Fifth Circuit Reverses Tax Court’s Valuation in Conversion of Exempt Organization

Tax Controversy Alert
08.01.06

The Fifth Circuit recently reversed the Tax Court’s decision in Caracci v. Comm’r, 118 T.C. 379 (2002), where the Tax Court had imposed section 4958 ("intermediate-sanction") excise taxes on a home health care agency that converted from a tax-exempt entity to a nonexempt corporation. See Caracci v. Comm’r, 2006 U.S. App. LEXIS 17370 (5th Cir., July 11, 2006). Because there were, in the Fifth Circuit’s view, "so many legal and factual errors many of which the Commissioner acknowledge[d] infecting [the] case from the outset," the Fifth Circuit simply rendered a decision in favor of the taxpayer without remanding the case to the Tax Court for further consideration. The Fifth Circuit determined that the burden of proving that the taxpayers were liable for the assessed excise taxes had shifted to the IRS, found that the IRS had failed to meet that burden, and further found that the Tax Court erred as a matter of law in adopting a faulty valuation method of its own design after it had rejected the valuation methods of the taxpayers' expert and the IRS’s expert.

A change in Medicare regulations prompted three non-stock, tax-exempt home health care agencies (collectively, "Sta- Home") to convert to nonexempt subchapter S corporations. Sta-Home transferred assets from the old exempt corporations to the new S corporations in exchange for assuming the other exempt corporation’s debts and liabilities. Notwithstanding contemporaneous appraisals the taxpayer had obtained that showed that the debts and liabilities to be assumed in the transactions exceeded the value of the assets to be transferred, the IRS determined that this conversion resulted in an "excess benefit" to Sta-Home because the value of the assets transferred to Sta-Home exceeded the value of the liabilities and debts it assumed. When Sta-Home refused to pay the proposed excise tax amounts, the IRS issued deficiency notices to Sta-Home, imposing section 4958 excise taxes on Sta- Home. Sta-Home challenged the determination in Tax Court.

At trial, Sta-Home’s expert used an adjusted-balance-sheet method to value Sta-Home’s assets, which adjusts the values of assets identified on a company’s balance sheet to their fair market value equivalent. Sta-Home’s expert also used a “market approach” to check this asset valuation, which compared the Sta-Home transactions to thirteen private transactions involving other home-healthcare providers. Under both methods, Sta-Home’s expert found that liabilities assumed in the transaction exceeded assets, such that no excess benefit resulted from the transaction. The IRS’s expert used market-based and income-based approaches to value Sta- Home’s assets in general, without valuing any of Sta-Home’s assets in particular, and concluded that there was an excess benefit under either method. The Tax Court rejected both valuation methods used by Sta-Home’s expert, rejected the IRS’s expert’s income valuation method, and partially adopted the IRS’s expert’s market-value approach, "making adjustments and filling in gaps to reach its own conclusions as to value" (as characterized by the Fifth Circuit). Based on its own valuation method, the Tax Court upheld the imposition of a portion of the excise tax amount assessed against Sta-Home. Sta-Home appealed.

The Fifth Circuit pointed to the IRS's issuance of the deficiency notices as the starting point of what the Fifth Circuit dubbed a "cascade of errors" in the case. At trial, the IRS had conceded that the deficiency notices issued to the corporation were excessive and erroneous; moreover, on cross-examination, the IRS’s expert witness had admitted that the deficiency notices were excessive, incorrect, and erroneous. Yet despite the finding of errors in the IRS’s calculation and the erroneous deficiency notices, the Tax Court held against the taxpayers.

Quoting Portillo v. Comm’r, 932 F.2d 1128, 1133 (5th Cir. 1991), the Fifth Circuit found that the legal effect of the IRS’s concession of error was clear: "'In a . . . deficiency proceeding, once the taxpayer has established that the assessment is arbitrary and erroneous, the burden shifts to the [IRS] to prove the correct amount of any taxes owed.'" The Fifth Circuit found that the Tax Court failed to impose this burden on the IRS. Further, the Fifth Circuit determined that, notwithstanding the Tax Court’s failure to shift the burden to the IRS, the IRS failed to meet its burden of proof when the Tax Court rejected most of the only support the [IRS] provided for the net excess benefit finding, the testimony of the [IRS’s] valuation expert. At that point, the Tax Court should have found in the taxpayer’s favor. Its failure to do so was error, as a matter of law.
Finally, the Fifth Circuit found that “the Tax Court made a number of errors in the valuation method it selected and in the facts it found in selecting and applying that method.” The court emphasized that in determining whether a corporation received an “economic benefit,” the valuation method must take into account the attributes of the entity whose assets are being valued. Dunn v. Comm’r of Internal Revenue, 301 F.3d 339 (5th Cir. 2002). The Tax Court used what it considered to be “comparable” companies as a frame of reference, but these companies were not substantially similar to Sta-Home because they were publicly traded, had capital, were not limited to offering basic and unprofitable therapies to patients, and did not depend on Medicare for over 95% of their revenues. The Fifth Circuit noted that the Tax Court was aware that the comparables were “different from Sta-Home in critical aspects.” Nevertheless, the Tax Court simply applied a discount to the multiplier in its valuation method without explaining its rationale and without accounting for the differences between the comparables and Sta-Home.

While it reversed the Tax Court, the Fifth Circuit reserved its most trenchant criticism for the IRS:

This case began and ends with the [IRS’s] refusal to recognize the legal effect of its own errors. The [IRS] issued erroneous and excessive deficiency notices, yet persisted in defending them for nearly two years of litigation before the Tax Court. After the [IRS admitted the deficiency notices were erroneous, the [IRS] . . . failed to meet [its] burden of proving that the excise taxes . . . were correct. The [IRS] presented an expert who used an inappropriate valuation method and lacked basic factual information essential to the asset valuation he was called on to provide.

The Fifth Circuit’s decision shows that where the IRS persists in taking a position in litigation that is “so incongruous as to call [the IRS’s] motivation into question,” courts may very well see that position for what it is:

[O]ne aimed at achieving maximum revenue at any cost . . . seeking to gain leverage against the taxpayer in the hope of garnering a split-the-difference settlement – or, failing that, then a compromise judgment somewhere between the value returned by the taxpayer . . . and the unsupportedly excessive value eventually proposed by the Commissioner.

Dunn, 301 F.3d at 349. For taxpayers, that sort of jurisprudence is priceless.

District Court Rules on Retroactive Son-of-BOSS Regulations

In Klamath Strategic Investment Fund LLC v. United States, a case in the Eastern District of Texas, U.S. District Judge T. John Ward held that the taxpayers’ obligation to return a $25 million loan premium in the event the loan was prepaid constituted a contingent liability and under Helmer v. Comm’r, 34 T.C.M. (CCH) 272 (1975), and its progeny was not a liability under section 752. “It is clear from the record that the government has often and consistently relied on the principle that a ‘liability’ under Section 752 does not include an obligation that is contingent,” Judge Ward wrote in the opinion, declining to give the term a different meaning “simply based on whose ox is being gored.”

Treatment as a non-section 752 liability meant that the assumption of the obligation by a partnership reduced partnership value but not tax basis. Under the technical application of the partnership rules, the net result was a built-in loss in the partnership interest equal to the amount of the loan premium.

The court also ruled that Treasury abused its discretion when issuing interpretative regulations in 2003 that were retroactive to October 18, 1999. The court held that the narrow time period covered by the 2003 regulations, as well as language in the preamble specifically targeting transactions covered by Notice 2000-44, indicated strongly that the 2003 regulations were crafted to support the government’s litigation position and therefore were not entitled to deference.

The Klamath decision is significant for the many taxpayers who entered into Son-of-BOSS transactions prior to the issuance of Notice 2000-44 and declined to participate in the settlement initiative announced in 2004.

For more information, please contact any of the following lawyers:

Shane T. Hamilton, shamilton@milchev.com, 202-626-5873

Patricia Sweeney, psweeney@milchev.com, 202-626-5926

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