Tax Court Upholds IRS Determination in First Intermediate Sanctions
By Harry J. Friedman, Greenberg Traurig,
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On May 22, 2002, the Tax Court upheld the decision of the Internal Revenue
Service (the "Service") to impose excise taxes under Section 4958 of the
Internal Revenue Code, commonly referred to as "Intermediate Sanctions,"
in Caracci, et ux., et al. v. Commissioner, a case involving a sale
of three tax-exempt home healthcare entities to for-profit corporations
controlled by the tax-exempt organizations. As the first judicial decision
addressing the application of Intermediate Sanctions, this case will be
closely read by the tax practitioners and the exempt organization community.
|"The Tax Court upheld the decision
of the Internal Revenue Service to impose excise taxes under Section
4958 of the Internal Revenue Code, commonly referred to as 'Intermediate
Section 4958 is generally effective for transactions occurring after
September 13, 1995. Intermediate Sanctions were enacted as part of the Taxpayer
Bill of Rights II in 1996, providing the Service with long sought-after
tools to impose penalties, short of revocation of exempt status, on insiders
of Section 501(c)(3) and (4) organizations who improperly benefit from the
organizationsí activities. Section 4958 was patterned after the Chapter
42 excise taxes applicable to private foundations. Instead of penalizing
the exempt organization by revocation of exempt status, Section 4958 imposes
penalties on the "wrong doers" when a disqualified person receive an improper
benefit from an exempt organization.
A disqualified person, generally a person who has substantial influence
with regard to the organization, who participates in an "excess benefit
transaction" (e.g., compensation in excess of reasonable compensation or
a purchase of property for an amount less than fair market value) is liable
for a tax of 25% of the excess benefit. If the transaction is not corrected,
a disqualified person can be subject to an additional penalty of 200% of
the amount of the excess benefit he, she or it received. In addition, organization
managers who participate in an excess benefit transaction, knowingly, willfully
and without reasonable cause are liable for a tax of 10% of the excess benefit,
not to exceed $10,000.
On January 23, 2002, the Service issued Treasury Regulations under Section
4958. The Final Regulations replaced Temporary Regulations that were issued
on January 10, 2001, and had been effective to govern transactions since
that date. However, the Treasury Regulations played no part in this decision.
Sale of the Assets of Three Tax Exempt Entities
The Caracci Family (the "Family") had formed three Mississippi tax-exempt
not-for-profit corporations in the mid-1970ís. The tax-exempt entities operated
home health agencies in Mississippi. In 1995, the Family determined to convert
the three tax-exempt entities into for-profit corporations. The Family received
an appraisal from the entitiesí accounting firm. The appraisal concluded
that the value of the assets of each of the tax-exempt entities was less
than the amount of its liabilities.
Effective October 1, 1995, each of the tax-exempt home health agencies
transferred their tangible and intangible assets to a mirror for-profit
corporation. The consideration in each case was the assumption of the transferorís
liabilities. All three for-profit corporations were controlled by members
of the Family.
The Service concluded that the fair market value of the transferred assets
exceeded the assumed liabilities by approximately $20 million. The Service
asserted that the individuals and the for-profit corporations were liable
for deficiencies totaling over $256 million based on joint and several liability
for the excise taxes (in reality, the excise taxes payable were $46,460,477).
The magnitude of the tax liability was a result of the imposition of the
200% penalty for failure to correct the excess benefit transactions.
Tax Court Decision
None of the taxpayers seriously disputed that they were disqualified
persons with respect to each of the tax-exempt corporations. Three of the
Family members were directors and officers of each of the entities. Other
Family members were disqualified persons because of their relationships.
The purchasing for-profit corporations were 100% owned by the Family.
The Tax Courtís decision focused on the determination of the fair market
value of the property. The Tax Court noted that fair market value reflects
the highest and best use of the property on the valuation date. While the
test for value seeks the price for which a hypothetical willing-buyer and
willing-seller would enter into a transaction, the Tax Court concluded that
a hypothetical buyer may be one of a class of buyers who is in a position
to use the purchased assets more profitably than other potential buyers.
In particular, the Tax Court noted that certain buyers of home health agencies
could take advantage of the tax-exempt entityís cost-shifting attributes.
Thus, under the test used by the Tax Court, hypothetical buyers can have
The Family argued that a common sense valuation required a decision in
their favor. They urged that the fact that the tax-exempt entities had operating
losses for several years and that the liabilities assumed exceeded the value
of the assets should control the Tax Courtís determination.
In reviewing the valuation evidence of both parties, the Tax Court noted
that in valuing tax-exempt entities, earnings and profits are less meaningful
than in the case of for-profit entities. In the case of the home health
agencies funded by Medicare, the program was not designed to produce corporate
profits. Instead, the Medicare program was designed to reimburse providers
for their costs, including administrative salaries and overhead. The Tax
Court observed that the system permitted the operators of a home health
agency to generate substantial salaries and benefits for themselves. The
Tax Court concluded that the best evidence of the value of the tax-exempt
entities arose from the use of a comparable value method. This compares
the privately held tax-exempt entity to similarly situated corporations
whose shares are publicly traded.
The Tax Court specifically noted the importance of non-book intangibles
in valuing the home health care agencies. The Tax Court noted there was
a substantial value in the workforce in place, as a result of an assemblage
of a work force of approximately 1,000 health care professionals. The Tax
Court also valued the intangible benefit that provided a cost benefit to
certain qualifying buyers.
The net value of the assets according to the Tax Court was in excess
of $18 million. Consequently, the Tax Court imposed substantial excise tax
penalties on the Family and the for-profit buyers.
Revocation of Exemption
The Tax Court also considered the revocation of tax-exempt status of
the three exempt entities. The Tax Court noted that the presence of a single
substantial non-exempt purpose can destroy the exemption if a tax-exempt
entity regardless of the number or importance of its exempt purposes, citing
Better Business Bureau vs. United States. The Tax Court noted that
in a case arising before the effective date of Intermediate Sanctions,
Anclote Psychiatric Center v. Commissioner, the Tax Court had revoked
the tax-exempt status of a tax-exempt hospital where its assets were sold
for less than fair market value to a for-profit corporation whose shareholders
were directors of the tax-exempt entity. The Tax Court observed that the
legislative history of Section 4958 provided that "the intermediate sanctions
for excess benefit transactions may be imposed by the IRS in lieu of (or
in addition to) revocation of an organizationís tax-exempt status." The
legislative history goes on to state that "in general, the intermediate
sanctions are the sole sanction imposed in those cases in which the excess
benefit does not rise to a level where it calls into question whether, on
the whole, the organization functions as a charitable or other tax-exempt
organization." The Tax Court observed that the legislative history "indicates
that both a revocation and the imposition of intermediate sanctions will
be an unusual case."
In concluding that revocation of exemption was not appropriate, the Tax
Court stated that the tax-exempt entities had not operated contrary to their
tax-exempt purpose since the transfers. Further, the Tax Court observed
that the continuation of the tax-exemption would be necessary in order for
the taxpayers to utilize the correction provisions in the Code. Thus, the
ability to correct the excess benefit transaction would support retention
of exempt status.
The Tax Court decision provides additional guidance on the Tax Courtís
view of the appropriate method of valuation of assets of tax-exempt organizations.
The amount of compensation paid by the organization will be considered in
valuing the assets. Further, non-book intangibles will be included as valuable
Obtaining an appraisal did not prevent imposition of the excise tax penalties.
The legislative history of Section 4958 describes a rebuttable presumption
of reasonableness if independent valuations are obtained by the directors
of the exempt organization and certain other requirements are met, including
approval by an independent directors. The Caracci case evidences
that merely obtaining an appraisal of the assets sold is inadequate alone
to prevent an imposition of penalties. The appraisal must be based on appropriate
We believe that obtaining contemporaneous valuations and compliance with
the other requirements of the Treasury Regulations in order to create a
rebuttable presumption of reasonableness can be valuable in avoiding Intermediate
Sanctions. It is unclear whether the Family would have been successful if
independent directors had approved the transaction. While the Service may
still challenge the valuation in the face of approval by independent directors,
the standard of proof the Service must meet will be greater.
The Tax Courtís determination to permit the exempt organizations to retain
their exempt status confirms the legislative history position that revocation
of exempt status will be, with the enactment of Intermediate Sanctions,
an unusual and extraordinary penalty. The contrast of the decision in the
Anclote case, arising prior to Intermediate Sanctions, from the
Caracci decision, arising after the enactment of Intermediate Sanctions,
illustrates the importance of Intermediate Sanctions in altering the penalties
the Tax Court will impose.
© 2002 Greenberg Traurig
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