In Michael T. Caracci et al. v. Commissioner, No. 02-60912 (11 July 2006), the federal Fifth Circuit Court of Appeals did the right thing and dumped an IRS intermediate sanction against a group of Sta-Home Health Agencies (the "Agency") in rural Mississippi that was obscene in its character and amount. The Agency, owned by the Caracci family served the rural poor in Mississippi as an alternative to the alternative of nursing homes and other similar facilities in the area. The Agency never made a profit in its existence. It was originally a tax exempt entity as required by earlier existing law. 95 percent of its patients were Medicare patients (compared to a national average of 38%), which meant that they were paid a percentage of their costs, inherently resulting in a loss each year.
Because Mississippi requires a certificate of need to operate an agency in the state and because it had imposed a moratorium on certificates of need there was no way for new agencies to enter the market without acquiring a company with an existing certificate, which gave the Agency some value. In 1995 the Agency converted to a for profit entity because of a change in the law. In the transfer of assets from the exempt company to the for profit entity the IRS determined that the Agency's assets exceeded the transferred liabilities resulting in a "net excess benefit" of $18.5 Billion Dollars. The IRS issued deficiency notices against the agency and its owners in the amount of $250 Million Dollars in excise taxes under 26 U.S.C. Section 4958 which permits a 25% and a 200% surcharge.
The tax court using a modified form of the IRS valuation methodology reduced the net excess benefit amount to just $5 Million and the sanctions to approximately $ 70 Million. The parties agreed that the debt assumed by the new companies was $13.5 Million dollars. The dispute was over the valuation of the Agency itself. The Caraccis obtained a comprehensive evaluation of the assets of the companies and the IRS relied upon comparative valuations of other publicly traded companies in the industry, all of which had made profits.
The tax court adopted the argument of the IRS that a bonuses paid to the employees of the companies represented a profit difference in disguise and that the company would have been in the black but for the bonuses paid. The problem, however, is that since Medicare only pays based upon costs, there would be no reimbursement without the bonus expense and the bonus expense reimbursement from Medicare would not cover the cost, leading to further deficits.
The Court of Appeals took the IRS to task for its refusal to credit the taxpayers for the amount of liabilities assumed in the transaction.
This court has recognized that when, as here, the Commissioner persists in taking a position in litigation that is so incongruous as to call his motivation into question,. . .[i]t can only be seen as one aimed at achieving maximum revenue at any cost, . . .seeking to gain leverage against the taxpayer in the hope of garnering a split-the-difference settlement - or, failing that, then a compromise judgment-somewhere between the value returned by the taxpayer. . and the unsupportedly excessive value eventually proposed by the Commissioner.
The Court held that once the taxpayer has established that hte assessment is arbitrary and erroneous, the burden shifts to the government to prove the correct amount of any taxes owed. Since the Tax Court rejected most of the support provided by the IRS expert, the IRS failed to meet its burden and the Tax Court should have found in the taxpayer's favor. The court went on to shred the valuation procedures that the IRS used. It condemned the use of public company information to value private concerns. It criticized the lack of comparability in medicare reimbursement percentage. It rejected the concept of the "hidden profit" in the bonuses because they were apocryphal. It solidly endorsed the careful and exhaustive adjusted balance sheet asset valuation approach of the taxpayer's expert, which determined the value of the assets was less than the assumed liabilities. The case provides a wonderful tutorial on health care asset valuation for tax purposes.
Comments