Fifth Circuit Court Decision on Intermediate Sanctions Issued in Favor of Taxpayer

January 4, 2008 — 1,517 views  
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In a closely followed case, the U.S. Court of Appeals for the Fifth Circuit recently provided important guidance on application of intermediate sanctions on tax exempt organizations and the use of third party appraisals when engaging in transactions with insiders. In Sta-Home Health Agency, et al. v. Commissioner, Case No. 02-60912 (5th Cir.), issued July 11, 2006, the appellate court reversed the earlier Tax Court decision and held entirely in favor of the taxpayer.


If a 501(c)(3) organization enters into a transaction resulting in an excess benefit (non-fair market value) to an insider (e.g., officers and directors), the IRS may impose an excise tax on the organization, the benefited insider, and organization managers, including a 200% penalty if the excess benefit is not corrected. The case stemmed from the imposition of such excise taxes on a transaction in which members of the Caracci family caused three tax-exempt home health agencies to transfer their assets to newly formed, for-profit corporations owned by the family members in exchange for assumption of the exempt entities' liabilities. Based on two appraisals, the exempt organizations determined that the liabilities assumed exceeded the fair market value of the assets transferred, and thus no cash was paid by the for-profit corporations.

The IRS reviewed the transaction and determined that it resulted in an $18.5 million transfer of net value to the for-profit entities and therefore imposed intermediate sanctions in excess of $250 million. Importantly, on the eve of the trial the IRS admitted the $250 million assessment was excessive and based on an incomplete review of the transaction and the assets involved. At trial, the Tax Court did not accept either party's appraisal in its entirety, instead adopting portions of each appraisal in determining that the excess benefit was about $5.1 million.

Circuit Court Decision

Upon review, the Fifth Circuit reversed the Tax Court and held for the taxpayer. The Court held that the burden of proof shifted to the IRS because of its arbitrary and excessive $250 million assessment that it refused to correct until the eve of the trial, even though the IRS's own internal documents indicated the calculation was incomplete. The Circuit Court then determined that, since the Tax Court rejected key aspects of the appraisal presented by the IRS, the IRS could not possibly meet its burden of proof. The Court also expressed its own doubt about the IRS's appraisal, noting that the IRS's expert had no specific experience in the home health industry, had spent relatively little time on-site investigating Sta-Home's operations, that his methodology was inappropriate for an asset valuation, and the comparables used in the valuation were not sufficiently similar. The errors were so egregious that the Court took the unusual step of holding for the taxpayer, rather than remanding the case to the Tax Court for further consideration.

The decision highlights two important considerations for taxpayers. The first is that large, excessive assessments by the IRS should not necessarily intimidate the taxpayer or force an unreasonable settlement. The decision reminds taxpayers that courts frown on arbitrary assessments and when they occur the IRS will be expected to prove the validity of the assessment. Second, the decision emphasizes not only the importance of an appraisal for a transaction with insiders, but also the need for the appraisal to be prepared by a suitable expert. An exempt organization should insure that the appraiser has adequate experience in the organization's industry and that the appraiser spends an ample amount of time reviewing the organization's operations.

Baker Donelson