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GT Alert

Tax Court Upholds IRS Determination in First Intermediate Sanctions Case

June 2002
By Harry J. Friedman, Greenberg Traurig, Phoenix Office

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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.

Harry J. Friedman
"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 Sanctions.'"

Intermediate Sanctions

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 particular characteristics.

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 assets.

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 standards.

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

Additional Information:

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