$256 Million in Intermediate Sanctions Reduced to Zero

(Tax Planning Alert dated August 24, 2006)

The first Tax Court case involving Internal Revenue Service (“IRS”) invoked intermediate sanctions has been reversed. The Fifth Circuit reversed the controversial Tax Court decision to impose intermediate sanctions stating that the Tax Court and IRS failed to conduct an appropriate valuation of the assets of the tax-exempt entities. Originally, the IRS assessed penalties totaling over $256 million against the Caracci family, founders of three nonprofit home health organizations. The Tax Court sided with the IRS but reduced the penalties to over $70 million. The Fifth Circuit case is not only significant because it reduces the penalties to zero but also because it demonstrates the importance of proper asset valuations.

What are Intermediate Sanctions?

Tax-exempt organizations should not engage in excess benefit transactions (defined as transactions which provide a disqualified person with an economic benefit worth more than what the organization receives in return). A disqualified person is any individual who is in a position to exercise substantial influence over the organization, such as a Chief Executive Officer or a founder. The term also includes family members and certain businesses owned by disqualified persons. Prior to the passage of the intermediate sanction provisions, the IRS was forced to either ignore excess benefit transactions or to revoke the tax-exempt status of the organization involved in the transaction. As an alternative, the IRS may now impose penalties upon disqualified persons for engaging in such transactions and upon organization managers who knowingly and willfully approve such transactions.

A disqualified person involved in an excess benefit transaction is subject to a first-tier excise tax of 25% of the amount of the excess benefit. In general, excess benefit is the amount by which the total value of the transaction exceeds fair market value. Additionally, organization managers who knowingly participate in an excess benefit transaction are also liable for a 10% excise tax, up to $10,000 per transaction. If an excess benefit transaction is not timely corrected, the disqualified person is subject to an additional 200% excise tax.

Facts of the Case

Three home health organizations, the Sta-Home Health agencies, were originally organized and operated in Mississippi as nonprofit organizations serving their communities and providing care to a large number of Medicare patients. After several years of losses, the Caracci’s decided to convert the home health agencies into for-profit organizations. To do so, the family created new S corporations, which then purchased the assets from the nonprofit organizations based on the valuations performed by a CPA firm. According to the valuations, each home health agency had a negative worth, and, thus, the purchase price for each was the assumption of the nonprofit’s liabilities. In its own valuation, the IRS instead determined that each agency was worth over $5 million and subsequently assessed both tiers of penalties under the intermediate sanction provisions.

Keys to the Fifth Circuit Ruling

On appeal, the Fifth Circuit focused much of their attention on the valuation methods used by the IRS to determine the excess benefit received. Furthermore, the Fifth Circuit harshly criticized the IRS valuation expert indicating the necessary work required to perform an asset-valuation analysis was not performed. Specifically, the court held that the IRS expert:

• maintained no experience appraising healthcare companies;
• was unfamiliar with the home health agency market in general as well as in Mississippi;
• spent only two days in the state with one of those days spent in the hotel room tracking down lost luggage;
• lacked knowledge about the Sta-Home agencies, except for the single day spent interviewing the Chief Financial Officer.

The Fifth Circuit also found fault with the Tax Court’s valuation method which utilized components presented by the IRS valuations expert. The Tax Court compared the Sta-Home entities with profitable, publicly-traded companies, all of which had capital, profits, and were not dependent on Medicare for over 95% of their revenues. The Fifth Circuit argued that the comparables were indeed not comparable to Sta-Home and cited that “a ‘comparable’ must be substantially similar to the entity or asset that is at issue.” Additionally, the Fifth Circuit cited a Tax Court 1959 revenue ruling requiring the IRS to assign zero value to unprofitable intangible assets and stated that the Tax Court violated its own ruling in failing to recognize that the Sta-Home entities’ intangible assets had little or negative value.

Tax-exempt organizations must exercise extreme caution when engaging in transactions with disqualified persons. Valuation experts should be used for each transaction, and the organization should strive to meet the intermediate sanctions safeharbor, the rebuttable presumption of reasonableness. If you have any questions or concerns about intermediate sanctions or if your organization is engaging in transactions with disqualified persons, potential disqualified persons, or their family members or businesses, please contact Eddie Phillips, Terry Haefner, or Debbie Ernsberger at 800-270-9629.

WE ARE REQUIRED BY IRS CIRCULAR 230 TO INFORM YOU THAT THE FOLLOWING DISCUSSION WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, NOR RELIED UPON, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING ANY PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW.  THE ADVICE WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED IN THE DISCUSSION.  EACH TAXPAYER SHOULD SEEK ADVICE BASED ON ITS PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.

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