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FIRST INTERMEDIATE SANCTIONS CASE: TAX COURT UPHOLDS PENALTY TAXES ON DIRECTORS IN STA-HOME HEALTH

By LaVerne Woods and Tracey Hawk
[June 2002]

In the first case addressing the tax law’s intermediate sanctions rules, the Tax Court has upheld penalty excise taxes of $11.6 million against nonprofit directors and entities controlled by them. The case is Michael T. Caracci, et ux., et al., v. Commissioner, commonly known as Sta-Home Health, decided May 22, 2002.

Overview of Intermediate Sanction Rules

The intermediate sanctions rules, enacted in 1996, are intended to penalize persons who use their influence over tax-exempt organizations in order to derive an impermissible benefit. Under prior law, the only remedy for such transactions was revocation of the organization’s tax exemption. The intermediate sanctions rules provide an “intermediate” means of addressing improper transactions by penalizing the persons who benefit from them.

Under the rules, a “disqualified person” who engages in an “excess benefit” transaction with a tax-exempt organization is subject to penalty excise taxes. A disqualified person is any person in a position to exercise substantial influence over the affairs of the organization, including directors and officers, as well as their family members and affiliated entities. An excess benefit transaction is one in which the disqualified person receives greater value than that provided to the organization.

A disqualified person who benefits from such a transaction is subject to an initial tax of 25 percent of the excess benefit. An additional tax of 200 percent of the excess benefit applies if the disqualified person does not “correct” the transaction by restoring any excess benefit to the organization. In addition, organization managers, such as directors and officers, who knowingly approve an excess benefit transaction may be liable for a tax of 10 percent of the excess benefit.

Facts of Sta-Home Health

Sta-Home Health involved five nonprofit, tax-exempt home health care organizations (the “Sta-Home” organizations). Members of a single family were the only board members of all five organizations. The family formed for-profit corporations, which they owned and controlled, and caused the Sta-Home organizations to transfer all of their assets to the for-profit corporations in exchange for the corporations’ assumption of the Sta-Home organizations’ liabilities. The family’s CPA had determined that the Sta-Home organizations had a negative fair market value. Once the transfers were completed, the family members had an indirect ownership interest in the assets, and rights to the income stream from the home health operations, previously owned and conducted by the nonprofit organizations.

The IRS characterized the transactions as “grossly abusive,” and asserted that the fair market value of the Sta-Home organizations was more than $5 million at the time of the transfers. It further maintained that the family members and their for-profit corporations were “disqualified persons” under the intermediate sanction rules, and that the transfers constituted excess benefit transactions. The IRS imposed both initial and second-tier intermediate sanctions taxes in excess of $40 million against the individuals and their corporations.

In addition to imposing intermediate sanctions, the IRS retroactively revoked the Sta-Home organizations’ tax exemptions under Section 501(c)(3) on the grounds that the transfers constituted prohibited private inurement transactions with insiders.

Tax Court Analysis: Valuation

The Tax Court ruled that the Sta-Home asset transfers were excess benefit transactions and upheld the imposition of intermediate sanctions taxes against the family members and their corporations. Surprisingly, however, the court ruled against the IRS on its revocation of the Sta-Home organizations’ exempt status.

The Tax Court agreed that the family members and their corporations were clearly disqualified persons. It devoted the bulk of the opinion to critiquing the expert testimony regarding the value of the Sta-Home assets in order to determine whether there was an excess benefit transaction. The opinion underscores the critical importance in any transaction involving disqualified persons and exempt organizations of an independent, expert valuation analysis.

The taxpayers’ valuation expert, in determining that the Sta-Home organizations had a negative fair market value, relied primarily on the fact that the organizations had operated at a loss for several years preceding the transfers. The court rejected that analysis and accepted the IRS expert’s position that even a company that showed losses could have substantial value to potential purchasers because of the importance of intangible assets in service businesses. It ruled that the transfers were excess benefit transactions that directly benefited the for-profit corporations, and indirectly benefited their shareholders, the family members.

Correction and Abatement

Perhaps the most significant aspect of the case is the court’s apparent willingness to be flexible regarding abatement of intermediate sanctions taxes. The taxes may be abated if the disqualified person “corrects” the excess benefit transaction. The disqualified person must restore the excess benefit to the organization and establish that the excess benefit transaction was due to reasonable cause and not due to willful neglect.

The Tax Court declined to rule on the issue of abatement because the excess benefit transactions had not been corrected. Correction is a pre-requisite for abatement, and the question whether the taxpayers qualified for abatement of the excise taxes therefore was not ripe for decision. The court left the door open for abatement, however, by noting that the period for correction of the transactions would not close until 90 days after the court’s decision became final.

No Revocation of Exemption

The Tax Court’s refusal to revoke the Sta-Home organizations’ tax-exempt status is intriguing, and may be an important bellwether. The court noted that the legislative history of the intermediate sanctions rules indicates that revocation of exemption in addition to imposition of intermediate sanctions taxes should occur only in “an unusual case,” and concluded that this was not such a case. The court did not believe that the excess benefit rose to a level that called into question whether the Sta-Home organizations, overall, functioned as tax-exempt organizations.

In support of its conclusion, the court noted that since their asset transfers the Sta-Home organizations had not been operated contrary to their tax-exempt purposes. This is a perplexing justification, given that the organizations had been dormant shells since the transfers. The court further noted that the excess benefit was the result of only a single transaction, suggesting a move towards a de facto “single transaction exception” to the general prohibition against private inurement. If a single impermissible transaction involving a transfer of all of an exempt organization’s assets was not grounds for revocation, however, it is hard to imagine what single transaction could lead to that result.

Don’t Be a Sta-Home: Creating the Rebuttable Presumption

The Sta-Home Health case illustrates that the IRS will aggressively pursue intermediate sanctions in situations where it perceives abuse. The best protection to minimize exposure for officers and directors is to follow a procedure set out in the intermediate sanctions regulations for approving transactions with disqualified persons. When followed, the procedure creates a rebuttable presumption that a transaction is reasonable. In order to invoke the presumption, (i) the transaction must be approved by an independent board or board committee without the disqualified person(s) participating; (ii) the board or committee must rely on “appropriate comparability data” that documents the arms’ length nature of the transaction (e.g., an independent compensation survey or appraisal by a qualified expert with knowledge of the industry); and (iii) the board or committee must document the transaction in writing, generally board or committee minutes.

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Any questions about this Advisory should be directed to :

LaVerne Woods, Seattle, (206) 757-8173, lavernewoods@dwt.com

This TEO Group Alert is a publication of the Tax-Exempt Organizations Group of Davis Wright Tremaine LLP. Our purpose in publishing this Alert is to inform our clients and friends of recent developments in tax-exempt and nonprofit organizations law. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

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