Fall 2002

Case Notes

Fifth Circuit Reverses Tax Court — and Scolds IRS Commissioner

The Fifth Circuit went beyond reversing the Tax Court in its opinion concerning Estate of Beatrice Dunn v. Commissioner, T.C. Memo. 2002-12. It went so far as to question the motivation of the IRS Commissioner’s positions in the case.

The Fifth Circuit reversed the Tax Court on two key issues — weighting the valuation between the higher-yielding asset and lower-yielding income approaches and the reduction for trapped-in capital gain.

In the Tax Court case, the Commissioner argued that the asset approach should be used exclusively and that no allowance should be made for trapped-in gain. The Tax Court weighted the asset approach at 65 percent and allowed a 5 percent reduction for trapped-in gain.

The Fifth Circuit ruled that the lower-yielding income approach should be weighted at 85 percent, reducing the asset approach weighting to 15 percent, and that the trapped-in gain should be recognized at the full 34 percent tax rate.

The Fifth Circuit went beyond reversing the Tax Court’s findings, however. It strongly rebuked the IRS, calling the Commissioner’s positions at the Tax Court “ ... so incongruous as to call his motivation into question. It can only be seen as one aimed at achieving maximum revenue at any cost ... ” The Fifth Circuit further instructed the Tax Court to consider taxpayer claims for costs and fees under I.R.C. Section 7430.

Tax Court Stresses Fair Market Value in Conversion of 501(c)(3) Entities to S Corp Status

In Caracci v. Commissioner, 118 T.C. No. 25, the Tax Court significantly increased the valuation of a home health care entity switching from 501(c)(3) to S corporation status. The entity, which had a history of net operating losses and a negative book value, proposed a negative value. The IRS expert proposed a value of $7 million, which the Tax Court reduced to $5,164,000.

The key issue that led to the significant increase in value despite the entity’s current negative results was the potential attractiveness that the converted S corporation would present to the healthcare marketplace. Hospitals or other healthcare entities would likely find the entity’s cost-shifting attributes attractive.

The Tax Court held that “ ... fair market value takes into account special uses that are realistically available because of a property’s adaptability to a particular business ... assets are not valued in a vacuum, but, instead, are valued at their highest and best use.”

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© 2002