                         118 T.C. No. 25



                     UNITED STATES TAX COURT



        MICHAEL T. CARACCI AND CINDY W. CARACCI, ET AL.,1
    Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 12481-99, 12482-99,       Filed May 22, 2002.
                 12483-99, 14711-99X,
                 17333-99, 17334-99,
                 17335-99, 17336-99X,
                 17337-99, 17338-99,
                 17339-99X,17340-99,
                 17341-99, 17342-99.




     1
       Cases of the following petitioners are consolidated
herewith: Vincent E. and Denise A. Caracci, docket No. 12482-99;
Christina C. and David C. McQuillen, docket No. 12483-99;
Sta-Home Home Health Agency, Inc., of Grenada, Mississippi,
docket No. 14711-99X; Sta-Home Health Agency of Carthage, Inc.,
docket No. 17333-99; Sta-Home Health Agency of Greenwood, Inc.,
docket No. 17334-99; Michael Caracci, docket No. 17335-99;
Sta-Home Home Health Agency, Inc., of Forest, Mississippi, docket
No. 17336-99X; Victor Caracci, docket No. 17337-99; Christina C.
McQuillen, docket No. 17338-99; Sta-Home Home Health Agency,
Inc., docket No. 17339-99X; Joyce P. Caracci, docket No.
17340-99; Vincent E. Caracci, docket No. 17341-99; and Sta-Home
Health Agency of Jackson, Inc., docket No. 17342-99.
                               - 2 -

           Members of the C family wholly own three home
     health care organizations (P1, P2, and P3) exempt from
     Federal income taxes under sec. 501(c)(3), I.R.C. In
     1995, the C family created three S corporations (S1,
     S2, and S3) and collectively received all of the
     resulting stock. P1, P2, and P3 then transferred all
     of their assets to S1, S2, and S3, respectively, in
     exchange for each transferee’s assumption of the
     transferor’s liabilities. R determined that the fair
     market value of the transferred assets substantially
     exceeded the consideration received in exchange.
     Accordingly, R determined S1, S2, S3, and members of
     the C family were liable for excise taxes under sec.
     4958, I.R.C., and members of the C family who received
     stock in S1, S2, or S3 but did not have an ownership
     interest in P1, P2, and P3 were liable for income taxes
     on the value of the stock received. R also revoked the
     tax exemptions of P1, P2, and P3. Held: The
     transferred assets’ value at the time of transfer
     decided. Held, further, the value of the transferred
     assets exceeded the value of the consideration
     received; thus, S1, S2, S3, and members of the C family
     are “disqualified persons” subject to excise taxes
     under sec. 4958, I.R.C., as beneficiaries of “excess
     benefit transactions”. Held, further, although P1, P2,
     and P3 engaged in “excess benefit transactions”, a
     revocation of their tax-exempt status is inappropriate
     given the “intermediate sanctions” under sec. 4958,
     I.R.C. Held, further, the three members of the C
     family are not liable for the income taxes determined
     by R.



     David D. Aughtry and Vivian D. Hoard, for petitioners.

     Robin W. Denick and Mark A. Ericson, for respondent.



     LARO, Judge:   These cases are before the Court consolidated.

Petitioners seek review of respondent’s determinations for 1995

of income tax deficiencies, excise tax deficiencies under section

4958, accuracy-related penalties under section 6662(a), and
                                     - 3 -

revocations of exempt status under section 501(c)(3).2

Respondent determined the following income tax deficiencies and

accuracy-related penalties:

                                                       Accuracy-related penalty
         Petitioner                    Deficiency            sec. 6662(a)

Michael T. and Cindy W. Caracci       $2,192,643              $438,528.60
Vincent E. and Denise A. Caracci       1,272,216               254,443.20
Christina C. and David C.
  McQuillen                            1,272,307              254,461.40

Respondent determined the following excise tax deficiencies:

                                                     Deficiency

                                   Sec. 4958   Sec. 4958           Sec. 4958
         Petitioner                 (a)(1)       (a)(2)               (b)

 Sta-Home Health Agency        $1,948,559             -0-         $15,588,474
   of Carthage, Inc.
 Sta-Home Health Agency            1,384,944          -0-          11,079,522
   of Greenwood, Inc.
 Sta-Home Health Agency            1,302,420         -0-           10,419,362
   of Jackson, Inc.
 Joyce P. Caracci                  4,635,923        $30,000        37,087,388
 Michael Caracci                   4,635,923         30,000        37,087,388
 Victor Caracci                    4,635,923          -0-          37,087,388
 Vincent E. Caracci                4,635,923          -0-          37,087,388
 Christina C. McQuillen            4,635,923         30,000        37,087,388

Respondent determined that the three Sta-Home tax-exempt entities

failed to qualify for tax-exempt status under section 501(c)(3).3




     2
       Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the year in issue, and Rule
references are to the Tax Court Rules of Practice and Procedure.
     3
       The three Sta-Home tax-exempt entities are Sta-Home Home
Health Agency, Inc., Sta-Home Home Health Agency, Inc., of
Forest, Mississippi, and Sta-Home Home Health Agency, Inc., of
Grenada, Mississippi. The three entities against which
respondent determined excise tax deficiencies are the Sta-Home
for-profit entities.
                              - 4 -

     Following respondent’s concession that none of petitioners

are liable for section 4952(a)(2) excise taxes or section 6662(a)

accuracy-related penalties, we are left to decide:   (1) Whether

Joyce Caracci, Michael Caracci, Victor Caracci, Vincent Caracci,

Christina McQuillen, and the Sta-Home for-profit entities are

liable for excise taxes under section 4958 because of the

transfers of assets from the Sta-Home tax-exempt entities to the

Sta-Home for-profit entities in exchange for the transferees’

assumption of the transferors’ liabilities (the asset transfer);

(2) whether Michael Caracci, Vincent Caracci, and Christina

McQuillen, as shareholders of the Sta-Home for-profit entities

but not of the Sta-Home tax-exempt entities, are liable for

income taxes in connection with the asset transfer; and

(3) whether the asset transfer resulted in a revocation of the

Sta-Home tax-exempt entities’ tax-exempt status on account of a

violation of section 501(c)(3); i.e., the transfer resulted in

the Sta-Home tax-exempt entities’ being operated for a

substantial nonexempt purpose, constituted prohibited inurement,

and impermissibly benefited private interests.4




     4
       The parties also dispute who bears the burden of proof as
to the central issue in this case; namely, the value of the
transferred assets. We do not decide that dispute. Our findings
of value are based on our examination of the evidence in the
well-developed record, which, in relevant part, includes
stipulated facts, expert reports, other exhibits, and witness
testimony.
                                - 5 -

                          FINDINGS OF FACT

     Some facts have been stipulated.   We incorporate herein by

this reference the parties’ stipulation of facts and the exhibits

submitted therewith.   We find the stipulated facts accordingly.

The couples, Michael and Cindy Caracci, Victor and Joyce Caracci,

Vincent and Denise Caracci, and Christina and David McQuillen,

are husband and wife, each of whom resided in Mississippi when

the petitions were filed.   Christina McQuillen is the sister of

Michael and Vincent Caracci, and the three of them are the

children of Victor and Joyce Caracci (the father, mother, and

three children are referred to collectively as the Caracci

family).    The principal place of business of the various Sta-Home

entities also was in Mississippi at that time.

     From 1973 to 1976, Joyce Caracci served as a consulting

nurse for the State of Mississippi Board of Health, surveying

health care facilities for participation in the Medicare/Medicaid

programs.   On May 3, 1976, Joyce Caracci, Victor Caracci, and a

third individual not relevant herein started Sta-Home Home Health

Agency, Inc.   Approximately 1 year later, Joyce Caracci, Victor

Caracci, and a third individual not relevant herein formed the

other two Sta-Home tax-exempt entities.      Each of the Sta-Home

tax-exempt entities was formed as a nonstock corporation under

Mississippi law, with Victor and Joyce Caracci as the owners
                                - 6 -

during all relevant times.   In the early years of their business,

Victor and Joyce Caracci borrowed money collateralized by their

residence to fund the Sta-Home tax-exempt entities’ operations,

and they (the individuals) guaranteed the extension of credit to

the entities.   Throughout the years, the managers of the three

separate entities generally operated the entities as one

integrated unit.    (Because the parties also generally treat the

three separate entities as one integrated unit, so do we.)

During the subject year, Joyce Caracci, Michael Caracci, and

Christina McQuillen were the Sta-Home tax-exempt entities’ only

directors and officers.   Those entities employed or retained the

following Caracci family members or spouses in the corresponding

position:

      Individual                        Position

    Victor Caracci         Consultant
    Joyce Caracci          Chief operating officer/administrator
    Michael Caracci        Chief executive officer
    Christina McQuillen    Director of personnel
    Vincent Caracci        General counsel
    Denise Caracci         Nurse (from August 1991 to May 1995)
    David McQuillen        Maintenance man

     The Sta-Home tax-exempt entities participated in the

Medicare program.   Medicare was established in title XVIII of the

Social Security Act, Pub. L. 89-97, 79 Stat. 291 (1965), and is

the principal health care insurance for individuals who are
                                - 7 -

either disabled or aged 65 or older.    It is administered by the

Healthcare Financing Administration (HCFA), a division of the

U.S. Department of Health and Human Services, with whom private

insurance companies in different regions of the country have

contracted to serve as fiscal intermediaries.

     In 1995, Medicare reimbursed home health care providers at

an amount that equaled the lesser of the actual reasonable cost

or customary charges, up to the maximum “cost cap”; i.e., the

aggregate per-visit costs limitation under the law applicable to

Medicare.   During 1995, Medicare paid home health care agencies

for the necessary services they provided to covered beneficiaries

on a retrospective cost system under which Medicare sent a

“periodic interim payment” (PIP) every 2 weeks to home health

care agencies to cover claims activity.    The Sta-Home tax-exempt

entities used the PIP payments to fund their payroll, which was

paid biweekly.    Home health care agencies also submitted

quarterly reports and filed annual cost reports with the fiscal

intermediary.    If PIP payments differed from the payments

allowable as ascertained from the cost report, the fiscal

intermediary made the appropriate adjustment by reimbursing the

home health care agency for an underpayment or requiring the

agency to remit an overpayment.    The Aetna Insurance Co., which

was the fiscal intermediary for the Sta-Home tax-exempt entities,
                               - 8 -

disallowed the Sta-Home tax-exempt entities’ claimed costs on

various items such as advertisements, pencils, cell phones,

pagers, desks, and nurse recruiting.   The average amount of

disallowed costs annually was .7 percent.

     Under Mississippi law, a certificate of need (CON) is

required to operate a licensed home health agency.   Since 1983,

Mississippi has had a moratorium on issuing new home health care

licenses.   In 1995, the only method of establishing a new home

health care agency business in Mississippi was to purchase the

license of an existing licensed home health care agency.

Although several bills have been introduced in the Mississippi

legislature to lift the moratorium, none has ever been enacted.

Michael Vincent, the chief executive officer of the Sta-Home

corporations, had personally contacted members of the Mississippi

legislature to urge them not to lift the moratorium.   He also had

urged others to ask the Mississippi legislators not to lift the

moratorium.   From 1986 to 1993, the home health care business in

Mississippi increased 340 percent (as compared to doubling

nationally), but no new home health care agencies had entered

that State.

     In 1995, the Sta-Home tax-exempt entities ranked first or

second in market share in 14 of the 19 counties in their service

area.   “Sta-Home” was a recognized name in home health care in
                               - 9 -

Mississippi, and it had a generally good reputation among

Mississippi’s elderly population.   In 1993, the Sta-Home tax-

exempt entities were the first freestanding agencies in

Mississippi to become accredited by the Joint Commission on

Accreditation of Healthcare Organizations (JCAHO).   JCAHO

accreditation required achieving or exceeding certain regulatory

standards, including conditions as to the quality of patient

care.   During 1995, the Sta-Home tax-exempt entities provided

834,596 home health care visits, and over 95 percent of the

entities’ services were to Medicare beneficiaries.   The Sta-Home

tax-exempt entities also had several manuals that they had

developed in-house regarding policies and procedures, including

personnel, nursing, home health aid, physical therapy, and social

work manuals.

     It was generally recognized that under the Medicare

reimbursement system in place in 1995, there was no ability for

home health agencies to realize profits beyond costs and that the

reimbursement system provided little incentive for providing

services efficiently.   This situation prevailed because Medicare

reimbursed a home health agency only for “allowable” costs at its

discretion.   Therefore, any denied claim for reimbursement

produced a cash outflow to the business.   The Sta-Home tax-exempt
                                  - 10 -

entities generated gradually increasing revenue, but also

commensurate losses, in the 3 years preceding October 1, 1995.

     The Sta-Home tax-exempt entities’ accounting firm prepared

unaudited combined financial statements.        The results from

operations reported by the combined Sta-Home tax-exempt entities

on their returns for fiscal years ended September 30, 1991

through 1995, were:



          Year        Revenue       Expenses      Net Income (Loss)

          1991      $11,736,061   $11,799,721        ($63,660)
          1992       18,442,072    18,414,315          27,757
          1993       25,162,701    25,208,255         (45,554)
          1994       36,882,957    37,141,686        (258,729)
          1995       44,101,849    44,535,239        (433,390)

According to those combined financial statements, the total

assets and liabilities of the Sta-Home tax-exempt entities for

those years were:

          Year          Assets     Liabilities        Deficit

          1991      $3,203,759     $3,787,285       ($583,526)
          1992       5,404,925      5,960,696        (555,771)
          1993       6,910,710      7,639,855        (729,145)
          1994       7,515,492      8,417,027        (901,535)
          1995      10,736,407     12,144,655      (1,408,248)

     To ease their financial statuses, the Sta-Home entities

required their employees–-including the Caracci family members

themselves--to forgo payment for the first 6 weeks of employment.

After that initial period, the employees were entitled to collect
                                - 11 -

a paycheck for 2 weeks’ work.    The 4 weeks’ initial earnings were

withheld until the employees left the companies.

     The Sta-Home tax-exempt entities had a policy of giving its

employees discretionary bonuses.    For the pay period ended

December 12, 1994, the entities paid bonuses totaling $966,204 to

all personnel with the exception of new hires.    On April 10,

1995, the entities also approved for the directors bonuses of 15

percent.   For the pay period ended June 23, 1995, the entities

approved additional bonuses totaling $664,116.    On September 29,

1995, the entities approved further bonuses totaling $2,314,086;

this bonus created a $2,314,086 liability that was assumed by the

Sta-Home for-profit entities incident to the asset transfer.

     Mississippi historically reports the lowest per capita

income of any State with corresponding high unemployment and low

education levels.   An official Mississippi State Health Plan,

prepared in 1995, indicated that poorly educated, low-income, and

ill-housed people often had greater health care needs than other

members of society.   The socioeconomic characteristics of the

Sta-Home tax-exempt entities’ service territory produced a higher

use of home health care services in comparison to other areas of

the country.   In 1992, Medicare paid an average of $13,432 per

Mississippi patient, ranking the State highest in Federal

payments per recipient among all States.    During 1994 and 1995,
                              - 12 -

95 percent of all visits made by home health agencies operating

in Mississippi were paid for by Medicare.

     During 1994 and 1995, the prospect arose of Medicare’s

shifting from a PIP cost reimbursement system to a prospective

payment system (PPS).   Several groups discussed the proposal in

theory, but no one knew exactly what form PPS might take.     The

Sta-Home tax-exempt entities, through Vincent Caracci, an

attorney whose job included keeping abreast of current events,

learned of these proposed changes.     Petitioners came to

understand that the Sta-Home tax-exempt entities would not under

a PPS receive a check every 2 weeks but would have to file a

claim for every service rendered and wait for the claim to be

processed and paid.   Petitioners became concerned about the lack

of cashflow under a PPS.   They also believed that a PPS would

reduce the Sta-Home tax-exempt entities’ income.

     Late in December 1994, the Caracci family consulted an

attorney named Thomas Kirkland (Kirkland) about converting the

Sta-Home tax-exempt entities into for-profit corporations.

Kirkland’s firm represented many home health care agencies, and

he had recommended that all of those agencies make such a

conversion.   Kirkland’s recommendation was based, in part, on his

discussions with bankers who were reluctant to lend money to

nonprofit home health care agencies.     By 1991, petitioners’
                               - 13 -

regular accountant, Danny Hart (Hart), also recommended that the

Sta-Home tax-exempt entities convert to nontax-exempt status.

     Kirkland retained a tax attorney named James Pettis (Pettis)

to help Kirkland convert the Sta-Home tax-exempt entities into

for-profit entities.    Subsequently, Pettis learned that

Kirkland’s firm had not obtained an appraisal for any of its

previous conversions.   Pettis informed Kirkland that Pettis

“strongly [disagreed]” with that approach.    By letter dated July

7, 1995, Kirkland’s firm retained Hart’s accounting firm to

appraise the Sta-Home tax-exempt entities’ net assets as of a

proposed transaction date of October 1, 1995.

     The appraisal was slow in coming.    Pettis, the tax adviser,

insisted on seeing the appraisal before proceeding with any

transaction that would effect a conversion.    After reading the

appraisal, Pettis was concerned that it failed to deal with

issues concerning intangible assets.     He believed that the mere

fact that an entity had lost money or had a negative cashflow did

not mean that the entity was worthless.    He also was concerned

that the appraisal failed to address Rev. Rul. 59-60, 1959-1 C.B.

237, where the Commissioner has set forth standards on valuation

for Federal income tax purposes.    Upon Pettis’s request, he

received a second appraisal.    Because some of his concerns as to

intangible assets remained after reading the second appraisal, he
                              - 14 -

sought and received assurance that the Sta-Home tax-exempt

entities’ liabilities far exceeded the value of their assets and

that the value of the intangibles would not give the entities a

positive fair market value.

      On July 11, 1995, the Sta-Home tax-exempt entities’ boards

of directors authorized the conversion of those entities into S

corporations.   The S status was chosen so that the shareholders

could deduct the new entities’ future losses.    On August 22,

1995, in anticipation of a transfer of the Sta-Home tax-exempt

entities’ assets, Kirkland’s firm, with petitioners’ approval,

formed the Sta-Home for-profit entities under Mississippi law.

Each of those corporations subsequently elected to be taxed as an

S corporation for Federal income tax purposes.    Since their

formation, the only shareholders of each of the Sta-Home for-

profit entities have been Joyce Caracci (17.5 percent), Victor

Caracci (17.5 percent), Michael Caracci (30 percent), Christina

McQuillen (17.5 percent) and Vincent Caracci (17.5 percent).     The

only directors and officers have been members of the Caracci

family.

     On August 28, 1995, Hart’s accounting firm tendered an

appraisal stating that the value of the Sta-Home tax-exempt

entities’ assets was less than their liabilities.    Kirkland had

assumed that this would be the case.   On September 1, 1995,
                              - 15 -

Kirkland executed and filed on behalf of each of the Sta-Home

tax-exempt entities “Notices of Intent to Change Ownership” with

the State of Mississippi Department of Health.

     Effective October 1, 1995, Sta-Home Home Health Agency,

Inc., transferred all of its tangible and intangible assets to

Sta-Home Health Agency of Jackson, Inc., Sta-Home Home Health

Agency, Inc., of Forest, Mississippi, transferred all of its

tangible and intangible assets to Sta-Home Health Agency of

Carthage, Inc., and Sta-Home Home Health Agency, Inc., of

Grenada, Mississippi, transferred all of its assets to Sta-Home

Health Agency of Greenwood, Inc.   The consideration paid by each

transferee was the assumption of the related transferor’s

liabilities.   Since the transfers, the transferors have not

engaged in any activities, charitable or otherwise, nor have they

been dissolved under Mississippi law.

     On October 19, 1995, Robert Crowell, Hart’s accounting

partner, sent a letter to Kirkland setting forth several reasons

that Sta-Home should convert to a profit corporation from a

nonprofit.   These included the need to raise capital and/or enter

into profit-making ventures, in view of the past losses and

accumulated deficit; the ability to participate in major changes

taking place in the health care industry, including mergers and

acquisitions; the provision of ownership interests for succession
                              - 16 -

plans to keep key management in place; and the ability to deal

with changes in the reimbursement system within the near future.

Four days later, the documents were executed that constitute the

contract under which all of the transferors’ assets were

transferred to the transferees.

     Other than State and Federal filing requirements and the

slight changes in the names of the entities, the Sta-Home

operations remained the same after the transfer as they were

before.   The Sta-Home for-profit entities continued to use a

fiscal year ending on September 30 for financial accounting and

Medicare reporting purposes, although not for tax purposes.     As

part of the transfers, the Sta-Home for-profit entities accepted

assignment of the Sta-Home tax-exempt entities’ Medicare provider

agreements and continued to use the provider numbers of the Sta-

Home tax-exempt entities.   The Sta-Home for-profit entities

continued to receive PIP payments and lump-sum settlements from

the Medicare program, including quarterly payments based on

quarterly PIP reports.   The Sta-Home for-profit entities received

a net preacquisition payment relating to settlement of the Sta-

Home tax-exempt entities’ 1987 fiscal year.   Substantially, the

same employees continued to do the same work, and the same assets

were used in the same three locations.   The Caracci family

members continued to be employed by the Sta-Home for-profit
                                - 17 -

entities in the same positions in which they were employed by the

Sta-Home tax-exempt entities, and each member’s compensation and

employment benefits remained subject to review by HCFA through

the cost reporting process.    The 1995 and 1996 combined salaries

paid to Joyce Caracci, Michael Caracci, Vincent Caracci, and

Christina McQuillen5 by the Sta-Home entities were as follows:

             Individual            1995           1996

          Joyce Caracci          $140,472       $141,685
          Michael Caracci         226,483        232,686
          Vincent Caracci          70,180         65,434
          Christina McQuillen      64,514         55,952

     The mid-1990's showed significant growth in the home health

care industry.    Natl. expenditures for home nursing care grew

from $3.8 billion in 1990 to $20.5 billion in 1997.      There was

also substantial activity in home health care agency

acquisitions.    There were 42 such acquisitions in 1994, 60 in

1995, 112 in 1996, and 139 in 1997.

     During 1995, the primary buyers of home health agencies were

hospitals, nursing homes, and other home health agencies.      They

were able to take advantage of a mechanism known as “cost-

shifting”.   This attribute enabled a buyer such as a hospital

(which generally received reimbursement under the PPS) to shift

some of its costs to a cost reimbursement system for payment by


     5
       Victor Caracci was paid on a consulting basis that varied
significantly from year to year.
                               - 18 -

the Medicare program.    Cost shifting was possible because:

(1) The purchased home health care agencies had room under their

cost cap because they had sought less than the maximum

reimbursement allowed by Medicare and (2) Medicare reimbursed

home health care providers for costs, such as overhead, that were

not directly related to home visits.    Hospitals and nursing homes

could benefit by acquiring a home health care agency and shifting

some of their overhead costs to that agency to the extent that

there was room under its cost cap.

     During 1994 and 1995, a number of home health agencies in

Mississippi were sold.   The State Board of Health identified 11

such acquisitions.   Seven were by hospitals; two were by home

health care agencies; one was by an individual from a bankruptcy

trustee, and one was a corporate reorganization.    All of the

acquisitions by hospitals involved home health agencies in or

near Mississippi, although on occasion the corporate headquarters

of the acquiring corporations were located outside Mississippi.

In 1995, the Deaconess Hospital Corp. of Cincinnati, Ohio,

acquired the stock of Southern Mississippi Home Health, Inc., a

Mississippi corporation.

     Home health agencies remained under a cost reimbursement

system until September 30, 1999, when legislation passed by

Congress in 1997 providing a PPS for home health agencies took
                                  - 19 -

full effect.     HCFA encountered problems implementing the system,

and it was not finally implemented until October 1, 2000.

                                  OPINION

I.    Introduction

       Respondent has determined that petitioners’ participation in

the asset transfer made them liable for deficiencies totaling

$256,114,435.6    Respondent’s determination rests on his expert’s

determination that the fair market value of the transferred

assets exceeded the assumed liabilities by approximately $20

million.    Petitioners argue that the assumed liabilities exceeded

the fair market value of the transferred assets.      Petitioners

rely on their expert, who concluded similarly.       It is with this

backdrop that we proceed to decide the assets’ value at the time

of the transfer.       We bear in mind the wide difference in values

ascertained by the experts.

II.   Fair Market Value

       A.   Overview

       A determination of fair market value is factual, and a trier

of fact must weigh all relevant evidence of value and draw



       6
       Of course, were the respondent to prevail in full, he
would be entitled to only $46,460,477 of approximately
$256,114,435. The lion’s share of the $256,114,435 is
attributable to excise taxes under sec. 4958(a)(1) and (2) and
(b) totaling $41,753,311 ($4,635,923 + $30,000 + $37,087,388),
for all or part of which respondent has determined that eight
petitioners are jointly and severally liable.
                               - 20 -

appropriate inferences.   Commissioner v. Scottish Am. Inv. Co.,

323 U.S. 119, 123-125 (1944); Helvering v. Natl. Grocery Co.,

304 U.S. 282, 294 (1938); Zmuda v. Commissioner, 79 T.C. 714, 726

(1982), affd. 731 F.2d 1417 (9th Cir. 1984); Mandelbaum v.

Commissioner, T.C. Memo. 1995-255, affd. without published

opinion 91 F.3d 124 (3d Cir. 1996).     Fair market value is the

price that a willing buyer would pay a willing seller, both

persons having reasonable knowledge of all relevant facts and

neither person being under any compulsion to buy or to sell.

United States v. Cartwright, 411 U.S. 546, 551 (1973); Kolom v.

Commissioner, 644 F.2d 1282, 1288 (9th Cir. 1981), affg. 71 T.C.

235 (1978); Estate of Hall v. Commissioner, 92 T.C. 312, 335

(1989).   See generally Rev. Rul. 59-60, 1959-1 C.B. 237.    The

willing buyer and the willing seller are hypothetical persons,

rather than specific individuals or entities, and the

characteristics of these hypothetical persons are not necessarily

the same as the personal characteristics of the actual seller or

a particular buyer.    Propstra v. United States, 680 F.2d 1248,

1251-1252 (9th Cir. 1982); Estate of Bright v. United States,

658 F.2d 999, 1005-1006 (5th Cir. 1981); Estate of Jung v.

Commissioner, 101 T.C. 412, 437-438 (1993); Mandelbaum v.

Commissioner, supra.

     Fair market value reflects the highest and best use of the

relevant property on the valuation date and takes into account
                              - 21 -

special uses that are realistically available because of the

property’s adaptability to a particular business.     Mitchell v.

United States, 267 U.S. 341, 344-345 (1925); Symington v.

Commissioner, 87 T.C. 892, 896 (1986); Stanley Works v.

Commissioner, 87 T.C. 389, 400 (1986); Estate of Proios v.

Commissioner, T.C. Memo. 1994-442.     Fair market value is not

affected by whether the owner has actually put the property to

its highest and best use.   The reasonable and objective possible

uses for the property control the valuation thereof.     United

States v. Meadow Brook Club, 259 F.2d 41, 45 (2d Cir. 1958);

Stanley Works v. Commissioner, supra at 400.     The hypothetical

willing buyer and seller are presumed to be dedicated to

achieving the maximum economic advantage, Estate of True v.

Commissioner, T.C. Memo. 2001-167, and the “hypothetical sale

should not be construed in a vacuum isolated from the actual

facts”, Estate of Andrews v. Commissioner, 79 T.C. 938, 956

(1982).

     Here, the parties dispute whether any value should be given

to the Sta-Home tax-exempt entities’ cost-shifting attribute.

Cost-shifting could attract prospective purchasers, such as

hospitals, that desired to acquire a home health care agency and

use its cost-shifting capacity.   At our request, the parties have

discussed whether attributing value to this mechanism is

consistent with the requirement that fair market value be
                              - 22 -

determined using a “hypothetical” buyer.    We conclude that it is.

A hypothetical buyer may be one of a class of buyers who is

positioned to use the purchased assets more profitably than other

entities.   Accordingly, we have held that fair market value takes

into account special uses that are realistically available

because of a property’s adaptability to a particular business.

Stanley Works v. Commissioner, supra at 400.    Acknowledging the

existence of such businesses in the universe of hypothetical

buyers also is consistent with the standard that assets are not

valued in a vacuum but, instead, are valued at their highest and

best use.

     The cases petitioners cite do not require a different

conclusion.   The cases of Morrissey v. Commissioner, 243 F.3d

1145 (9th Cir. 2001), revg. and remanding Estate of Kaufman v.

Commissioner, T.C. Memo. 1999-119, Estate of Andrews v.

Commissioner, supra, and Estate of Magnin v. Commissioner, T.C.

Memo. 2001-31, stand for the proposition, which we accept, that

the attributes of a hypothetical willing buyer cannot be limited

to those of a particular buyer.   That proposition is inapplicable

where, as here, we do not confine the hypothetical buyer to a

specific and identifiable buyer but include the entire class of

buyers for whom the Sta-Home tax-exempt entities’ cost-shifting

attributes could be especially adaptable.    Stanley Works v.

Commissioner, supra.
                               - 23 -

     Nor are petitioners assisted by citing Estate of Davis v.

Commissioner, 110 T.C. 530 (1998).      There, we rejected the

Commissioner’s attempt to narrow the field of hypothetical

willing buyers.    The Commissioner had done so by advancing the

unwarranted assumption that a hypothetical buyer would cause the

acquired corporation to escape its potential tax liabilities by

having it elect S corporation status and by not permitting it to

sell any of its assets for 10 years thereafter.     Unlike the

assumption there, the assumption here that the cost-shifting

attribute is a valuable asset is fully warranted.     In fact, as

explained below, both experts have ascribed value to the Sta-Home

tax-exempt entities’ cost-shifting mechanism.     In addition,

petitioners’ expert, Alfred D. Hahn (Hahn), has elsewhere written

that “transaction prices reflect the value to a buyer to shift

overhead costs”.    Hahn et al., “Home Health Agency Valuation:

Opportunity Amid Chaos”, Intrinsic Value (Spring 1998).

     B.   Role of the Expert

     As typically occurs in a case of valuation, each party

relies primarily upon an expert’s testimony and report to support

the respective positions on valuation.     A trial judge bears a

special gatekeeping obligation to ensure that any and all expert

testimony is relevant and reliable.      Kumho Tire Co. v.

Carmichael, 526 U.S. 137, 147 (1999); Daubert v. Merrill Dow

Pharm., Inc., 509 U.S. 579, 589 (1993).
                               - 24 -

     The Court has broad discretion to evaluate the cogency of an

expert’s analysis.    Neonatology Associates, P.A. v. Commissioner,

115 T.C. 43, 85 (2000).   Sometimes, an expert will help us decide

a case.   E.g., Booth v. Commissioner, 108 T.C. 524, 573 (1997);

Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274, 302

(1996); see also M.I.C., Ltd. v. Commissioner, T.C. Memo.

1997-96; Estate of Proios v. Commissioner, supra.      Other times,

he or she will not.   E.g., Estate of Scanlan v. Commissioner,

T.C. Memo. 1996-331, affd. without published opinion 116 F.3d

1476 (5th Cir. 1997); Mandelbaum v. Commissioner, T.C. Memo 1995-

255 Aided by our common sense, we weigh the helpfulness and

persuasiveness of an expert’s testimony in light of his or her

qualifications and with due regard to all other credible evidence

in the record.    Neonatology Associates, P.A. v. Commissioner,

supra at 85.   We may embrace or reject an expert’s opinion in

toto, or we may pick and choose the portions of the opinion to

adopt.    Helvering v. Natl. Grocery Co., 304 U.S. at 294-295;

Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976),

affg. T.C. Memo. 1974-285; IT & S of Iowa, Inc. v. Commissioner,

97 T.C. 496, 508 (1991); see also Pabst Brewing Co. v.

Commissioner, T.C. Memo. 1996-506.      We are not bound by an

expert’s opinion and will reject an expert’s opinion to the

extent that it is contrary to the judgment we form on the basis

of our understanding of the record as a whole.      Orth v.
                             - 25 -

Commissioner, 813 F.2d 837, 842 (7th Cir. 1987), affg. Lio v.

Commissioner, 85 T.C. 56 (1985); Silverman v. Commissioner, supra

at 933; IT & S of Iowa, Inc. v. Commissioner, supra at 508; Chiu

v. Commissioner, 84 T.C. 722, 734 (1985).

     Here, the experts began by observing that the methodology

traditionally used in business appraisals includes an income

approach, a cost approach, and a market approach.    In an income

approach, value depends upon the present value of future economic

benefits to be derived from ownership.    An enterprise’s price-

per-share value is then estimated by discounting the net

cashflows available for distribution back to their present value,

at market-based rates of return.   The cost approach uses

estimates of current costs to replace the enterprise’s fixed

assets and certain intangible assets.    The market approach

establishes the value of a privately held corporation through

analyses of sales or transfers of guideline companies.    The

information derived from this analysis is then used to form an

opinion of market value for a subject company.

     C.   Expert Testimony for Petitioners

     To support their contention that the value of the Sta-Home

tax-exempt entities’ assets was less than the liabilities

assumed, petitioners rely upon the report and testimony of Hahn.

Hahn, a director in PricewatershouseCoopers Northeast Region

Corporation Valuation Consulting Group, has written extensively
                                - 26 -

on the valuation of home health care agencies and has frequently

appeared as an expert witness.

     Hahn started by noting that because of the predominance of

Medicare in the payor mix of most home health agencies, a

conventional cashflow or earnings approach to valuation would

produce “a very different result from other, more appropriate

approaches.”   This is so because home health agencies, with a

preponderance of Medicare-eligible patients, earn little if any

profit.7

     Hahn instead relied principally upon an “Adjusted Balance

Sheet” methodology, a form of the cost approach.   That

methodology restates a company’s accounting balance sheet to its

fair market value equivalent.    Hahn explained that this approach

involves the identification and valuation of tangible and

intangible assets and liabilities, whether or not they appear on

the subject company’s accounting balance sheet.

     Hahn started with the unaudited balance sheets prepared by

petitioners’ accounting firm in 1995.    He concluded that several

of the Sta-Home tax-exempt entities’ asset accounts required

revaluation.   He noted that there were several “unrecorded


     7
       The evidence includes an article written by Hahn wherein
he reports that his firm’s database reflects that “more than 75
percent of home health agency acquisitions involved agencies that
recorded losses.” Hahn, “Payment Reform Will Shift Home Health
Agency Valuation Parameters”, Healthcare Financial Management
(Dec. 1998).
                               - 27 -

material assets and liabilities” in addition to the assets and

liabilities on the balance sheets.      In terms of the assets, he

indicated that economic intangible assets should be adjusted to

fair market value.   He also included some liabilities that were

not recorded on the unaudited balance sheet, such as a balance

due to Medicare from the Jackson and Grenada facilities for the

fiscal year 1993.    He further made allowance for pending events

which, he opined, suggested the possibility of future claims

against the companies, such as a reserve for future downward

reimbursement adjustments by Medicare.

     Hahn observed that the passage of time had obscured the

then-current value of the companies because the analysis was

prepared 5 years after the actual transaction.      Accordingly, Hahn

prepared both a “base case” and a “best case” scenario to develop

a range of fair market values.   He concluded that the fair market

value of the Sta-Home tax-exempt entities’ total tangible and

intangible assets was between $10.5 million and $11.5 million.

He noted that the entities’ total recorded and contingent

liabilities were between $12 million and $12.5 million.      His

result indicates that the combined liabilities of the Sta-Home

tax-exempt entities exceeded the value of their assets by $.5

million to $2 million.

     The following tables set forth Hahn’s “base case” and “best

case” adjusted balance sheets.   The first figure column lists the
                                               - 28 -

unaudited balance sheets for the fiscal year ended September 30,

1995.    The next column (PwC Valuation Adjustments) shows changes

made by Hahn.          The last column shows Hahn’s estimate of the fair

market value of each category after making his changes.
                               Valuation of Sta-Home Agency, Inc. - Combined
                                     Adjusted Balance Sheet Approach
                                    Valuation Performed as of 9/30/95

                                             Best Case Scenario

                                                             Compiled       PwC      Fair Market Value
                                                               FYE        Valuation         FYE
                                                             9/30/95     Adjustments      9/30/95

 Cash                                                      $1,271,031        --              $1,271,031
 Accounts receivable                                        9,115,026     ($857,786)          8,257,240
 Allowance for contractual adjustments                     (4,205,058)      274,701          (3,930,357)
 Allowance for bad debts                                       --          (264,444)           (264,444)
 Est. third-party payor settlements--Medicare               2,269,063      (295,473)          1,973,590
 Allowance for unsuccessful claims                             --          (543,803)           (543,803)
 Accounts receivable-–employees                                51,518        --                  51,518
 Accounts receivable--other                                    96,820        --                  96,820
 Prepaid expenses                                             656,465        --                 656,465
   Total current assets                                     9,254,865        --               7,568,060

 Property, plant & equipment                                2,850,538           --            2,850,538
 Accumulated depreciation                                  (1,456,464)          --           (1,456,464)
   Total PP&E                                               1,394,074           --            1,394,074




 Deposits                                                       9,033           --                9,033
 Long-term accounts receivable–-other                          78,435          (59,610)          18,825
   Total other assets                                          87,468           --               27,858

 Workforce-in-place                                             --        2,100,000           2,100,000
 Cost-shifting capacity                                         --          667,467             667,467
   Total intangible assets                                      --           --               2,767,467
                                                                             --
     Total assets                                          10,736,407                        11,757,459

 Current portion of long-term debt                            369,967           --              369,967
 Accounts payable                                             750,199           --              750,199
 Accounts payable–-other                                      165,808           --              165,808
 Accrued payroll                                            5,009,968           --            5,009,968
 Accrued payroll taxes                                      1,141,431           --            1,141,431
 Other accrued expenses                                     4,206,978           --            4,206,978
 Due to Medicare                                                --             201,000          201,000
   Total current liabilities                               11,644,351           --           11,845,351

 Notes payable, long-term portion                             500,304           --              500,304

   Total liabilities                                       12,144,655           --           12,345,655

 Liabilities in excess of assets                           (1,408,248)          --             (588,196)

                        Valuation of Sta-Home Agency, Inc. - Combined APPENDIX C
                                    Adjusted Balance Sheet Approach
                                   Valuation Performed as of 9/30/95

                                      Base Case Scenario

                                                             Compiled       PwC           Fair Market Value
                                                               FYE        Valuation              FYE
                                           - 29 -
                                                    9/30/95      Adjustments     9/30/95

 Cash                                           $1,271,031           --        $1,271,031
 Accounts receivable                             9,115,026      ($1,072,232)    8,042,794
 Allowance for contractual adjustments          (4,205,058)         274,701    (3,861,682)
 Allowance for bad debts                                           (142,885)     (142,885)
 Est. third-party payor settlements--Medicare    2,269,063         (295,473)    1,973,590
 Allowance for unsuccessful claims                               (1,087,606)   (1,087,606)
 Accounts receivable--employees                     51,518           --            51,518
 Accounts receivable--other                         96,820           --            96,820
 Prepaid expenses                                  656,465           --           656,465
   Total current assets                          9,254,865           --         7,000,045

 Property, plant & equipment                     2,850,538           --         2,850,538
 Accumulated depreciation                       (1,456,464)          --        (1,456,464)
   Total PP&E                                    1,394,074           --         1,394,074
 Deposits                                            9,033           --             9,033
 Long-term accounts receivable-–other               78,435          (59,610)       18,825
   Total other assets                               87,468           --            27,858

 Workforce-in-place                                    --         2,100,000     2,100,000
   Total intangible assets                             --            --         2,100,000

     Total assets                               10,736,407           --        10,521,977

 Current portion of long-term debt                 369,967           --           369,967
 Accounts payable                                  750,199           --           750,199
 Accounts payable--other                           165,808           --           165,808
 Accrued payroll                                 5,009,968           --         5,009,968
 Accrued payroll taxes                           1,141,431           --         1,141,431
 Other accrued expenses                          4,206,978           --         4,206,978
 Due to Medicare                                     --             201,000       201,000
   Total current liabilities                    11,644,351           --        11,845,351

 Notes payable, long-term portion                    500,304         --           500,304




 Unaudited cost reports                               --           (517,909)      517,909

   Total liabilities                            12,144,655         (718,909)   12,863,564

 Liabilities in excess of assets                (1,408,249)        (933,338)   (2,341,587)


      To corroborate his findings of net asset value, Hahn used a

market-transaction approach.                This approach involved valuing the

Sta-Home tax-exempt entities on the basis of market values of

comparable companies that had been sold.                       To Hahn, the comparable

approach was only a secondary indication of value, because sales

of other individual home health care agencies appeared to be too

“idiosyncratic” to provide a principled basis for valuation.                                 In

any event, Hahn noted that approximately 50 applications to

change ownership had been filed by home health care agencies in
                               - 30 -

Mississippi during the 11-year period ended in 1995.    Little

information was available as to these ownership changes, and Hahn

found only two guideline transfers.

     Hahn further noted that the Sta-Home tax-exempt entities

were focused almost entirely upon traditional home health care

and depended almost entirely upon Medicare payments.    Publicly

traded companies, by contrast, usually utilized traditional home

health care agencies as part of a broader mix of health care

business.    Hahn concluded, therefore, that a comparison to

publicly traded companies would not be appropriate to value the

Sta-Home tax-exempt entities, and he instead utilized “readily

available” information on 13 comparable sales derived from

privately held transactions engaged in by those publicly traded

companies.   From these privately held transactions, Hahn excluded

sales of privately held home health agencies that provided

sophisticated “infusion or respiratory therapy” because those

could attract reimbursement at a higher rate than those available

to the more traditional home health care agencies such as Sta-

Home.

     Principally upon the basis of his adjusted balance sheet and

comparable market computations, Hahn reached an ultimate

conclusion that the Sta-Home tax-exempt entities’ liabilities

exceeded their total tangible and intangible assets by $600,000

to $2,350,000.
                              - 31 -

     Finally, Hahn turned his attention to making adjustments to

the Sta-Home for-profit entities’ stock for “control premiums”

and lack of marketability.   He hypothecated that no additional

premium for control of the Sta-Home tax-exempt entities was

appropriate because the sale of 100 percent of the Sta-Home tax-

exempt entities was contemplated (therefore, all of the value of

the companies would be included in the transaction price).    He

also concluded that any adjustment to reflect the fact that

Mississippi presented an unattractive market for the sale of the

Sta-Home tax-exempt entities had been incorporated into his

adjusted balance sheet valuation.

     With respect to the value of the stock held by the

individual shareholders, Hahn noted that no one individual could

control the Sta-Home tax-exempt entities.   While he believed that

this usually would require that a minority discount be reflected

in the value of the shares held by the noncontrolling

shareholders, he concluded that a minority discount was not

appropriate here because the shares represented equity interests

in a loss corporation.   He noted, however, that at the time of

the asset transfer the appropriate control premium and market

discount in the home health care industry were approximately 36

percent and 26 percent, respectively.

     D.   Expert Testimony for Respondent
                                - 32 -

     Charles A. Wilhoite (Wilhoite) presented expert testimony on

behalf of respondent.   Wilhoite, a certified public accountant,

is a principal of Willamette Management Associates and codirector

of that firm’s office in Portland, Oregon.   He has performed a

number of assignments involving the analysis and appraisal of

professional practices, with a heavy concentration in the health

care field.   He has been involved with assignments requiring the

valuation of intangible assets, including CONs, customer

relationships, goodwill, and workforces.

     Petitioners argue that Wilhoite’s testimony should be

stricken because, they claim, his qualifications as an expert and

his methodology are insufficient to meet the standards set forth

in Daubert v. Merrill Dow Pharm., Inc., 509 U.S. 579 (1993).

These contentions are nonsensical and border on the frivolous.

Gross v. Commissioner, T.C. Memo. 1999-254, affd. 272 F.3d 333

(6th Cir. 2001).   We have no reason to question our recognition

of Wilhoite as an expert on the fair market valuation of health

industry and related businesses; i.e., the business of the

Sta-Home tax-exempt entities.    Nor are we unsatisfied as to the

reliability of his methodology, including ascertaining the fair

market values of invested capital for comparable entities.     BTR

Dunlop Holding, Inc. v. Commissioner, T.C. Memo. 1999-377.

     Turning to Wilhoite’s testimony, Wilhoite, like Hahn,

considered the three principal means of valuing a company’s
                              - 33 -

assets; i.e., the income, cost, and market approaches.    Wilhoite

rejected the cost approach as a means of valuing the Sta-Home

tax-exempt entities.   He noted that the value of the Sta-Home

tax-exempt entities’ intangible assets was especially important

because the entities were service-based business with a

relatively low investment in tangible assets.   He noted that the

Sta-Home tax-exempt entities’ intangible assets included

operating licenses, Medicare certifications, patient lists,

referral relationships, a trained and assembled workforce,

proprietary policies and procedures and trade name, and a going

concern value.   He noted that the CONs had been subject to a

moratorium for the 12 years prior to the valuation date.   He

noted that “health issues” prevented him from learning details

about the Sta-Home tax-exempt entities’ intangible assets from

the Sta-Home tax-exempt entities’ management and that much of

that information was simply not available.

     He explained that several of the home health care agencies

acquired in recent transactions had incurred losses immediately

before their sale.   He observed, however, that the purchasers of

those agencies still had paid considerable amounts to acquire

them.   To Wilhoite, this factor indicated that the intangible

assets even of companies that showed losses were worth

considerable sums to potential acquirers.    Moreover, it indicated

to Wilhoite that an examination of similar acquisitions would
                              - 34 -

result in an indication of a value which included the value of

intangible assets.

     Wilhoite decided that a better valuation would come from

employing the market approach; i.e., examining transfers of

ownership of comparable home health care agencies.   His market

approach utilized two types of transfers.   One involved the

valuation of comparable publicly traded home health care

agencies.   The other valued the consideration paid for merged or

acquired companies.   In addition to the two-pronged market

approach, Wilhoite also utilized an income method, wherein he

calculated the value of the Sta-Home tax-exempt entities’ cost-

savings attribute to a potential buyer.

     As a basis for his valuations under both the market and

income approaches, Wilhoite ascertained the market value of

invested capital (MVIC) for the Sta-Home tax-exempt entities.

The MVIC represents the market value of a company’s capital

structure–-all of its ownership equity and all of its interest-

bearing debt.   The MVIC method is commonly used in the valuation

of closely held companies.   Its use operates to minimize

differences in capital structure between a closely held company

and publicly traded companies which are used as comparables.    See

Pratt et al., Valuing Small Business and Professional Practices

548 (3d ed. 1998).
                               - 35 -

     Wilhoite turned first to the market approach, examining the

value of publicly traded companies that operated home health care

agencies.   For each of these, he ascertained a “revenue pricing

multiple”; i.e., a percentage that when multiplied by the annual

revenues of a home health care agency would reflect the MVIC of

that agency.   The MVIC of the comparable companies reflected a

median revenue multiple of .61.    Because Sta-Home tax-exempt

entities were nonprofit companies, however, their returns on

invested capital were considerably lower.    Wilhoite selected a

multiple of .3, noting that this multiple represented a discount

of 50 percent from the median guideline company multiple.    He

then multiplied .3 times the Sta-Home tax-exempt entities’ 1995

revenues of $45,209,000 to arrive at an MVIC for the Sta-Home

tax-exempt entities of $13,563,000.

     Wilhoite next turned his attention to the guideline merged

and acquired company method.   He examined figures available from

publications such as the “Home Health Care M&A Report” published

by Irving Levin Associates, Inc.    He pointed out that two of the

comparable merged or acquired companies were very close in

revenues to the Sta-Home tax-exempt entities; of those two, the

MVIC of Patient-Care, Inc., represented a revenue multiple of

.40, and the MVIC of Magellan Health Services, Inc., reflected a

revenue multiple of 1.08.   With respect to a comparable company

that operated at a loss, namely, Nurse-Care, Inc., Wilhoite noted
                                - 36 -

that when acquired, it had reported revenues of $15.3 million but

overall losses of 1.9 percent.    Nurse-Care, Inc., sold for an

MVIC revenue multiple of .21.    Taking these factors into

consideration, Wilhoite selected a revenue multiple of .25 times

the last year’s revenue.    This amount was approximately 20

percent higher than that of Nurse-Care, Inc., but 50 percent

lower than the guideline for the median merged or acquired

companies.   Having applied the .25 multiple to the Sta-Home tax-

exempt entities’ last 12-month revenue of $45,209,000, Wilhoite

arrived at an MVIC of $11,302,000.

     Wilhoite then turned to the income approach.   He ascertained

that the Sta-Home tax-exempt entities could generate meaningful

income for a purchaser that was positioned to use the cost-

shifting strategy.   An officer of Sta-Home tax-exempt entities

had indicated to Wilhoite that the entities had historically

received reimbursed costs in an amount that was 5 percent below

the limit they were allowed.    Wilhoite ascertained that the

annual value of such a saving in 1995 was $1,408,168.    To

ascertain the present value of a stream of such payments,

Wilhoite ascertained an appropriate multiplier by examining the

weighted average cost of capital for Sta-Home tax-exempt

entities, less the anticipated increases generated by long-term

growth.    Wilhoite arrived at a capitalization rate of 12.8

percent.   This capitalization rate yielded a value for the Sta-
                                - 37 -

Home tax-exempt entities, on the basis of use of the cost gap, of

$11,001,000.

     To conclude his study, Wilhoite assigned a weighted

percentage to each of the three values he had derived under the

two market approaches and the single income approach.    He gave

the most weight to the income approach, somewhat less weight to

the publicly traded comparable approach, and the least weight to

the merged or acquired comparable approach.    His weighted average

was $11,604,000 for the MVIC.    Wilhoite then took into account

the fact that, although they were ongoing businesses, the Sta-

Home tax-exempt entities had nevertheless generated a net working

capital deficit; i.e., the current liabilities exceeded the

current assets by more than $2 million.    While sufficient current

assets would usually be present in an ordinary operating business

to pay for current liabilities, this was not the case for the

Sta-Home tax-exempt entities.    A purchaser would quickly have to

come up with additional moneys to pay the bills.    Wilhoite viewed

the necessity for such a “working capital infusion” as a factor

that would lower the value of the calculated MVIC.    Thus, from

the $11,604,000 value for the MVIC, he subtracted the $2,020,000

deficit that a buyer of the Sta-Home tax-exempt entities would

have to provide following an acquisition of the companies.

     To the resulting figure for the now-discounted MVIC,

Wilhoite added the companies’ current liabilities.    He did so
                              - 38 -

because accounting rules require the asset side and the liability

side of a company’s balance sheet to be equal.   His calculated

MVIC, which comprised long-term liabilities and owners’ equity,

did not include current liabilities.   Wilhoite reasoned that, by

adding the known current liabilities to the MVIC, he would

complete the liability side of the balance sheet.   The asset

sheet would thus be an amount that equaled the liabilities so

computed.   He compared the inclusion of current liabilities as a

means of ascertaining value by showing that petitioners had done

essentially the same operation.   Their position was that the

companies’ value was equal to the total liabilities, both long-

term and short-term debt.   The difference between Wilhoite’s view

and that of petitioners is that Wilhoite concluded, on the basis

of his MVIC analysis, that the companies had some value, which

was expressed on the liabilities side as owners’ equity.

Petitioners, however, maintained that there was no owners’ equity

and, hence, they did not include it in the balance sheet.      His

explanation stated:



     Basic accounting requires that the total asset value of
     an entity (i.e., the “left-hand side” of the balance
     sheet) is equal to the sum of the total liabilities and
     equity, or net asset value, of an entity (i.e., the
     “right-hand side” of the balance sheet). * * * [The
     Sta-Home for-profit entities] and the Caraccis reported
     acquired all of the assets of the tax-exempt agencies
     by assuming all of the liabilities of the tax-exempt
     agencies. Because the Caraccis assumed no equity value
     existed, and because basic accounting requires that the
                                - 39 -

     “left-hand side” of the balance sheet equal the “right-
     hand side”, our independently determined estimate of
     the fair market value of Sta-Home’s invested capital
     (i.e., interest-bearing debt and equity, reduced by the
     estimated working capital infusion) combined with
     reported current liabilities, provides the total
     “right-hand side” of the balance sheet.

The result is as follows:

     Indicated MVIC                      $11,604,000
     Less working capital infusion         2,020,000
     Plus current liabilities             11,274,000
     Indicated asset value                20,858,000

     E.   Our Valuation of the Sta-Home Tax-Exempt Entities

     The traditional determinants of fair market value persist

even when valuing a nonprofit, tax-exempt company.     There are

differences, however, in the amount of weight usually given to

the earnings and profits of regular business organizations and

those of tax-exempt entities.    Earnings and profits are obviously

less meaningful in the case of nonprofit organizations.     Here,

Medicare funded 95 percent of the Sta-Home tax-exempt entities’

operations.   As applicable herein, the Medicare program was not

designed to produce corporate profits nor to contribute to the

capital growth of health care organizations.   It was designed to

reimburse providers of home health care services for their costs,

including administrative salaries and overhead.   The system

nevertheless permitted the operators of such agencies to generate

executive-level salaries and benefits for themselves.     It also

permitted them to accumulate substantial assets in their

businesses without paying income taxes on any of their earnings.
                               - 40 -

     Petitioners urge that “common sense” requires a decision in

their favor.    They argue that they incurred losses, not gains, on

the transactions leading to formation of the Sta-Home for-profit

entities.    They point to balance sheets which show that the

liabilities they assumed exceeded the value of the assets they

acquired.

     We disagree with petitioners’ so-called common sense

rationale.    To the contrary, we think it obvious that a company’s

negative book value does not require a finding that the company

had a fair market value of less than zero.    Nor does the fact

that a company operates at a loss mean that its intangible assets

have no value.    Those assets are still capable of generating

revenue, thus proving they have value.    Even petitioners’ tax

adviser, Pettis, testified to that effect.

     Moreover, the Sta-Home tax-exempt entities’ assets generated

revenues of approximately $45 million in the year they were

transferred to the Sta-Home for-profit entities.    The Sta-Home

tax-exempt entities reported a modest income from operations,

but, after deducting interest and depreciation (mostly for their

fleet of automobiles), they reported a loss of $506,713.

Although in 1995 they also reported an increase for the third

consecutive year in the negative net asset value to a new total

of $1,408,248, the evidence shows that their fourth employee

bonus in that year amounted to some $2,314,086.    Had they not
                               - 41 -

declared that bonus, they would have reported nontaxable income

of approximately $1,785,000, or, in other words, more than enough

to eliminate the accumulated deficit in net asset value.

     The Sta-Home tax-exempt entities’ expert also reported that

their total payroll for 1995 was $34,600,000, or about 80.5

percent of operating expenses, and that this amount of employee

compensation was “generous”.   A common range of compensation for

other home health care agencies was between 70 and 75 percent.

Had petitioners not declared the last bonus, their compensation

expense would have been $34,085,914, or 75.4 percent of operating

expenses.   This amount would have exceeded the industry average

and still enabled the companies to eliminate their accumulated

deficit and show a modest profit.   Thus, even though the Sta-Home

tax-exempt entities reported a history of losses, they at least

had the potential to generate income and thus demonstrate a

substantial fair market value.

     We believe that the best evidence of the value of the Sta-

Home tax-exempt entities arises from the use of the comparable

value method employed by both experts.   We also are persuaded

that the fair market value is best determined by relying upon the

rationale of Wilhoite.   His use of the MVIC approach to compare

the privately held Sta-Home tax-exempt entities to similar

publicly traded businesses is especially appropriate here.    That

approach harmonizes the differences between debt and equity usage
                               - 42 -

by publicly traded companies and privately held entities.    It

also considers the total investment, which, as discussed infra,

is especially important for the Sta-Home tax-exempt entities.

     We do not agree, however, that Wilhoite ascertained an

accurate price-to-revenue multiple for ascertaining the Sta-Home

tax-exempt entities’ MVIC.   His .3 multiplier was approximately

half that applicable to the median of the publicly traded

comparables.   His discount reflects petitioners’ demonstration

that many of these publicly traded companies functioned in areas

where combinations of businesses, including managed care

operations, produced more favorable prospects than were generally

available in Mississippi.    Wilhoite’s discount does not, however,

sufficiently take into account the absence from the Sta-Home

services of some of the more sophisticated, and remunerative,

home health care techniques, such as infusion and respiratory

therapies.   These techniques were utilized by many of the

comparison companies.   We therefore believe that the price-to-

revenue multiple for publicly traded companies should be no

higher than the .25 that he applied to the merged and acquired

comparable companies.

     We also fail to find Wilhoite’s valuation particularly

meaningful solely on the basis of the capitalization of Sta-Home

tax-exempt entities’ intangible known as the “cost gap”.

Wilhoite has correctly noted that the cost gap has substantial
                              - 43 -

potential value to a hospital purchaser, and, in fact, Hahn has

written extensively about the value of this cost-shifting

attribute.   We feel, however, that Wilhoite has included too many

imponderables in his calculation.   For example, we do not believe

that the entire value of the Sta-Home tax-exempt entities is

appropriately bound up in the marketability of a single

intangible asset–-the cost gap.   Nor do we believe that it is

justified to conclude that the cost gap would produce economic

benefits indefinitely, especially in view of the official

scrutiny it had received before, and during, 1995.   Finally, we

observe that Wilhoite has assumed that the cost gap would equal

95 percent of the allowable cost ceiling (i.e., be 5 percent less

than the ceiling).   This percentage appears to have been accurate

for earlier years, but the most recent cost gap was only 2.86

percent below the cost ceiling.   The way for a potential buyer to

increase the cost-gap percentage would be to reduce costs

further.   We do not think, however, that a buyer of the Sta-Home

tax-exempt entities would necessarily decrease expenses to move

the cost gap asset from its most recent 2.86-percent level back

to historic 5-percent level and then continue this cost gap

indefinitely.   On balance, we believe that the most weight is

properly given to Wilhoite’s estimate of the MVIC for the Sta-

Home tax-exempt entities, using a price-to-revenue multiple of

.25.   This results in an MVIC of $11.3 million.
                               - 44 -

     Petitioners have raised a number of issues concerning the

Sta-Home tax-exempt entities’ MVIC, and we believe that one of

their points has merit.    Their principal contention arises from

their concession that the Sta-Home tax-exempt entities’ capital

structure was “different”.    They explained that the entities’

practice of requiring employees to forgo paychecks for the first

6 weeks created a pool of approximately $6.1 million.    Although

they identified this amount as a current liability in the form of

accrued payroll and accrued payroll taxes, this permanent pool

actually functioned as a source of permanent capital.    To prove

their point, they show that their reported current liabilities

for 1995 were 108 percent of invested capital, an amount several

times greater than that of comparable companies.    In effect, they

argue, their employees had made a collective long-term loan to

the company.   We agree.   In operation, much of the $6.1 million

which had been held back from the employees’ payroll and payroll

taxes functioned as a source of long-term financing.

     Not all of the withheld payroll, however, is properly

considered long-term financing.    Petitioners’ accountant, Hart,

testified that the Sta-Home tax-exempt entities originally had a

“two-week payroll” which was extended to 4 weeks, and then to 6

weeks, as a source of working capital.    Hahn’s report states that

Medicare pays home health care agencies no less frequently than

every 2 weeks based on estimated costs.    To aid their cashflow
                              - 45 -

situation, the Sta-Home entities paid their employees 6 weeks in

arrears.   Thus, an employee was required to wait 6 weeks before

getting his or her first paycheck, for 2 weeks’ work.    In the

meantime, however, Medicare reimbursed the companies for the

amount of accrued wages every 2 weeks.    The entities thus

received 6 weeks’ worth of wages per employee before being

required to pay out 2 weeks’ worth.    The deferral of actual

payment meant, in effect, that each employee made a loan of 4

weeks’ wages to the company, and the “loan” would not be repaid

until the employee left his or her employment.    When one employee

left, another was presumably hired, and the new employee would be

required to forgo 4 weeks’ salary, thus keeping the total amount

of deferrals relatively stable.    By 1995, this practice had

generated a “float” of approximately $4.1 million that the

entities possessed and were not required to repay until some

unspecified time in the future.    It appears that 2 weeks’ worth

of payroll and payroll taxes is properly characterized as short-

term liabilities.   We conclude that the amounts of payroll that

were withheld for longer than 2 weeks were not, in this case,

properly characterized as current liabilities.    For purposes of

this valuation, they should be considered part of the invested

capital.   Accordingly, of the $6,150,000 withheld, two-thirds (or

4 weeks’ worth) should be excluded from the current liabilities

that Wilhoite added to the MVIC.   Wilhoite based his calculation
                              - 46 -

of MVIC upon an informed estimate of the value of invested

capital (i.e., long-term debt plus owner’s equity) that would

produce the known revenues.   For 1995, his calculations showed

that invested capital of $11.3 million would produce the reported

$45,209,000 in revenue that the Sta-Home tax-exempt entities

generated.   Some part of this MVIC is readily discernible; it

includes $500,000 of long-term debt.   Additionally, as we have

explained, it also includes the $4.1 million of deferred wages

that functioned as long-term debt for the companies.   As earlier

observed, however, a buyer would have to include as part of the

purchase price not only the value of the invested capital, the

MVIC, but also the current liabilities that the purchased company

would have to pay.   Wilhoite accordingly added current

liabilities of $11,475,000 from the Sta-Home tax-exempt entities’

balance sheets to his calculated MVIC of $11.3 million.   That

amount of current liabilities, however, includes $4.1 million of

withheld wages that operate as long-term debt and thus form part

of the MVIC.   To avoid duplicating this $4.1 million figure in

arriving at a fair market value for the companies, we believe

that it should be excluded from current liabilities.   (Removing

$4.1 million from current liabilities, however, also restores the

$2,020,000 working capital shortfall resulting from the failure

of current assets to match current liabilities.   Accordingly,

there is no longer a need to reduce the asset value by the amount
                                - 47 -

of the capital infusion.)   Finally, we also believe that current

liabilities should be increased by $201,000, as suggested by

Hahn, to reflect a reserve for disallowed claims on its Medicare

cost reports.   This increases the current liabilities to

$11,475,000, before deducting the amount of withheld payroll that

is to be considered part of the MVIC.

     When we take these modifications into account, we arrive at

a fair market value of $18,675,000:

     Indicated MVIC                        $11,300,000
     Plus current liabilities               11,475,000
     Less withheld payroll                  (4,100,000)
     Indicated asset value                  18,675,000

     We are unimpressed and unpersuaded by Hahn’s conclusions as

to the fair market value of the Sta-Home tax-exempt entities, and

we have decided not to accept them.      His reasoning that the Sta-

Home tax-exempt entities had a fair market value of less than

zero is unconvincing, and, in fact, appears to be more an

advocacy of petitioners’ litigating position than a candid fair

market appraisal.   We think a willing buyer would be puzzled and

confused by his conclusions.    Neither Hahn’s “adjusted balance

sheet” approach nor his backup market approach justify the

finding of a negative net worth.

     First, in one substantial respect, even Hahn’s “best case”

adjusted balance sheet is seriously deficient.     Hahn’s report

states:   “Most buyers concentrate on the intangible assets of a

home health agency.”   His conclusions, however, fail to account
                               - 48 -

for much of the substantial value of the Sta-Home tax-exempt

entities’ intangible assets.   Hahn ascertained a value for two

intangible assets.   He first developed a value for the Sta-Home

tax-exempt entities’ workforce in place of $2.1 million to $3.4

million.   He used the $2.1 million value in both the “base case”

and “best case” scenarios.   He fails to justify using the lower

value in the “best case” scenario.      Petitioners have assembled a

workforce of approximately 1,000.    A very substantial proportion

of them are highly trained professionals, including registered

nurses and other trained medical personnel.     The Sta-Home tax-

exempt entities employed 25 percent of the full-time and 17

percent of the part-time home health care staff in the State of

Mississippi.   If Hahn has developed an approximate value of $3.4

million, we see no reason not to employ this estimate in the

“best case” scenario.   Indeed, we suspect that the value of the

workforce is higher, but on this record, we cannot reasonably

estimate how much.

     With respect to another intangible asset, Hahn’s “best case”

scenario ascribed a value of $667,000 to the “cost gap” attribute

that the Sta-Home tax-exempt entities presented for a qualifying

buyer.   His valuation is based on the assumption that the value

of this attribute would end after 1 year.     This value is too low.

The cost gaps were available under the then-current reimbursement

program.   They would cease to exist under a PPS.    Although there
                               - 49 -

had been discussions of a PPS for several years, Congress had

passed no such legislation at the time of the transfer, and there

is no evidence that the prospect of such legislation had a

negative effect upon the value of home health care agencies.    In

fact, one of Hahn’s articles, published in the Spring of 1998,

demonstrates a “furious pace of home health transfers” from 1994

through 1997.   The article contains a chart showing that the

number of home health agency transfers did not begin to decrease

until the second quarter of 1997.   A “best case” scenario would,

we think, indicate at least a 2-year value for the cost gap

asset.   By using a 2-year figure in Hahn’s computations, we

arrive at a value of more than $1 million for the cost-shifting

attribute.

     Hahn’s valuation of the intangible assets also fails to

address the value of the CONs held by the Sta-Home tax-exempt

entities.    These certificates effectively closed the home health

care market to competition during a period of high growth for the

industry.    Michael Caracci acknowledged his efforts to lobby the

Mississippi legislature in the interests of keeping the CON

moratorium in place, thus preserving the monopoly of the Sta-Home

tax-exempt entities and others who had received CONs before the

moratorium.   His efforts indicate that the CONs possessed by the

Sta-Home tax-exempt entities would be worth considerable amounts

to a willing buyer, but Hahn did not ascribe any value to them.
                              - 50 -

     We conclude that the absence of a candid valuation for the

Sta-Home tax-exempt entities’ intangible assets explains the

considerable gap between the adjusted balance sheet value

ascertained by Hahn and the $18,675,000 value we have decided

today.8

     We also reject Hahn’s assertion that his alternate “market”

approach to valuation guideline supports his adjusted balance

sheet approach.   Initially, we find that his selection of

guideline companies is at least adequate.   Most of them value

“traditional” visiting nurse companies, such as petitioners, and

thus Hahn avoids the problem of including home health care

agencies that offer more technical home health care services.      He

has also included both publicly traded and privately held

companies in his survey, and he has included both companies that

have positive income and companies that reported losses.     His

guideline companies also include those with a positive net worth

and companies that indicate a negative equity capital.




     8
       Hahn’s “best case” scenario indicates that the value of
the intangible assets represents 17.68 percent of the total
assets. In one of his recent articles, he presents a chart
showing the goodwill value of seven publicly traded home health
care companies. The lowest of these indicates a goodwill value
to total asset ratio of 22 percent, and the others indicate
values at 31 percent, 39 percent, 47 percent, 52 percent, and two
others at 56 percent. Hahn et al., “Home health Agency
Valuation: Opportunity Amid Chaos”, Intrinsic Value (Spring
1998).
                              - 51 -

     We are unable, however, to accept Hahn’s conclusions of fair

market value on the basis of his market approach.    Hahn has

derived two “Implied Valuation Multiples”.    The first is a

ranking based upon the ratio of selected comparable companies’

sale prices to their most current revenues.    The second is a

ranking of the companies’ sale prices to their total book

assets.9   The median sale prices were .68 times annual revenues

and 1.9 times total book assets.    Here, however, in his “best

case” scenario, he has ascertained that the Sta-Home tax-exempt

entities would sell at a price only .22 times annual revenues

and, further, that they would sell at a price only 1.1 times

their total book assets.   Hahn’s “best case” scenario ranks the

Sta-Home tax-exempt entities next to last in both categories.      In

contrast, none of the comparable companies ranks as low in both

categories.   Clausen Health Services, for example, sold at a

multiple of .22 times revenues, a ratio close to that ascribed to

the Sta-Home tax-exempt entities.    Clausen’s sale price, however,

also represented a price-to-asset ratio of 1.64, ranking seventh

among the comparables.   If the Sta-Home tax-exempt entities sold

at this multiple, the indicated fair market value would be



     9
       It is important to keep in mind that Hahn’s valuation
multiples generated a figure that represented the total asset
value of a company, while Wilhoite’s multiples generated the
value of its invested capital, or MVIC. Thus, application of the
same valuation multiple, say .25, will generally yield different
fair market values, depending upon which method is used.
                                - 52 -

$17,670,040.10    Another example shows that House Call, Inc., sold

at a price 1.08 times its total assets, a ratio close to the 1.10

that Hahn has ascribed to the Sta-Home tax-exempt entities.

House Call, Inc.’s sale price, however, also indicates that it

sold at a multiple of .74 times revenues, ranking second of the

13 comparables.    If the Sta-Home tax-exempt entities were sold at

this ratio, the indicated sales price would be approximately $33

million.   Moreover, in an article published in the spring of

1997, Hahn indicated that for the prior 2 years, a standard

market benchmark for valuing traditional visiting nursing

agencies, such as the Sta-Home tax-exempt entities, was a price-

to-revenue multiple of .55.    Hahn & Spieler, “Valuation of Home

Health Care Companies,” Intrinsic Value (Spring 1997).    We fail

to understand why the Sta-Home tax-exempt entities had a much

lower multiple of .26.    We recognize that the Sta-Home tax-exempt

entities operated at a loss for the prior year, but so did 8 of

the 13 comparable companies.    We further recognize that the

Sta-Home tax-exempt entities’ equity capital was a negative

amount, but so was that of 7 of the 13 comparable companies.

These characteristics reflect the accepted conclusion that exempt

entities operating under the Medicare reimbursement system stood



     10
       The book value used for the Sta-Home tax-exempt entities’
total asset value excludes any value for intangible assets. It
is unclear whether Clausen’s book value for total assets includes
intangibles.
                              - 53 -

little chance of turning a profit.     In fact, Hahn’s 1997 article

states that “Analysis of recent VNA [i.e. traditional visiting

nursing agency] transactions indicates that companies with

operating losses have transacted at multiples of revenue similar

to agencies with operating profits.”     Id. at 3.

     Accordingly, we conclude that the sale price we have decided

more accurately reflects the fair market value of the Sta-Home

tax-exempt entities than does that of Hahn.    We note that our

valuation of $18,675,000 indicates that the Sta-Home tax-exempt

entities would sell at a price-to-revenue multiple of .42, lower

than the .68 median applicable to Hahn’s comparable home health

care agencies.   Our finding also indicates that the ratio of

price to book value would be 1.75, which again is less than the

1.90 median for the same comparable companies.

     In reaching this value, we have also considered, but

rejected, petitioners’ arguments that conditions in Mississippi

require a finding that the assets of the Sta-Home tax-exempt

entities were worth less than the liabilities assumed.

Petitioners argue strenuously that the Sta-Home tax-exempt

entities’ operation in Mississippi, a relatively poor and rural

State, dramatically reduces their fair market value.    Petitioners

do not mention, however, that the Federal per-patient Medicare

payment was higher for Mississippi than for any other State.      We
                                 - 54 -

think that this factor substantially offsets the demographic

challenges of operating home health care agencies in Mississippi.

     Petitioners also maintain that there was no market in

Mississippi for acquisition of the Sta-Home tax-exempt entities.

The record in this case, however, indicates that there were many

such sales, including the purchase of Mississippi home health

care agencies by out-of-State hospitals.     We are not convinced

that reasonable exploration by a willing seller would have failed

to turn up a willing buyer, whether in Mississippi or elsewhere.

     F.   Excess Value

     Having found the fair market value of the Sta-Home tax-

exempt entities, we turn to decide the value in excess of the

assumed liabilities.     We are satisfied that the Sta-Home for-

profit entities intended to, and did, assume all of the

liabilities of the predecessor businesses.     The evidence includes

an audited balance sheet, prepared for purposes of this case,

which indicates that the total liabilities as of September 30,

1995, were $13,310,860.     To this amount we think there is

properly added $201,000, as ascertained by Hahn, representing a

reserve account for cost claims disallowed by Medicare.     Total

liabilities assumed were therefore $13,511,000.     Subtracting the

total liabilities from the fair market value we have decided,

results in an excess of $5,164,000:

           Fair market value                    $18,675,000
           Assumed liabilities                  (13,511,000)
                                 - 55 -

            Excess                               5,164,000

III.    Excise Taxes Under Section 4958

       Section 4958, the provisions of which are set forth in the

appendix to this report, was added to the Internal Revenue Code

by the Taxpayer Bill of Rights 2, Pub. L. 104-168, sec. 1311(a),

110 Stat. 1452, 1475 (1996).11    Section 4958 is patterned after

section 4941, which applies to acts of self-dealing between

private foundations and disqualified persons.    Section 4958

applies to public charities and social welfare organizations

which are exempt from Federal income taxes.12

       Section 4958 was enacted to impose penalty excise taxes as

“intermediate” sanctions in cases where organizations exempt from

tax under section 503(c) engage in “excess benefit transactions.”

H. Rept. 104-506, at 56 (1996), 1996-3 C.B. 49, 104.    An excess



       11
       No regulations apply to the transactions at issue. The
Treasury Department published proposed regulations under sec.
4958 on Aug. 4, 1998, secs. 53.4958-1 through 53.4958-7, Proposed
Excise Tax Regs., 63 Fed. Reg. 41486 (Aug. 4, 1998), which were
revised and replaced by temporary regulations effective Jan. 10,
2001, secs. 53.4958-1T through 53.4958-8T, Temporary Excise Tax
Regs., 66 Fed. Reg. 2144 (Jan. 10, 2001). On Jan. 23, 2002, the
Treasury Department removed the temporary regulations and
published final regulations effective Jan. 23, 2002. Secs.
53.4958-0 through 53.4958-8, Excise Tax Regs., T.D. 8978, 2002-7
I.R.B. 500.
       12
       Sec. 4958 is generally effective for transactions
occurring after Sept. 13, 1995. At trial, the parties directed
considerable attention to the effective date of the transfers at
issue. On brief, however, petitioners did not argue that the
transfers were effective on or before Sept. 13, 1995, and we deem
that argument to have been abandoned.
                               - 56 -

benefit transaction is one in which a tax-exempt organization

provides an economic benefit to one or more of the organization’s

insiders, called “disqualified persons”, if the fair market value

of the benefit exceeds the value of what the organization

receives in return.   Sec. 4958(c)(1)(A); H. Rept. 104-506, supra

at 56, 1996-3 C.B. at 104.    Disqualified persons include not only

those who are able to exercise substantial influence over the

tax-exempt organization, but also their family members and

entities in which those individuals have 35 percent of the voting

power.   Disqualified persons are subject to the excise penalties,

whether the excess benefit transactions are accomplished

“directly or indirectly”.    Sec. 4958(c).

      Before the enactment of section 4958, if an organization

within its purview did not comply with the rules regarding tax

exemption, the Commissioner’s only recourse was to revoke the

organization’s exemption.    The Treasury Department realized that

such a response might be inappropriate when the exempt

organization did not conform to all the applicable rules but was

nevertheless capable of functioning for a charitable purpose.

See U.S. Department of the Treasury’s Proposals to Improve

Compliance by Tax-Exempt Organizations: Hearing Before the

Subcommittee on Oversight of the House Comm. On Ways and Means,

103d Cong., 2d Sess. 17 (1994).    At the urging of the Treasury
                              - 57 -

Department, Congress enacted section 4958.   See H. Rept. 104-506,

supra at 56, 1996-3 C.B. at 104.

     A disqualified person who receives an excess benefit from an

excess benefit transaction is liable for an initial excise tax

equal to 25 percent of the excess benefit.   Sec. 4958(a)(1).   If

the initial tax is imposed and the transaction is not corrected

within the taxable period, then the disqualified person is liable

for an additional tax of 200 percent of the excess benefit.     Sec.

4958(b).

     Here, the fair market value of the Sta-Home tax-exempt

entities’ transferred assets far exceeded the consideration paid

by the Sta-Home for-profit entities.   Thus, the asset transfers

were excess benefit transactions which directly benefited the

transferees (i.e., the Sta-Home for-profit entities) and

indirectly benefited the Sta-Home for-profit entities’

shareholders (i.e., the Caracci family members).    Petitioners do

not seriously dispute that they are disqualified persons with

respect to the Sta-Home tax-exempt entities.   Joyce P. Caracci,

Michael Caracci, and Christina C. McQuillen, as directors and

officers of each of the three Sta-Home tax-exempt entities, are

disqualified persons because they were in positions to exercise

substantial influence over the entities’ affairs.   Sec.

4958(f)(1)(A).   Victor Caracci and Vincent Caracci are

disqualified persons because of their familial relationships to
                              - 58 -

Joyce P. Caracci, Michael Caracci, and Christina C. McQuillen.

Sec. 4958(f)(1)(B).   Sta-Home Health Agency of Carthage, Inc.,

Sta-Home Health Agency of Greenwood, Inc., and Sta-Home Health

Agency of Jackson, Inc., are disqualified persons because they

are entities that are 35-percent controlled by disqualified

persons; in fact, members of the Caracci family own 100 percent

of the Sta-Home for-profit entities’ voting stock.    Sec.

4958(f)(1)(C).   Accordingly, petitioners are subject to excess

benefit taxes under section 4958.

     Because we have decided the value of the Sta-Home tax-exempt

entities’ assets on the basis of a revenue multiple, it is

appropriate to ascribe the excess benefit to each of the Sta-Home

for-profit entities in proportion to the amounts the 1995

revenues of their respective predecessors bore to the total

revenue.   This produces the following results:

     Entity                    Percentage              Benefit

Sta-Home Health Agency              42.1             $2,173,682
  of Carthage, Inc.
Sta-Home Health Agency              30.1              1,554,105
  of Greenwood, Inc.
Sta-Home Health Agency              27.8              1,435,353
  of Jackson, Inc.

Because each of the three entities acquired or assumed its

predecessor’s assets and liabilities, as opposed to acquiring its

predecessor’s stock, we see no basis to apply a minority discount

to the value of the excess benefits each has received.    Nor for

that reason is an application of a minority discount appropriate
                               - 59 -

as to the excise taxes imposed upon the individual shareholders

of the Sta-Home for-profit entities.

     We conclude that each of the disqualified person/petitioners

is jointly and severally liable for the initial and additional

taxes under section 4958(a)(1) and (b) as to the excess benefits.

The effect of our holding is that the individual petitioners are

jointly and severally liable for the total excess benefit of

$5,164,000 from the three Sta-Home entities, while the Sta-Home

for profit entities are liable for taxes as specified in the

above table.    In so concluding, we decline at this time

petitioners’ invitation to abate the initial and additional

excise taxes pursuant to section 4961 (second-tier tax abatement)

and section 4962(a) (first-tier tax abatement).    Because the

excess benefit transactions have never been corrected for

purposes of section 4958(f)(6), petitioners’ invitation is, at

best, premature.    Petitioners have not as of yet met the

prerequisite for the requested abatement; i.e., a timely

correction.    In this regard, however, we note that sections

4961(a) and 4963(e)(1) generally allow for the abatement of a

section 4958 excise tax if the excess benefit transaction giving

rise thereto is corrected within 90 days after our decision

sustaining the tax becomes final.    Cf. Morrissey v. Commissioner,

T.C. Memo. 1998-443.   Because the issue of whether petitioners
                                - 60 -

will or would qualify for an abatement is not yet ripe for

decision, we express no opinion on this issue.

IV.   Revocation of Tax-Exempt Status

      Section 501(c)(3) requires, among other things, that an

organization be operated exclusively for one or more specified

exempt purposes.   An organization is not operated exclusively for

one or more exempt purposes unless it serves a public rather than

a private interest and its net earnings do not inure to the

benefit of any shareholder or individual.    Sec. 1.501(c)(3)-1,

Income Tax Regs.

      The presence of a single substantial nonexempt purpose can

destroy the exemption regardless of the number or importance of

exempt purposes.     Better Bus. Bureau v. United States, 326 U.S.

279, 283 (1945); Am. Campaign Acad. v. Commissioner, 92 T.C.

1053, 1065 (1989).    When an organization operates for the benefit

of private interests, such as designated individuals, the creator

or his family, or persons directly or indirectly controlled by

such private interests, the organization by definition does not

operate exclusively for exempt purposes.    Prohibited benefits may

include an advantage, profit, fruit, privilege, gain, or

interest.   Am. Campaign Acad. v. Commissioner, supra at 1065-

1066.   We have held that when a section 501(c)(3) tax-exempt

entity sells its assets for less than fair market value to a for-

profit corporation whose shareholders are directors of the tax-
                              - 61 -

exempt entity, the sale constitutes inurement and revocation may

be appropriate.   Anclote Psychiatric Ctr., Inc. v. Commissioner,

T.C. Memo. 1998-273.

     With the enactment of section 4958, however, the issue

whether the tax-exempt status of the Sta-Home tax-exempt entities

should be revoked must now be considered in the context of the

“intermediate sanction” provisions.    As noted above, the

intermediate sanction regime was enacted in order to provide a

less drastic deterrent to the misuse of a charity than revocation

of that charity’s exempt status.   The legislative history

explains that “the intermediate sanctions for ‘excess benefit

transactions’ may be imposed by the IRS in lieu of (or in

addition to) revocation of an organization’s tax-exempt status.”

H. Rept. 104-506, supra at 59, 1996-3 C.B. at 107.    A footnote to

this statement explains:   “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”.     Id. n.15, 1996-3 C.B. at 107.

Although the imposition of section 4958 excise taxes as a result

of an excess benefit transaction does not preclude revocation of

the organization’s tax-exempt status, the legislative history

indicates that both a revocation and the imposition of

intermediate sanctions will be an unusual case.
                                - 62 -

     We do not believe that this is such an unusual case.    The

dormant state of the Sta-Home tax-exempt entities precludes

calling into question whether, on the whole, they are functioning

tax-exempt entities.   Moreover, we perceive three reasons why it

is not appropriate to remove their tax-exempt status at this

time.   First, the excess benefit represented the fair market

value of the Sta-Home tax-exempt entities’ assets less the

liabilities assumed by the Sta-Home for-profit entities.    Given

that we have already sustained the imposition of intermediate

sanctions as to this excess value, we do not believe it

appropriate under the facts herein to conclude that the single

transaction (as to each entity) underlying the excess value also

requires our revocation of each entity’s tax-exempt status.

Second, the Sta-Home tax-exempt entities have not since the

transfers been operated contrary to their tax-exempt purpose.

Third, we find some credence in petitioners’ suggestion that

maintenance of the tax exemption may enable them to utilize the

correction provisions made available in sections 4961 through

4963.   While the issue is not ripe for us to decide at this time,

we note that a permissible correction may require that the

Sta-Home for-profit entities transfer the assets back to the

Sta-Home tax-exempt entities.    If we were to remove the Sta-Home

tax-exempt entities’ tax-exempt status at this stage, however,
                              - 63 -

those entities would no longer be tax-exempt entities available

to receive the assets.

     The legislative history quoted above indicates that “the

term ‘correction’ means undoing the excess benefit to the extent

possible and taking any additional measures necessary to place

the organization in a financial position not worse than that in

which it would be if the disqualified person were dealing under

the highest fiduciary standards.”   H. Rept. 104-506, supra at 59,

1996-3 C.B. at 107.   Petitioners suggest that preserving the tax-

exempt status of the now-dormant tax-exempt Sta-Home entities may

leave petitioners with a means of correction by placing the

entities back into a “financial position not worse than it would

be” if the disqualified persons had observed the proper

standards.   While, as noted above, we do not address the issue of

timely corrections, we believe that leaving the exemptions intact

is consistent with both the legislative history underlying

section 4958 and the provisions for abatement in sections 4961

through 4963.

V.   Income Taxes

      Michael Caracci, Vincent Caracci, and Christina McQuillen

(collectively, the Caracci children) had no ownership interest in

the Sta-Home tax-exempt entities.   The Caracci children also did

not contribute any property to the Sta-Home for-profit entities

in exchange for the stock that they received in those entities
                                - 64 -

upon their formation.   Respondent determined that the Caracci

children realized gross income by virtue of the fact that the

Sta-Home for-profit entities, in connection with their

organization, received the assets of the Sta-Home tax-exempt

entities.   Respondent argues in brief that the assets of the Sta-

Home tax-exempt entities were constructively transferred to the

Caracci children who, in turn, contributed those assets to the

Sta-Home for-profit entities.    Respondent argues in brief that

the constructive transfer is an accession to wealth that is

includable in the Caracci children’s gross income under section

61.

      We disagree with respondent that the asset transfer resulted

in gross income to the Caracci children.    Although section 61

provides broadly that gross income includes all income “from

whatever source derived”, section 102(a) generally exempts from

that provision the value of any property received by gift.    When

property is transferred for less than adequate and full

consideration in money or money’s worth, the amount by which the

value of the property exceeds the value of the consideration is

deemed a gift.   Sec. 2512(b); Commissioner v. Wemyss, 324 U.S.

303 (1945); Georgia Ketterman Trust v. Commissioner, 86 T.C. 91,

96 (1986); Estate of Higgins v. Commissioner, T.C. Memo. 1991-47.

In the corporate setting, such a transfer may be a gift by the

donor to the individual shareholders of the corporation to the
                              - 65 -

extent of their proportionate interests in the corporation.

Kincaid v. United States, 682 F.2d 1220, 1224 (5th Cir. 1982);

Chanin v. United States, 183 Ct. Cl. 840, 393 F.2d 972 (1968);

Estate of Hitchon v. Commissioner, 45 T.C. 96, 103-104 (1965);

Tilton v. Commissioner, 88 T.C. 590, 597 (1987); Estate of

Trenchard v. Commissioner, T.C. Memo. 1995-121; sec. 25.2511-

1(h)(1), Gift Tax Regs.   When the shareholders of a recipient

corporation are members of the donor’s family, that fact is

strongly indicative of a gift.   See Kincaid v. United States,

supra; Tilton v. Commissioner, supra; Estate of Hitchon v.

Commissioner, supra; Estate of Trenchard v. Commissioner, supra;

Estate of Higgins v. Commissioner, supra.

     Here, Victor and Joyce Caracci set up transactions pursuant

to which their three children each received stock in the Sta-Home

for-profit entities that, in connection therewith, had a total

net asset value of more than $5 million.    The Caracci children,

the natural heirs of Victor and Joyce Caracci, paid nothing for

that stock, nor did they contribute property for it.   The

transfers were effectively gifts to the Caracci children.

     The fact that the children were also employees of the new

corporations does not transform their receipt of 65 percent of

the corporate stock into compensation subject to income tax.     We

are aware that section 102(c) provides that the transfer of

property to an employee is generally deemed to be compensation,
                                - 66 -

rather than a gift.   We believe, however, that a transfer of

property to an employee who is a member of the employer’s family

is more properly considered a gift when the transfer is not made

in recognition of the employee’s work but is made in connection

with the family relationship.

     The transfer of most of the assets involved in this case is

clearly attributable to the familial relationship between the

Caracci parents and their children.      It contrasts strongly to

situations cited by respondent involving compensation, such as

Strandquist v. Commissioner, T.C. Memo. 1970-84 (president of car

sales company taxable on value of new cars he received in excess

of value of used cars he turned in).      Nor is this a situation

involving disguised rentals paid to a lessor-shareholder, as in

Haag v. Commissioner, 334 F. 2d 351, 355 (8th Cir. 1964), affg.

40 T.C. 488 (1963).   Nor is it, in substance, a distribution with

respect to the stock of a controlling shareholder for his

personal benefit, as in Kenner v. Commissioner, T.C. Memo. 1974-

273 (doctor who owned tax-exempt hospital corporation taxed on

relatively small amounts it transferred to corporation that

operated his ranch in Arizona).    Here, during the year in issue,

none of the home health care assets was distributed to any of the

children, and none of the children sold the stock or otherwise

benefited personally from the transfer of the home health care

assets to the for-profit entities.
                             - 67 -

     On the evidence before us, we conclude that the transfers of

the home health care assets to the for-profit entities

constituted gifts to the Caracci children, and not the

realization of taxable income by them.      They are not subject to

income taxes on those transfers.

     In view of the foregoing,


                                      Decisions will be entered for

                                 petitioners in docket Nos.

                                 14711-99X, 17336-99X, and

                                 17339-99X, and will be entered

                                 under Rule 155 in the remaining

                                 dockets.
                           - 68 -

                          APPENDIX

SEC.   4958.   TAXES ON EXCESS BENEFIT TRANSACTIONS

       (a)   Initial Taxes.--

            (1) On the disqualified person.--There
       is hereby imposed on each excess benefit
       transaction a tax equal to 25 percent of the
       excess benefit. The tax imposed by this
       paragraph shall be paid by any disqualified
       person referred to in subsection (f)(1) with
       respect to such transaction.

            (2) On the management.--In any case in
       which a tax is imposed by paragraph (1),
       there is hereby imposed on the participation
       of any organization manager in the excess
       benefit transaction, knowing that it is such
       a transaction, a tax equal to 10 percent of
       the excess benefit, unless such participation
       is not willful and is due to reasonable
       cause. The tax imposed by this paragraph
       shall be paid by any organization manager who
       participated in the excess benefit
       transaction.

     (b) Additional Tax on the Disqualified Person.–-In
any case in which an initial tax is imposed by
subsection (a)(1) on an excess benefit transaction and
the excess benefit involved in such transaction is not
corrected within the taxable period, there is hereby
imposed a tax equal to 200 percent of the excess
benefit involved. The tax imposed by this subsection
shall be paid by any disqualified person referred to in
subsection (f)(1) with respect to such transaction.

     (c) Excess Benefit Transaction; Excess
Benefit.-–For purposes of this section--

             (1) Excess benefit transaction.--

                  (A) In general.--The term
             “excess benefit transaction” means
             any transaction in which an
             economic benefit is provided by an
             applicable tax-exempt organization
             directly or indirectly to or for
                   - 69 -

     the use of any disqualified person
     if the value of the economic
     benefit provided exceeds the value
     of the consideration (including the
     performance of services) received
     for providing such benefit. For
     purposes of the preceding sentence,
     an economic benefit shall not be
     treated as consideration for the
     performance of services unless such
     organization clearly indicated its
     intent to so treat such benefit.

          (B) Excess benefit.--The term
     “excess benefit” means the excess
     referred to in subparagraph (A).

     (2) Authority to include certain other
private inurement.--To the extent provided in
regulations prescribed by the Secretary, the
term “excess benefit transaction” includes
any transaction in which the amount of any
economic benefit provided to or for the use
of a disqualified person is determined in
whole or in part by the revenues of 1 or more
activities of the organization but only if
such transaction results in inurement not
permitted under paragraph (3) or (4) of
section 501(c), as the case may be. In the
case of any such transaction, the excess
benefit shall be the amount of the inurement
not so permitted.

(d) Special Rules.--For purposes of this section--

     (1) Joint and several liability.--If
more than 1 person is liable for any tax
imposed by subsection (a) or subsection (b),
all such persons shall be jointly and
severally liable for such tax.

     (2) Limit for management.--With respect
to any 1 excess benefit transaction, the
maximum amount of the tax imposed by
subsection (a)(2) shall not exceed $10,000.
                        - 70 -

     (e) Applicable Tax-Exempt Organization.--For
purposes of this subchapter, the term “applicable tax-
exempt organization” means--

          (1) any organization which (without
     regard to any excess benefit) would be
     described in paragraph (3) or (4) of section
     501(c) and exempt from tax under section
     501(a), and

          (2) any organization which was described
     in paragraph (1) at any time during the 5-
     year period ending on the date of the
     transaction.

Such term shall not include a private foundation (as
defined in section 509(a)).

     (f) Other Definitions.--For purposes of this
section--

          (1) Disqualified person.--The term
     “disqualified person” means, with respect to
     any transaction--

               (A) any person who was, at any
          time during the 5-year period
          ending on the date of such
          transaction, in a position to
          exercise substantial influence over
          the affairs of the organization,

               (B) a member of the family of
          an individual described in
          subparagraph (A), and

               (C) a 35-percent controlled
          entity.

          (2) Organization manager.--The term
     “organization manager” means, with respect to
     any applicable tax-exempt organization, any
     officer, director, or trustee of such
     organization (or any individual having powers
     or responsibilities similar to those of
     officers, directors, or trustees of the
     organization).
                   - 71 -

     (3) 35-percent controlled entity.--

          (A) In general.--The term “35-
     percent controlled entity” means--

               (i) a corporation in
          which persons described
          in subparagraph (A) or
          (B) of paragraph (1) own
          more than 35 percent of
          the total combined voting
          power,

               (ii) a partnership
          in which such persons own
          more than 35 percent of
          the profits interest, and

               (iii) a trust or
          estate in which such
          persons own more than 35
          percent of the beneficial
          interest.

          (B) Constructive ownership
     rules.--Rules similar to the rules
     of paragraphs (3) and (4) of
     section 4946(a) shall apply for
     purposes of this paragraph.

     (4) Family members.--The members of an
individual’s family shall be determined under
section 4946(d); except that such members
also shall include the brothers and sisters
(whether by the whole or half blood) of the
individual and their spouses.

     (5) Taxable period.--The term “taxable
period” means, with respect to any excess
benefit transaction, the period beginning
with the date on which the transaction occurs
and ending on the earliest of--

          (A) the date of mailing a
     notice of deficiency under section
     6212 with respect to the tax
     imposed by subsection (a)(1), or
                   - 72 -

          (B) the date on which the tax
     imposed by subsection (a)(1) is
     assessed.

     (6) Correction.--The terms “correction”
and “correct” mean, with respect to any
excess benefit transaction, undoing the
excess benefit to the extent possible, and
taking any additional measures necessary to
place the organization in a financial
position not worse than that in which it
would be if the disqualified person were
dealing under the highest fiduciary
standards.
