Founders of Health Care Facilities Argue Tax Court Erred in Valuation of Assets

STATEMENT REGARDING ORAL ARGUMENT

TABLE OF CONTENTS

TABLE OF AUTHORITIES

STATEMENT OF ISSUES

STATEMENT OF FACTS

SUMMARY OF ARGUMENT

ARGUMENT

CERTIFICATE OF COMPLIANCE

CERTIFICATE OF SERVICE

Anclote Psychiatric Ctr., Inc. v. Commissioner, 76 T.C.M. (CCH) 175 (1998), aff'd without published opinion, 190 F.3d 541 (11th Cir. 1999)

B.F. Sturtevant Co. v. Commissioner, 75 F.2d 316 (1st Cir. 1935)

*Broadcast Music, Inc. v. Xanthas, Inc., 855 F.2d 233 (5th Cir. 1988)

Commissioner v. Acker, 361 U.S. 87 (1959)

Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993)

Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981)

*Estate of Dunn v. Commissioner, 301 F.3d 339, 348 (5th Cir. 2002)

Estate of Palmer v. Commissioner, 839 F.2d 420 (8th Cir. 1988)

Gross v. Commissioner, 272 F.3d 333 (6th Cir. 2001)

*McLendon v. Commissioner, 135 F.3d 1017 (5th Cir. 1998)

Missouri Pac. R. Co. v. Salazar, 254 F.2d 847 (5th Cir. 1958)

*Powers v. Commissioner, 312 U.S. 259 (1941)

Rauenhorst v. Commissioner, 119 T.C. 157 (October 7, 2002)

United States v. Cartwright, 411 U.S. 546 (1973)

REVENUE RULINGS

*Rev. Rul. 68-609,1968-2 C.B. 327

*Rev. Rul. 59-60,1959-1 C.B. 237

Rev. Rul. 93-12,1993-1 C.B. 202

*Asterisk denotes important authority

UNITED STATES CODE

26 U.S.C. § 4958

26 U.S.C. § 6213

26 U.S.C. § 7491

26 U.S.C. §§ 7602, et. seq.

MISCELLANEOUS

SHANNON P. PRATT, ET AL., VALUING SMALL BUSINESSES AND PROFESSIONAL PRACTICES, (3d ed. 1998)

SHANNON P. PRATT, VALUING A Business: THE ANALYSIS AND APPRAISAL OF CLOSELY HELD COMPANIES (2d ed. 1989)

[3] Based on the Commissioner's brief ("CIR Br."), this case is now ripe for de novo review and reversal under Dunn.

[6] On average, Medicare disallowed .7% of Sta-Home's costs every year. Those reimbursement disallowances necessarily created losses. In 1995, Sta-Home suffered $433,390 in losses. Doc. 86, Opin. 10. As revenue grew bigger, the commensurate losses necessarily deepened.

[7] Challenges to Commissioner's Description of Facts. The Commissioner's description of the facts is incomplete and inaccurate:

[9] No factual dispute remains on the record, other than the mixed question of fact and law relating to ultimate value. The competing asset valuation methods are the Adjusted Balance Sheet form of asset valuation and a variation on a method used to value invested capital. No one has appealed the Tax Court's proper rejection of the cost-gap capitalization as fraught with too many imponderables, though the Commissioner seems to insinuate his own version of that method back into his brief without having appealed that point. The Commissioner also never disputes his own rulings, the case law, or the valuation treatises which establish that unprofitable intangible assets bear little to negative value. Appellants respectfully submit that these points should lead to an outright reversal.

[12] The still undisputed points of law, the Tax Court's admitted errors, and common sense require -- as they did in Dunn -- reversal and entry of judgment.

[14] Never once does Dunn ever use the word "permissible" -- much less sanction this "permissible" principle. Not at page 348, not anywhere. On the contrary, this Circuit reversed the Tax Court in Dunn under a de novo review for giving primary weight to an asset-liquidation method over an earnings-based method -- both of which would be "permissible" in the Commissioner's characterization. Consider how this Circuit applied the appellate review standard:

Thus, Dunn directly contradicts the IRS view of diminished appellate review.

[15] Burden of Proof. In thousands of cases, the Tax Court imposes taxes upon citizens at the urging of the Commissioner solely for their failure to establish a prima facie case or prove their point by a preponderance of the evidence. A disturbing trend has arisen in the rare cases when the citizen has a basis for urging that the Commissioner bears the burden of proof; at the urging of the Commissioner, the Tax Court holds, as here, that the Court never reaches the burden of proof.⁴ This Circuit, the Third Circuit, and more recently the Ninth Circuit have been the most vigilant in allocating the burden in an even-handed fashion, reversing the Tax Court when appropriate, and imposing meaningful consequences on the Commissioner's failure to carry his burden.

[16] Based on the authorities set forth at App. Br. 25-26, this Circuit imposes upon citizens the burden of proving that the IRS notice of deficiency is either excessive, erroneous, arbitrary, or capricious. Upon that showing, the burden shifts to the Commissioner. In this case, the Commissioner had ACTUAL KNOWLEDGE that the Notices were excessive and erroneous, as well as arbitrary and capricious. If not sooner, he certainly learned of his obligation to subtract the consideration under 26 U.S.C. § 4958(c)(1)(A), upon receipt of the Motion for Partial Summary Judgment Regarding Subtraction of Liabilities. Doc. 17. The IRS then filed sworn affidavits, falsely denying that their Notices overstated the "excess benefit" claims by refusing to recognize the consideration in the controlling conveyance contracts (the liabilities now fixed at $13.5 million). See Dunn, 301 F.3d at 349-350 (IRS bears the statutory duty to assert the correct amount of tax, not the largest amount of tax). Under the Commissioner's stacked Notices, he continued to overstate the claims he held over Joyce, her family, and their agencies by greater than ONE HUNDRED MILLION DOLLARS. After prolonging the agony, the Commissioner admitted for the first time in his opening statement that his Notices overstated his claims. That is excessive, erroneous, arbitrary, capricious, and inhumane.

[17] That too should be dispositive, for the Commissioner cannot carry his burden by persuading trial courts that profit potential exists where it is prohibited, by failing to ever value the assets under an asset method of valuation, by relying exclusively upon incomparable solvent public companies and the universally dismissed "guideline" companies, or by evading his rulings relating to unprofitable intangible assets.

[19] The Commissioner now concedes that the Tax Court erred on the essential point of profit potential. To be sure, he relegates his concession to the oblique reference of "the Tax Court's misstatement of a fact" in the last paragraph of his Summary of Argument, acknowledges the specific error only in his catchall argument ("3. Taxpayers' remaining arguments lack merit"), and somehow dismisses the Tax Court's linchpin conclusion ("thus, demonstrate substantial fair market value") as "harmless error." CIR Br. 30, 62-63. Ironically, he bases his contention that this now undisputed error is harmless by then admitting Appellants' point: this mistaken premise of $1.78 profit potential is contradicted by the Tax Court's findings of fact that those "operating under the Medicare reimbursement system stood little chance of turning a profit." CIR Br. 63-64. The Court actually found that the Sta-Home Agencies were at least 95% dependent on Medicare, Medicare "was not designed to generate profits or contribute to capital growth," Medicare refused to reimburse on average .7% of actual expenses, and as a result, the Sta-Home Agencies incurred a pattern of increasing losses culminating in a 1995 loss of $433,390. Of course, an opinion at war with its findings, like irreconcilable contradictory findings, requires reversal under the authority of this Court. See, e.g. Broadcast Music, Inc. v. Xanthas, Inc., 855 F.2d 233, 237 (5th Cir. 1988) (trial court may have used different method to calculate damages if aware of its erroneous finding); Missouri Pac. R. Co. v. Salazar, 254 F.2d 847, 848-849 (5th Cir. 1958). Above all else, the Commissioner concedes that the assets are unprofitable and the Tax Court's twice stated belief of profit potential is wrong.

[21] Yet, the Commissioner says that the willing FMV buyer would still view the $1.78 million mistake about profits as harmless. As a matter of law and sound business judgment, this error could not have been harmless to the Tax Court. In reaching its valuation conclusions, the trial court is required to step into the shoes of the willing FMV buyer who is charged, as a matter of law, with "knowledge of all relevant facts" and who must base his price on the totality of those facts and circumstances. See, e.g., United States v. Cartwright, 411 U.S. 546, 551-552 (1973). Again as a matter of law, the Tax Court was therefore obligated to consider the $1.78 million profit potential if it thought it were true.

[22] Indeed, only the Tax Court's mistaken belief that the unprofitable Sta-Home assets could generate $1.78 million in 1995 profits and "thus, demonstrate a substantial fair market value" (Opin. 41), can explain why the Tax Court (i) rejected the PREFERRED and ONLY asset valuation method in the record; (ii) embraced a variation of an invested capital valuation method to value assets; (iii) relied exclusively upon public companies with profit potential; (iv) relied exclusively on a revenue based multiple drawn from these public companies with a profit potential; and (v) calibrated its chosen .25 invested capital/revenue multiple accordingly.

[23] Most importantly, only the non-existent $1.78 million profit potential can explain why the Tax Court never addressed the unbroken chain of cases, rulings, and treatises which recognize that unprofitable intangibles bear little to negative market value and which should dispose of this case.

[25] Even the Commissioner grudgingly agrees that the property that must be valued consists of (i) assets, (ii) belonging to three private Mississippi home healthcare agencies in financial distress and destined to lose an average of .7% of every dollar of Medicare cost, (iii) such that increased Medicare revenue means increased losses and increased losses mean increased capital erosion. CIR Br. 3, 5-6. With those three telltale signs in mind, the Commissioner's brief proves the Tax Court's valuation method is wrong as a matter of law for four systemic reasons.

[27] The Commissioner tries to blame the Sta-Home Agencies for his failure to use this universally preferred method for valuing assets -- or any form of asset valuation. CIR Br. 42. Compare the Commissioner's and Sta-Home's efforts. WITH NO DUTY, Sta-Home volunteered its Chief Financial Officer to explain all of the operations to the Commissioner's expert. Doc. 73, Tr. 695. The sheer volume of the Sta-Home documents in the FOUR sets of Stipulations of Facts proves that Sta-Home produced massive amounts of information -- both during the two year audit and during the litigation. The Commissioner bore the statutory duty under 26 U.S.C. § 6213 and Dunn to make an accurate determination of the liability. He now admits he failed to do that. Particularly as the party who bears the burden of proof as a result of his excessive claims, the Commissioner bore the duty to use the discovery processes uniquely available to him by statute (26 U.S.C. §§ 7602, et seq.) and the Tax Court Rules to obtain any information he or his expert genuinely needed. They needed none on this record. With all due respect, what they needed was a post-hoc excuse for the Commissioner never using an asset valuation method to support his terrifying claims and a post-hoc excuse for the Commissioner refusing to authorize his expert to spend more than two days in Mississippi to do an eight week job. Doc. 73, Tr. 499. Even if no one ever presented the Tax Court with this "preferred" asset valuation method, the Commissioner still bore the burden of proving the asset values through a method that matched those assets.

[29] No one disputes that the Sta-Home ASSETS are the target here⁷ -- not the Sta-Home INVESTED CAPITAL. Yet, the valuation method the Commissioner thrust upon the Tax Court was an indirect variation on the Market Value of Invested Capital ("MVIC") valuation method. That variation on MVIC is the VALUATION METHOD the Tax Court used. Opin. 41, 45-46.

[30] Consider the Tax Court's use of this method in the context of the Tax Court's rejection of the Cost-Gap capitalization method as too fraught with imponderables. Opin. 43. This indirect variation stacks dubious inference upon dubious inference. It begins with the recognition that private companies generally have large long-term debt and small equity, while public companies have large equity and small long-term debt. CIR Br. 17-18. Mr. Wilhoite's firm makes the dubious assumption that somehow the lopsided debt/equity mix of the private company can be equated to the reverse lopsided equity/debt mix of the public company by totaling long-term debt and equity. Ex. 197-R, 47-48. The Tax Court accepted that counter-intuitive equation without analysis. As the Commissioner now admits at page 55 of his brief, the Tax Court extracted its invested capital multiple by relying exclusively upon Mr. Wilhoite's seven PUBLIC COMPANIES. Further, the Tax Court and Mr. Wilhoite relied solely on the revenue version of the invested capital method -- passing over any consideration of the other five MVIC versions (focusing on earnings, etc.). Opin. 42.

[31] Next, the Tax Court assumes -- by way of a reversed cost accounting fiat -- that short-term debt necessarily equals asset value on a dollar-for-dollar basis (just as the invested capital multiple assumes that long-term debt necessarily equals asset value). Opin. 37-39, 47. In reliance on this same reverse cost accounting fiat, the Tax Court ADDS SHORT-TERM DEBT TO ASSET VALUE in order to extract what Mr. Wilhoite recognizes is a "plugged number." Doc. 73, Tr. 752.

[32] The best example of the "Alice in Wonderland" reverse logic in this variation lies in the Tax Court and the Commissioner ADDING $201,000 IN INHERENT LOSSES TO ASSET VALUE. Opin. 47. Mr. Hahn accrued a Medicare liability in the amount of $201,000 for the inherent loss arising from the refunds that would be due Medicare from Sta-Home under the anticipated disallowances. This loss reserve in creased the Tax Court's asset value. If only the Sta- Home Agencies had inherent losses of eight zillion dollars in refunds due back to Medicare, WHY THE ASSET VALUE WOULD NECESSARILY BE INCREASED BY EIGHT ZILLION DOLLARS -- under the Tax Court's theory. If only the agencies could assume all of the losses and liabilities of recent corporate failures, the Tax Court would view these agencies as the most valuable companies in America.

[34] The Commissioner concedes the essential threshold element of the third assignment of error:

[35] The Tax Court categorically excludes comparable companies and assets in its exclusive reliance on this public pool:

                                             Pre Tax     Asset

[37] These Mississippi home health agencies with their 95-97% Medicare dependence vary wildly from the non-Mississippi national norm of only 38% Medicare, as the Commissioner's expert acknowledged. Doc. 73, Tr. 683. That one difference sets the exclusively non- Mississippi transactions in Mr. Hahn's 1997-1998 articles in context. Further, the Commissioner's fixation with those articles mischaracterizes their factual and legal significance:

[42] The Tax Court found and the Commissioner does not dispute that the difference between its valuation opinion and that of Mr. Hahn is the true value of the intangible assets. Opin. 50. Hence, the value of the tangible assets determined by Mr. Hahn -- the only expert to address the value of tangible assets -- is undisputed by the Tax Court and the Commissioner at a range between $8,421,977 and $8,787,492. Ex. 191-P, App. C. The "excess benefit" question is thus sharpened to whether the value of the intangible assets exceeded the approximately $5 million difference between the $13.5 million in liabilities assumed and the value of the tangible assets.⁹

[43] Ultimately, the Tax Court concluded that the asset value was $18,675,000 thereby, yielding an intangible asset value of approximately $10,000,000 before correction of the $1.78 million profit potential mistake. Opin. 47. Therefore, the sharpened issue is whether the value of these unprofitable intangible assets exceeds the approximately $5 million difference.

[45] The Commissioner's own rulings, the caselaw, and even the theoretical valuation treatises recognize that such unprofitable intangible assets bear little to negative market value. See, eg., Rev. Rul. 59-60, 1959-1 C.B. 237, Sec. 4(f) ("The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets": emphasis added); Rev. Rul. 68-609, 1968-2 C.B. 327 (Same conclusion relating to valuation of intangible assets in general); and authorities discussed at App. Br. 57-65. Presumably due to its $1.78 million profit potential mistake, the Tax Court never analyzed, discussed, or cited these authorities.

[46] The Commissioner does not and cannot dispute these authorities on brief. He is bound by them under the precedent of this Court. Based on Fifth Circuit precedent, the Tax Court severely criticized the Commissioner only last October for taking litigation positions at odds with his published rulings. Rauenhorst v. Commissioner, 119 T.C. 157, 171-2 (October 7, 2002) holding that the Commissioner is bound by his rulings based on, inter alia, Estate of McLendon v. Commissioner, 135 F.3d 1017, 1024-5 (5th Cir. 1998). In this case, the Tax Court never addressed the Commissioner's obligation to follow his rulings relating to the value of unprofitable intangible assets. That too is error.

[47] The Commissioner simply dismisses his own rulings, the caselaw, and the valuation treatises as "beside the point." CIR Br. 65. When coupled with the only valuation method that actually addresses the assets (as opposed to invested capital) and that already attributes too much value to the intangibles, they are the dispositive point!

1. Exclusive of the exempted portions in FED. R. APP. 32(a)(7)(B) and 5th Cir. R. 32.2, the Reply Brief of Appellants contains 6997 words.

2. The brief has been prepared in proportionally spaced typeface using Times New Roman 14 point font in text produced by Microsoft Word software.

3. Undersigned counsel understands that a material misrepresentation in completing this certificate, or circumvention of the type-volume limits in FED. R. APP. P. 32(a)(7), may result in the Court's striking the brief and imposing sanctions against the person who signed it.

²No one disputes the fair market value of these unprofitable intangible assets must exceed approximately $5 million before any "excess benefit" arises under the applicable statute, Section 4958. All agree that Sta-Home conveyed consideration in the amount of $13,511,000 (in liabilities assumed) and no one disputes the uncontroverted valuation of the tangible assets at a range between $8,421,977 to $8,989,992. Opin. 28-29; Doc 48. Ex. 191-P, App. C. Thus, no dispute if the unprofitable intangible asset value is less than the $5 million difference.

³The Sixth Circuit's opinion in Gross v. Commissioner, 272 F.3d 333, 343 (6th Cir. 2001) is diametrically opposed to Dunn in every respect. It defers to the Tax Court's selection of a valuation method including disregarding the valuation impact of the built-in tax liability -- the exact opposite of the holding in Dunn.

⁴A quick computer run of the Tax Court opinions under the new burden of proof statute, 26 U.S.C. § 7491, proves the same pattern followed here.

⁵Dunn, 301 F.3d at 357, n.34 citing with approval, B.F. Sturtevant Co. v. Commissioner, 301 F.3d at 357, n.34 citing with Commissioner, 75 F.2d 316, 324 (1st Cir. 1935) for holding that good business judgment must prevail "and a failure or refusal to exercise that judgment constitutes an error of law."

⁶As noted, Daubert requires that this peculiar variation be "reliable" and "fit" the facts. That method should generally be rejected as "junk science" where, as here no one has subjected it to peer review, tested it for identifiable error rates, and found it acceptable within that field of knowledge. Daubert, 509 U.S. at 589-595.

⁷Notably, the willing buyer is not buying the jobs. To be sure, the one reason that Joyce any her family persevere is that the agencies provide good jobs to do good work for a good cause at a good salary. The buyer would have to pay someone to do that work.

⁸The .30 noted above relates to the ratio between the now fixed $13.5 million consideration and the revenue. Compare Ex. 191-P, App. D (.26). Also note that the multiples calculated by Mr. Wilhoite and Mr. Hahn are BASED ON ENTIRELY DIFFERENT VALUE MEASURES. See App. Br. 54, n. 13.

⁹Consistent with the general range concept stated in Anclote Psychiatric Or., Inc. v. Commissioner, 76 T.C.M. (CCH) 175 (1998), aff'd without published opinion, 190 F.3d 541 (11th Cir. 1999), the Court need not determine a precise value for the intangible assets under the language of the Section 4958 penalty provisions so long as the $13.5 million in liabilities exceed the economic benefit from the assets. Because Section 4958 is a penalty provision that must be narrowly construed, no penalty should be imposed unless the benefit of the assets clearly exceed the consideration -- that is, is clearly outside the range of what in reality the agencies could realistically expect to receive upon sale of assets. Commissioner v. Acker, 361 U.S. 87, 91 (1959). In the instance of greater asset value than consideration, a precise determination would be required.