benefits that
petitioners and the other SWMG physicians sought and obtained in
the transaction with SMF, such as avoiding signing noncompete
agreements and obtaining preferred working conditions.
Because it
does not fully account for the benefits that petitioners received
in the transaction with SMF, the Dutcher appraisal does not
establish that petitioners contributed property to SMF that
exceeded the values of the benefits they received in return.35
The quid pro quo nature of the transfer of petitioners'
medical practices (including both the tangible and intangible
assets) in exchange for the package of cash and contractual rights
35
Undoubtedly, some portion of the compensation and
benefits provided to the SWMG physicians in connection with their
posttransaction employment (through SWMG) with SMF is
attributable to the posttransaction services performed. However,
petitioners have not demonstrated what portion is attributable to
the services they provided, such as by showing what the fair
market values of those services were. The fair market values of
the services petitioners provided to SMF might be shown, for
example, by a comparison to the compensation paid to similarly
experienced physician-employees of an integrated delivery system
health care provider where the physician-employees had not
transferred existing medical practices to the employer. Whether
such an arrangement would have exhibited compensation comparable
to petitioners' in terms of salaries, initial $35,000 bonuses, no
requirements to execute noncompete agreements, etc. is a matter
of speculation on this record. Although Mr. Dutcher stated in
his appraisal that "it is my opinion the physician compensation
offered SWMG shareholders by Sutter had no market value beyond
the value of their professional medical services", there is no
data or analysis to support this conclusion.
- 57 that they received from SMF is also demonstrated by petitioners'
rejection of the proposed transaction with Foundation (wherein
they would have sold their practices to, and entered into an
agreement to provide future services for, Foundation).
Petitioners make much of the fact that Foundation, as a for-profit
entity, was willing to pay substantial sums for petitioners'
intangible assets because it was not constrained by the Federal
proscriptions on such payments applicable to nonprofit, tax-exempt
entities.
But when petitioners were offered the opportunity to
affiliate with Foundation (and receive an outright cash payment
for their intangibles), they collectively rejected the prospect in
favor of an acquirer that offered them working conditions they
preferred, greater economic security through multiple sources of
payment, a "free to compete" provision whereby any of them could
essentially "unwind" the transaction and retrieve his or her
patients if he or she desired to terminate the relationship with
the acquirer, a role in management, and other intangible benefits
that were negotiated between the SWMG physicians and SMF.
Viewed
in this light, it is apparent that the intangible benefits that
petitioners received in the transaction with SMF were of
substantial value to them.
Petitioners spurned a cash payment for
their medical practice intangibles in order to obtain these
benefits in a different transaction.
On this record, petitioners
have not shown that the value of what they received in the
- 58 transaction with SMF was less than the value of what they
transferred.
Thus they have not shown that the transfers of the
intangible assets of their medical practices were without adequate
consideration.
"The sine qua non of a charitable contribution is
a transfer of money or property without adequate consideration."
United States v. Am. Bar Endowment, 477 U.S. at 118; see also
Transamerica Corp. v. United States, 902 F.2d at 1545-1546.36
B.
Respondent's Duty of Consistency
Petitioners also argue that the Commissioner has previously
taken the position in rulings and other guidance covering similar
transfers of group medical practice assets to nonprofit health
care organizations that charitable contribution deductions for the
transferors are appropriate and that respondent is therefore bound
to follow that position in this case.
Petitioners cite the
Friendly Hills determination letter and several of the
Commissioner's annual Exempt Organizations Continuing Professional
Education Technical Instruction Program manuals (instruction
manuals) wherein the Commissioner indicated that a section
501(c)(3) organization could acquire the assets of a group medical
practice through purchase or through a charitable donation by the
group's physicians without jeopardizing the acquiring
36
Because we conclude that petitioners have failed to
demonstrate that they transferred property worth more than what
they received in return, we do not decide whether the claimed
deductions should be denied because petitioners failed to comply
with the requirements of sec. 1.170A-13, Income Tax Regs., and
sec. 170(f)(8).
- 59 organization's tax-exempt status.
Since in the foregoing
materials the Commissioner specifically contemplated a charitable
contribution under section 170 and did not put it into issue or
otherwise treat the matter as problematic, petitioners argue that
the Commissioner has thereby indicated that donative intent in
such transactions is presumed or is not a significant issue.
Thus, petitioners conclude, by challenging petitioners' donative
intent in a virtually identical transaction, respondent has
violated his duty of consistency between his rulings and
litigation position, contrary to our holding in Rauenhorst v.
Commissioner, 119 T.C. 157 (2002).
Respondent argues that:
(1) The transaction considered in
the Friendly Hills determination letter is materially
distinguishable from the transaction in this case, (2) neither
that letter nor the instruction manuals address the section 170
deduction issue, and (3) in any event, neither may be cited as
precedent.
Therefore, respondent considers Rauenhorst to be
inapposite.
We agree with respondent that, under Rauenhorst, neither the
Friendly Hills determination letter nor the instruction manuals
limit the position respondent may take in these cases.
The Friendly Hills determination letter did concern the
acquisition of the assets (including "intangible assets") of a
physicians' medical group by a nonprofit medical foundation in
- 60 which it was represented that the foundation would pay $110
million and the transferring physicians would "make charitable
donations in an aggregate amount, and deduct from their income
taxes proportionate amounts of that aggregate, which, when
combined with the [$110 million] cash purchase price, will not
total more than $125 million."
However, the issue addressed in
the determination letter was the tax-exempt status of the
acquiring foundation (which was granted).
The determination
letter thus had no occasion to consider the issue of donative
intent (much less rule on deductibility), observing only that
"Donors may deduct contributions to you as provided in section 170
of the Code."
Respondent also argues, and we agree, that there
are significant distinctions between the facts as represented in
the Friendly Hills determination letter and petitioners'
circumstances.
In the Friendly Hills transaction, unlike the
cases at issue, the transferring physicians had executed
noncompete agreements, there were no signing bonuses (i.e.,
"Physician Access Bonuses"), and the donations represented
approximately 12 percent of the transfer ($15 million/$125
million), whereas petitioners claim that approximately 61.5
percent of the "business enterprise value" of SWMG was given away
($2,515,255 intangibles/$4,088,450 "business enterprise value"37).
37
The figures above are taken from the Dutcher appraisal's
estimate of the intangible assets purportedly contributed by the
SWMG physicians, on which petitioners currently rely. On the
(continued...)
- 61 Most importantly, the Friendly Hills determination letter, as
petitioners concede on brief, pursuant to section 6110(j)(3)38 "may
not be used or cited as precedent."
Similarly, although the instruction manuals generally
describe methods by which an integrated delivery system may be
formed, including acquisition of medical group assets "by
donation, fair market value purchase, lease, license, stock
transfer or a combination thereof" (emphasis added), those
publications also focus on mergers of nonprofit hospitals or
medical foundations with physician groups from the standpoint of
the former entities' qualification for tax-exempt status under
section 501(c)(3).
Similar to the Friendly Hills determination
letter, the instruction manuals do not specifically address the
charitable contribution issue, which accounts for their failure to
emphasize the requirement of donative intent in connection with
any "donation" of assets by the physicians.
Moreover, the
introduction to each annual edition of the instruction manuals
contains the following statement:
purposes only.
"The text is for educational
It is not authority, and may not be cited as
such."
37
(...continued)
basis of the Houlihan appraisal used by petitioners for purposes
of filing their 1994 returns (but now abandoned by them), the
claimed donations would constitute approximately 41 percent of
the value of SWMG ($1,632,377 intangibles/$4 million business
enterprise value).
38
Currently codified as sec. 6110(k)(3).
- 62 In Rauenhorst v. Commissioner, supra at 183, we held that the
Commissioner may not take a litigating position contrary to his
own revenue rulings, which constitute public guidance.
Neither
the Friendly Hills determination letter nor the instruction
manuals are revenue rulings or are intended by the Commissioner to
constitute public guidance.
Therefore, even if they could be
viewed as supporting petitioners' claim that the Commissioner has
minimized the significance of donative intent in some transfers of
medical practice assets, since the cited materials are not revenue
rulings or similar public guidance they do not, under Rauenhurst,
constrain the position that respondent may take in these cases.
II.
Issues Involving Individual Petitioners
A.
The Kennedys
1.
Background
Respondent bases his $3,760 increase in Dr. Kennedy's 1994
Schedule C gross receipts on three documents, all of which are
stipulated exhibits:
(1) The examining agent's summary of certain
bank deposits of Dr. Kennedy's, totaling $23,797.26, that is
described as a schedule of Dr. Kennedy's 1994 accounts receivable
after sale of practice (agent's report); (2) a letter from Dr.
Kennedy to his accountant dated February 27, 1994,39 (sic)
(letter), in which he advises his accountant:
39
1995.
"I have collected
Given its contents, the letter was necessarily drafted in
- 63 $23,037.00 for November and December and I have included that on
my business income for 1994"; and (3) Dr. Kennedy's profit and
loss statement for October, 1994 (P & L statement), which shows
total year-to-date patient fees, as of October 31, 1994, of
$176,002.44.
On the basis of these documents, respondent posits
that Dr. Kennedy's total reported 1994 gross receipts from patient
fees (earned before he became an employee of SWMG as of November
1, 1994) were understated by $3,760.
Therefore, they must be
increased from $195,709 as reported to $199,469 as determined
after examination.
The Kennedys offer no documentary rebuttal.
They merely state, on brief, that the adjustment is 9 years old,
the records are "impossible to trace", and it is "Dr. Kennedy's
recollection" that the $195,709 reported on his return "is the
accurate dollar amount that he received as gross sales for his
medical practice."
2.
Discussion
Although the stipulated exhibits (in particular, the letter)
generally support respondent's determination, his numbers do not
quite add up.
Whether the $176,002 representing Dr. Kennedy's
1994 gross receipts through October 31, 1994, is increased by
$23,797 (per the agent's report) or $23,037 (per the letter), the
result differs slightly from the total 1994 Schedule C gross
receipts of $199,469 respondent determined.
On cross-examination
- 64 by respondent's counsel, Dr. Kennedy testified as follows
regarding the contents of the letter and the P & L statement:
Q
A
Would you look at Exhibit 629-J please? Do you
recognize this?
I think it's a letter I wrote to my accountant it
looks like, at least the first of it.
Okay. And then there's a lengthy paragraph on the
bottom of the page, which you know, as we get two-thirds
of the way down it states, "I have collected 23,037 for
November and December." Do you see that?
Yes.
Okay. And then would you look at Exhibit 631-J
please?
Yes.
Which is your profit and loss statement through the
end of October '94?
Um-hmm.
So it says, "Income Patient Fees Year To Date $176,002.”
That would have been what you collected through that
point in time?
(No audible response).
So then if we add the 176,000 to the 23,000, we get
about 199,000. So that would have been your income for
the year?
I suppose.
Q
A
Q
A
Q
A
Q
A
Q
A
We accept the foregoing exchange as a concession by Dr.
Kennedy that his November and December 1994 collections totaled
at least $23,000 and a concession by respondent that Dr. Kennedy's
total 1994 Schedule C gross receipts totaled $199,000, not
$199,469, an increase of $3,291 over the $195,709 Dr. Kennedy
reported.
Therefore, we sustain respondent's proposed increase in
Dr. Kennedy's 1994 Schedule C income to the extent of $3,291.
B.
The Derbys
1.
Background
- 65 There appears to be no dispute between the parties that there
is a $3,665 discrepancy between the amount reported as Schedule K1 nonpassive income from Dr. Derby's wholly owned professional (S)
corporation, Charles A. Derby, M.D., Inc. (the corporation), on
the Derbys' 1994 Schedule E ($4,209) and the amount of ordinary
income actually listed on the corporation's 1994 Schedule K-1
($7,874). During the trial, Dr. Derby testified as follows
regarding the discrepancy:
At the close of the year, I had -- I was in the
process of dissolving the "S" corporation, and one of
the reconciliations that was necessary was there were a
-- I had a petty cash drawer and in it there were
receipts. And there was one principal receipt that was
for the -- my computer that I had purchased earlier in
the year. It was around 2,600 -- 2,700. And then
around a thousand dollars of petty cash receipts that
were money from my own personal pocket that had been
utilized by the "S" corporation, and in dissolving the
"S" corporation, I think that's where the discrepancy.
Now, I tried to get in touch with my accountant,
Mr. Kramer, to go over this with him, and I just wasn't
able to do that, and I don't have specific receipts for
this at this particular time, but that's my best
recollection of the -- what the discrepancy was.
Dr. Derby further testified that the corporation reimbursed him
for the computer and the other items at the time of its
dissolution in late 1994.
Thus, it is Dr. Derby's position that
he, in effect, made a constructive loan to the corporation of the
amount in question by personally incurring expenses deemed to be
incurred by the corporation with the constructively borrowed funds
(which were reimbursed to Dr. Derby upon dissolution of the
- 66 corporation), and that the corporation's 1994 return mistakenly
overstated the corporation's net ordinary income by the amount of
those deductible expenses.
Respondent simply points to the
discrepancy between the two returns and argues that Dr. Derby
understated his 1994 ordinary income from the corporation by
$3,665.
2.
Discussion
The dispute between the Derbys and respondent raises three
issues:
(1) A factual issue as to whether Dr. Derby incurred the
expenses in question in 1994, (2) whether the expenses were
currently deductible business expenses under section 162(a), and
(3) assuming he did incur the expenses and that they were
currently deductible, whether they resulted in a constructive loan
and corporate purchase of the items in question or a capital
contribution of the purchased items by Dr. Derby to the
corporation.
At trial, Dr. Derby admitted that he had no "specific
receipts" that would substantiate the alleged expenditures or
their deductibility and that his oral testimony constituted his
"best recollection of * * * what the discrepancy was."
Assuming
arguendo that the Derbys are not required to satisfy the
substantiation requirements of section 274(d) in support of the
alleged expenditures, they were nonetheless required to maintain
records sufficient to substantiate the claimed deductions, in this
- 67 case, on behalf of the corporation.
1(a), Income Tax Regs.
See sec. 6001; sec. 1.6001-
Moreover, they have failed to provide even
the minimal substantiation that would permit us to estimate the
allowable deduction under Cohan v. Commissioner, 39 F.2d 540, 543544 (2d Cir. 1930).
Even under Cohan, there must be sufficient
evidence in the record to provide a basis upon which an estimate
may be made.
(1985).
Vanicek v. Commissioner, 85 T.C. 731, 742-743
Here, there is none.
By failing to provide any
substantiation that would corroborate Dr. Derby's somewhat
uncertain testimony, the Derbys have failed to sustain their
burden of proof under Rule 142(a) as to either the existence or
deductibility of the alleged expenditures.
Moreover, assuming arguendo that Dr. Derby actually incurred
the alleged expenditures and that they were of a type that would
be currently deductible by the corporation, the evidence does not
establish whether Dr. Derby incurred them on behalf of the
corporation with an expectation of reimbursement or intended that
they constitute a capital contribution to the corporation.
Dr.
Derby's oral testimony is consistent with either approach.40
The
Derbys' failure to prove the existence of a constructive loan
provides an additional basis for respondent's $3,665 adjustment.
40
Although Dr. Derby testified that he was reimbursed by
the corporation when the corporation was dissolved, that
"reimbursement" distribution is consistent with either a debt
repayment or a final cash distribution in connection with the
dissolution.
- 68 3.
Conclusion
The Derbys understated Dr. Derby's 1994 income from the
corporation to the extent of $3,665.
III.
Penalties
A.
Introduction
The notices of deficiency issued to petitioners contain the
following explanation for respondent's denial of a charitable
contribution deduction for each petitioner's alleged contribution
of practice intangibles to SMF:
The contribution claimed with respect to * * * [SMF] is
not allowable because it has not been established that
the fair market value of the assets sold exceeded the
sales price received by you or that the intangible
assets donated had any fair market value.
Based upon petitioners' alleged failure to establish that
their intangible assets had any fair market value, respondent
alleges, in his answers to the petitions, that "petitioners are
liable for the accuracy related penalty under [section] 6662(a) in
the amount of 40 [percent] of the deficiency for a gross valuation
misstatement under * * * [section] 6662(h), or in the alternative
are liable for a penalty in the amount 20 [percent] of the
deficiency for a substantial valuation misstatement under * * *
section 6662(e)" (sometimes, the overvaluation penalty).
Because
respondent raises the penalty issue in his answers, the issue
constitutes a "new matter" under Rule 142(a), and the burden of
proof with respect to that issue is upon respondent.
See Rule
- 69 142(a); see also Am. Ideal Cleaning Co. v. Commissioner, 30 B.T.A.
529, 531 (1934); Burnett v. Commissioner, T.C. Memo. 2002-181,
affd. 67 Fed. Appx. 248 (5th Cir. 2003).
Respondent argues, on the evidence in the record, that "the
allegedly donated goodwill had no value to SMF."
Therefore, the
values petitioners claimed as the bases for their section 170
deductions "were 400 percent or more of the correct value, zero."
Respondent further argues that petitioners may not rely upon the
"reasonable cause", "good faith" exception of section 6664(c)(1)
because:
(1) The valuation of their intangible assets transferred
to SMF was not "based on a qualified appraisal made by a qualified
appraiser" as required by section 6664(c)(2)(A), and (2)
petitioners failed to make "a good faith investigation of the
value of the contributed property" as required by section
6664(c)(2)(B).
See also sec. 1.6664-4(h), Income Tax Regs.41
Petitioners argue that the advice received from Mr. Grant and his
partners and, for several of petitioners, from their own
accountants furnished a "reasonable basis" for their charitable
contribution deductions and that the seeking of and reliance upon
that advice constituted a "good faith investigation of the value
of the contributed property" within the meaning of section
6664(c)(2)(B).
41
As applicable in 1994, the regulation was codified as
1.6664-4(e), Income Tax Regs.
- 70 B.
Analysis
On brief, respondent specifically acknowledges that, if we
deny petitioners' charitable contribution deductions for reasons
other than their overvaluation of the transferred intangibles,
"the penalty is not applicable", citing Gainer v. Commissioner,
893 F.2d 225 (9th Cir. 1990), affg. T.C. Memo. 1988-416.
In Gainer, the issue was whether the taxpayer was liable for
the overstatement penalty under circumstances in which his
depreciation deduction and investment tax credit with respect to
an equipment purchase were denied because:
(1) The equipment was
not placed in service during the taxable year, (2) the equipment
was overvalued, and (3) the promissory note given in connection
with the purchase was nonrecourse so that he was not at risk.
We
refused to apply the penalty on the ground that the deduction and
credit were disallowed because the equipment had not been placed
in service during the tax year.
Therefore, the underpayments were
not "attributable to" any overstatement of value.42
The Court of
Appeals for the Ninth Circuit affirmed, reasoning as follows:
Even if Gainer had correctly valued the container, the
underpayment of tax would be the same because the
container was not placed in service. Thus, Gainer's
actual tax liability, after adjusting for failure to
place the container in service, was no different from
42
Sec. 6662(b)(3), like its predecessor provision (sec.
6659) considered in Gainer, imposes an addition to tax on
underpayments "attributable to" any "substantial valuation
misstatement" (referred to, in sec. 6659, as "a valuation
overstatement").
- 71 his liability after adjusting for any overvaluation.
[Id. at 228.]
The Court stated that "no * * * [overvaluation] penalty * * * [may
be imposed] when there is some other ground for disallowing the
entire portion of a deduction that otherwise might be disallowed
for overvaluation."
Id.; see also Scoville v. Commissioner, 108
F.3d 1386 (9th Cir. 1997), affg. in part and revg. in part without
published opinion T.C. Memo. 1995-376; Todd v. Commissioner, 862
F.2d 540, 543 (5th Cir. 1988), affg. 89 T.C. 912 (1987).
We have denied petitioners' charitable contribution
deductions, in their entirety, on the ground that petitioners
received a commensurate quid pro quo.
Therefore, under Gainer,
because there is a separate, independent ground for disallowing
those deductions, the overvaluation penalty may not be imposed
against petitioners.
See also 885 Inv. Co. v. Commissioner, 95
T.C. 156, 163 (1990).43
C.
Conclusion
Petitioners are not liable for either a 40-percent or 20percent addition to tax under section 6662.
43
In light of our conclusion that the overvaluation penalty
may not be imposed, we need not address whether petitioners had
"reasonable cause" with the meaning of sec. 6664(c).
- 72 To reflect the foregoing,
Decisions will be entered
under Rule 155.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.