                       T.C. Memo. 2008-45



                     UNITED STATES TAX COURT



     CHARLES A. AND MARIAN L. DERBY, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 10930-02,   10931-02,   Filed February 28, 2008.
                 10932-02,   10933-02,
                 10934-02,   10935-02,
                 10936-02,   10937-02,
                 10939-02,   10941-02,
                 10942-02,   10943-02,
                 10945-02.




     1
       Cases of the following petitioners are consolidated
herewith: Peter E. and Geraldine Droubay, docket No. 10931-02;
James W. and Marilee G. Eusebio, docket No. 10932-02; Michael R.
and Ann J. Harris, docket No. 10933-02; Michael A. and Linda S.
Hirsch, docket No. 10934-02; John F. Hoefer and Elise R. Smith-
Hoefer, docket No. 10935-02; Daniel J. and Sean C. Kennedy,
docket No. 10936-02; Harris D. and Barbara F. Levin, docket No.
10937-02; Gerald R. MacLean and Joan L. Smith-MacLean, docket No.
10939-02; Estate of Hugh A. Patterson, Deceased, Elizabeth K.
Patterson, Executrix, and Elizabeth K. Patterson, docket No.
10941-02; Robert S. Silva and Susan C. Silva, a.k.a. Susan K.
Silva, docket No. 10942-02; Women's Health Associates, Leon
Schimmel, Tax Matters Partner, docket No. 10943-02; and Richard
H. White and Paula A. Watts-White, docket No. 10945-02.
                                 - 2 -

     Steven J. Mopsick and Betty J. Williams, for petitioners.

     Christian A. Speck and Kathryn K. Vetter, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     GALE, Judge:     Respondent determined deficiencies in

petitioners' Federal income taxes for the 1994 taxable year as

follows:

     Docket No.            Petitioner1               Deficiency

         10930-02       Derby                          $16,739
         10931-02       Droubay                          24,950
         10932-02       Eusebio                          14,237
         10933-02       Harris                            9,724
         10934-02       Hirsch                            8,008
         10935-02       Smith-Hoefer                     33,237
         10936-02       Kennedy                          13,917
         10937-02       Levin                            41,320
         10939-02       Smith-MacLean                    12,170
         10941-02       Patterson                        23,091
         10942-02       Silva                            26,976
                                                      2
         10943-02       Women's Health Assocs.          162,926
         10945-02       Watts-White                      13,341
     1
       Although petitioners filed joint returns, for
     convenience we use the surnames of the spouses whose
     medical practice transfers are at issue in these cases.
     2
       Adjustment to the charitable contribution deduction
     claimed by the partnership. The resulting deficiencies
     to the partners, Dr. Leon Schimmel and Dr. Carol Lynne
     Conrad-Forrest, are not at issue in these cases.

     In his answers, respondent affirmatively alleges that the

individual petitioners are liable for accuracy-related penalties

for gross valuation misstatements equal to 40 percent of the
                               - 3 -

deficiencies pursuant to section 6662(a)2 and (h).

Alternatively, respondent alleges that those petitioners are

liable for penalties for substantial valuation misstatements

equal to 20 percent of the deficiencies pursuant to section

6662(a), (b)(3), and (e)(1)(A).

     The issues common to all petitioners are whether:    (1)

Petitioners are entitled to the charitable contribution

deductions claimed under section 170(a)(1) for the transfer to a

tax-exempt medical foundation of intangible assets associated

with each petitioner physician's medical practice, and (2) the

individual petitioners are liable for the 40-percent accuracy-

related penalty for gross valuation misstatements pursuant to

section 6662(a) and (h) or, alternatively, for the 20-percent

penalty for substantial valuation misstatements pursuant to

section 6662(a), (b)(3), and (e)(1)(A).3   In addition, the

following issues involve certain of petitioners as indicated,

whether:   (1) Petitioners Daniel J. and Jean C. Kennedy (the

Kennedys) underreported Dr. Kennedy's 1994 gross receipts by

$3,760 on Schedule C, Profit or Loss From Business, and (2)


     2
       Unless otherwise noted, all section references are to the
Internal Revenue Code of 1986 as in effect for the year in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
     3
       The deficiencies also reflect adjustments   that are
derivative of the principal adjustments, are not   directly
disputed by petitioners, and will be resolved by   our resolution
of the principal adjustments. We do not further    discuss those
derivative adjustments.
                               - 4 -

petitioners Charles A. and Marian L. Derby (the Derbys)

underreported the 1994 income from Dr. Derby's S corporation by

$3,665.

                         FINDINGS OF FACT4

     Some facts are stipulated and are so found.   The stipulation

of facts, with accompanying exhibits, is incorporated herein by

this reference.

I.   Petitioners

     When they filed their petitions in these consolidated cases,

petitioners Charles A. and Marian L. Derby, Peter E. and

Geraldine Droubay, James W. and Marilee G. Eusebio, Michael A.

and Linda S. Hirsch, John F. Hoefer and Elise R. Smith-Hoefer,

Daniel J. and Sean C. Kennedy, Harris D. and Barbara F. Levin,

Gerald R. MacLean and Joan L. Smith-MacLean, Hugh A. and

Elizabeth K. Patterson, Robert S. and Susan C. Silva, and Richard

H. White and Paula A. Watts-White, resided in California;

petitioners Michael R. and Ann J. Harris resided in Oregon.

During the taxable year ended December 31, 1994, Women's Health

Associates (WHA) was a partnership as defined by section

6231(a)(1).   Its principal place of business was in California.



     4
       To the extent that petitioners have failed to set forth
objections to respondent's proposed findings of fact, or vice
versa, we conclude that these proposed findings of fact are
correct except to the extent that the nonobjecting party's
proposed findings of fact are clearly inconsistent therewith.
See Jonson v. Commissioner, 118 T.C. 106, 108 n.4 (2002), affd.
353 F.3d 1181 (10th Cir. 2003).
                                 - 5 -

WHA had two partners, Drs. Leon Schimmel (Dr. Schimmel) and Carol

Lynne Conrad-Forrest (Dr. Conrad-Forrest), both of whom practiced

obstetrics/gynecology.    Dr. Schimmel was the tax matters partner

of WHA.    At the time the petition for WHA was filed, Dr. Schimmel

resided in California.

      Petitioners were primary care physicians5 (with three

exceptions:    an orthopedic surgeon, an otolaryngologist, and a

psychiatrist) that had been practicing in individual and small

group practices (as sole proprietorships, S corporation

shareholders, or partners) in the Davis, California, area for

periods ranging from 1 to 21 years in 1994.

II.   Background

      A.   Healthcare Industry

      Through the early 1980s, medicine was generally practiced in

the Davis, California, area under a "fee-for-service" model, in

which physicians were paid fees when services were provided to

patients.    Patients with health insurance paid fixed premiums to

a health insurer, and the insurer would in turn contract directly

with physicians to establish a fee schedule for services provided

to its insureds.    Though collecting premiums, the insurer paid



      5
       Each individual petitioner physician filed a joint return
with his or her spouse, and the spouses are petitioners in these
cases by virtue of having filed joint returns. We shall refer to
the individual petitioner physicians as "petitioners". For
convenience, we shall also generally refer to the two partners of
WHA, Dr. Schimmel and Dr. Conrad-Forrest, as petitioners.
                               - 6 -

the physicians only when its insureds received medical services.

Consequently, the insurer bore the risk that a given patient

would require medical care costing more than the premiums that

patient had paid.

     In the fee-for-service environment, many doctors, including

petitioners, owned their own practices (alone or with partners)

and managed them independently, including hiring support staff,

purchasing equipment, and overseeing billing and collection.

     In the mid-1980s, the phenomenon of managed care, in the

form of health maintenance organizations (HMOs), began to take

hold in the provision of medical services, especially in

California.   Under managed care, HMOs, a form of health insurer,

would collect premiums from patients, but rather than pay

physicians for services as rendered, HMOs would instead pay to a

primary care physician a fixed monthly capitation fee to manage

the care of each patient who selected that physician.   Thus,

under the HMO model of managed care, the risk of having a patient

whose medical care costs exceeded the premiums paid was in

general shifted from insurers to physicians and other health care

providers.

     The penetration of the HMO model was low at first, but it

became much more prevalent over time.   HMOs generally would not

contract directly with individual physicians; instead, they would

enter into agreements only with larger groups.   Physicians in the
                                 - 7 -

Davis area became aware in 1985 that the University of California

at Davis (UC-Davis), the largest employer in the region, was

considering offering HMO style coverage as a health insurance

option for its employees.     In response, a group of Davis area

independent physicians, including several of petitioners, began

to meet monthly to consider options for dealing with any

significant penetration of the HMO model into the Davis area

patient population.

     B.    Formation of IPA

     One option for physicians desiring to serve patients with

HMO coverage was membership in an independent practice

association (IPA).    An IPA is a collection of independent

physicians formed (typically as a corporate entity) to serve as

an intermediary between its member physicians and HMOs.      IPAs

negotiate contracts directly with HMOs, administer claims,

collect capitation fees for the HMO patients who select a

physician member, and pay over those fees to the physician

members.

     The penetration of the HMO model into the Davis area

continued after 1985.    In 1987, several of petitioners and other

local doctors, principally primary care physicians, formed an

IPA, the Davis Area Medical Group, Inc., later renamed United

Health Medical Group, Inc. (UHMG).6      UHMG negotiated contracts


     6
         By 1994, each petitioner had become a member of UHMG,
                                                     (continued...)
                                    - 8 -

with HMOs, collected capitation fees paid under those contracts,

and distributed them to member physicians.         UHMG contracted with

a third-party administrator to perform the latter two functions

for a fee of 15 percent of receipts.         UHMG performed no other

consolidated functions for its member physicians, such as other

billing, patient record keeping, appointments, employment of

staff, etc.        Its member physicians continued to operate

independent practices and to directly bill fee-for-service and

preferred provider organization (PPO)7 patients.

III.       Decision To Affiliate

           A.   Necessity of Affiliation

       By approximately late 1992 or early 1993, several factors

prompted petitioners to consider affiliating with a larger health

care organization.        The penetration of the HMO model into the

Davis area had become substantial.          The principal employer in the

Davis area, UC-Davis, faced with burgeoning costs in providing

conventional fee-for-service health insurance coverage, arranged

to have HMOs among the health insurance options for its employees



       6
      (...continued)
although UHMG's approximately 70 shareholder/members also
included physicians who did not participate in the transactions
at issue.
       7
       A PPO is an organization created by an insurer consisting
of physicians and/or other health care providers who individually
contract with the insurer to provide medical services to its
insureds for reimbursement at a discount. The insureds have an
incentive to use the insurer's "preferred providers" because the
out-of-pocket costs of doing so are reduced.
                                 - 9 -

starting in 1994.   Because the out-of-pocket costs to the UC-

Davis employees of HMO coverage were considerably less than fee-

for-service coverage, petitioners believed UC-Davis's change

would result in a substantial additional migration to HMOs in the

area.   In fact, a significant fee-for-service insurer, Blue

Shield of California, faced with declining enrollments, dropped

out of providing coverage to UC-Davis employees for 1994.    This

left only a few very expensive fee-for-service insurance options

for UC-Davis employees; virtually all employees switched to HMO

or other managed care coverage.    By 1993, Sacramento, which is

approximately 15 miles from Davis, had the highest penetration of

HMO care in the United States.

     In California, the shift towards managed care was

accompanied by a significant consolidation of health care

providers and insurers into larger organizations, or integrated

delivery systems.   Both HMOs and hospitals had begun to acquire

physicians' practices as a means of expanding their patient base.

Primary care physicians were attractive acquisition targets,

given their patient rosters, especially organized groups of such

physicians.   The UHMG physicians, including petitioners, had in

addition developed a reputation as especially cost-efficient

practitioners; that is, they were perceived by insurers and

others in the field as having shorter-than-average hospital
                              - 10 -

stays,8 fewer-than-average Caesarian sections, etc.   The UHMG

physicians were therefore courted by several HMO and hospital

organizations in the area as acquisition targets.

     In petitioners' view, the IPA model, which they had adopted

in forming UHMG, did not prove to be an especially effective

means of preserving the economic viability of their medical

practice in a managed care environment, where the risk of having

sicker-than-average patients was shifted from insurers to health

care providers.   That was so because, while the IPA arrangement

provided a mechanism whereby petitioners could treat patients

with HMO coverage, the IPA arrangement did not create a capital

pool, or result in sufficient size, to allow for the management,

or effective spreading, of the foregoing new risk.    Instead,

petitioners believed, effective management of the risk would

require that they affiliate with a larger organization.    They

also believed that such an affiliation would bring them greater

leverage in negotiating capitation rates with HMOs and other

insurers.   A final impetus towards affiliation was the

anticipation, by petitioners and other members of the medical

community, that managed care would spread and consolidation of

healthcare providers would increase as a result of a major effort



     8
        UHMG physicians had pioneered the use of a "hospitalist",
i.e., the full-time assignment of a physician from their group to
a hospital to oversee the care of hospitalized patients of other
UHMG physicians, rather than having each physician individually
care for his or her hospitalized patients.
                                - 11 -

to restructure the provision of health care in the United States

in 1994 by the Federal Government, including the creation of some

form of national health insurance.

     Against this backdrop, petitioners concluded that practicing

medicine as independent or small group practitioners using an IPA

would no longer be economically viable for them.    Instead, they

decided, it would be advisable to affiliate with a larger health

care organization such as an HMO or a hospital.    Affiliation with

a larger organization provided a more secure means to practice

medicine in a managed care environment, in petitioners' view, as

it would provide them with a larger patient base for spreading

the risk of loss being transferred to them by health insurers,

greater capital resources for the same purpose, the benefits of

greater bargaining leverage in negotiating managed care

contracts, and greater efficiencies and economies of scale in

providing care.

     To facilitate the affiliation, it was also decided that

certain of the UHMG member physicians, including petitioners,

should form a medical group.9    Unlike an IPA, a medical group

involved the consolidation of the member physicians' medical

practices, so that patient revenues were pooled, expenses were

shared, and salaries were paid to member physicians.    The newly


     9
       Not all members of the UHMG IPA were asked to join the new
medical group, for various reasons, including that his or her
medical specialty, or personality and/or practice style, was not
perceived to be a good fit.
                              - 12 -

formed medical group would then affiliate with a larger

organization seeking to acquire group practices.   A "steering

committee" of six UHMG physicians was formed for purposes of

exploring an affiliation.   Letters announcing the physicians'

interest in forming a medical group and affiliating with a larger

organization were sent to five potential acquirers:   U.C.-Davis

Medical Center, Foundation Health Corp., Woodland Clinic,    Mercy

Healthcare of Sacramento, and Sutter Health, all of which were

seeking to acquire or affiliate with medical practices.

     B.   Rejection of Foundation Health Corp. Affiliation

     The steering committee met and negotiated with

representatives of the foregoing entities and recommended that

the group affiliate with Foundation Health Corp. (Foundation).

Foundation was an HMO operated for profit and publicly traded; it

had embarked on a course of becoming a "Kaiser model" HMO; i.e.,

one that acquired medical practices as a means of expanding its

patient base or "market share" in California.   Foundation had

offered what steering committee members believed was the most

generous financial consideration, including substantial cash

payments for the intangible assets, or goodwill, associated with

the UHMG physicians' practices.   Foundation considered the UHMG

physicians more valuable to it as a medical group (rather than

individual practices) because its experience had shown that

existing working arrangements between physicians, such as call
                               - 13 -

schedules, reduced the management effort required of Foundation

in organizing independent physicians to work together.

      When the steering committee presented its recommendation

(which had not been unanimous) to the group, it was soundly

rejected.    The remaining UHMG physicians, including several of

petitioners, were vehemently opposed to any affiliation with

Foundation.    Most had had unpleasant experiences with

Foundation's unwillingness to approve certain drugs and

procedures they had recommended for patients.    Foundation

employed "formularies", which were approved lists of drugs the

departure from which when prescribing for patients required

substantial justification by the physician.    This and other

Foundation practices, which many of petitioners attributed to

Foundation's for-profit, business-driven orientation, caused

petitioners to fear a significant loss of professional autonomy

were they to practice medicine as employees of Foundation.

IV.   Acquisition by Sutter Health

      A.   Selection of Sutter Health

      The discussions with Foundation were terminated, and after

some consideration of the remaining potential acquirers,

petitioners and the other UHMG doctors decided to pursue an

affiliation with Sutter Health.10    Sutter Health was the parent


      10
       Woodland Clinic had offered very little in the steering
committee's view, as negotiations revealed that it was merely
interested in the UHMG physicians' joining its organization
                                                   (continued...)
                              - 14 -

corporation of a regional health care system comprising a wide

range of inpatient and outpatient clinics as well as acute care

hospitals located in Northern California.     Sutter Health had a

section 501(c)(3) subsidiary, Sutter Medical Foundation (SMF),

that operated group medical practices that were integrated with

Sutter Health's affiliated hospitals in an integrated delivery

system.   SMF operated its group medical practices through

professional service agreements with groups of local physicians.

Sutter Health hoped to expand into the Davis area in 1994 by

acquiring a local medical group to integrate with its hospitals

in the area.   To accomplish this, Sutter Health envisioned having

SMF purchase the assets of local physicians and enter into a

professional services agreement with those physicians organized

as a medical group.   Acquiring a physician group was important to

Sutter Health, as it represented an immediate roster of patients

for its clinics and acute care hospitals.11

     Many of the UHMG physicians had privileges at the existing

Sutter Health hospital in Davis and had been involved in the



     10
      (...continued)
individually. Moreover, Woodland typically required physicians
it employed to sign noncompete agreements, and petitioners were
unwilling to agree to such restrictions. The committee
terminated discussions with U.C.-Davis and Mercy Healthcare for
reasons not fully disclosed in the record; at least one UHMG
physician believed U.C.-Davis Medical Center was too large and
"bureaucratic".
     11
       SMF was not interested in contracting with physicians
individually.
                              - 15 -

design of a new, state-of-the-art Sutter Davis Hospital scheduled

to open in September 1994.

     B.   Negotiations

     Negotiations between SMF and physician representatives of

UHMG began in 1993 and continued through most of 1994.   The

discussions covering the consideration that petitioners would

receive for their medical practices were protracted and sometimes

acrimonious.   Unlike Foundation, Sutter Health was unwilling to

pay anything for the intangible assets, or goodwill, that might

be associated with petitioners' medical practices.   Sutter Health

was unwilling to do so for two reasons:   First, and principally,

because Sutter Health's management believed that doing so might

constitute a crime under the Medicare and Medicaid antikickback

statute, 42 U.S.C. sec. 1320a-7b(b), prohibiting payments for

referrals of patients eligible for Medicare or Medicaid;12 and,


     12
       Sutter Health's nonprofit, tax-exempt subsidiaries,
including SMF, provided substantial goods and services for which
payment was made under Medicare and Medicaid. The Associate
General Counsel of the U.S. Department of Health and Human
Services had written a letter on Dec. 22, 1992, in response to a
request from the Internal Revenue Service Office of the Associate
Chief Counsel for Employee Benefits and Exempt Organizations for
the Department's views concerning the application of the Medicare
and Medicaid antikickback statute, 42 U.S.C. sec. 1320a-7b(b), in
the case of transactions involving the acquisition of physician
practices by tax-exempt hospitals and other health care
providers. The letter, widely circulated in the nonprofit health
care sector, had expressed the view that payments made in
connection with the acquisition of physician practices that were
in excess of the fair market value of the "hard assets" of the
practice, including payments for goodwill, patient lists, or
patient records, might be considered payments for patient
                                                   (continued...)
                               - 16 -

second, because Sutter Health's management believed, on the basis

of their projections of the financial performance of the UHMG

physicians' group after acquisition, that any additional payment

for intangibles would have rendered the deal financially

nonviable for Sutter Health.   Sutter Health's management

anticipated that petitioners and the other UHMG physicians could

be persuaded to affiliate with Sutter Health through additional

incentives, such as being given a management role, through

participation in various management committees of SMF and Sutter

Health.

     Many of petitioners were greatly concerned that they not be

required to sign any noncompete agreement in connection with

their affiliation with a larger health care organization.    It was

vitally important to them to be able to terminate their

affiliation in the event they judged it unsatisfactory and resume

the practice of medicine in the Davis, California, area without

having to relocate.   Many were familiar with the tribulations of

physicians in the area who had affiliated with the Woodland

Clinic, which required affiliating physicians to sign noncompete

agreements.   Petitioners were aware that when certain Woodland

Clinic physicians sought to terminate their relationships with

the clinic, they became embroiled in protracted litigation over


     12
      (...continued)
referrals in violation of the antikickback statute. Violations
of the statute could result in criminal penalties and/or
exclusion from participation in Medicare and Medicaid programs.
                               - 17 -

the noncompete agreements.   Petitioners were determined to avoid

that possibility.

     At some point in the negotiations, petitioners and the other

UHMG physicians decided to pursue exclusively an affiliation with

Sutter Health.   Thereafter they retained an attorney, Peter

Grant, to advise them with respect to the transaction with SMF.

Mr. Grant, whose fees were paid by SMF, was experienced in

matters affecting health care organizations, including

acquisitions of physician practices.    Mr. Grant recommended that,

in light of Sutter Health's unwillingness to pay cash for

goodwill or similar intangible assets associated with the

physicians' practices, petitioners should consider donating their

practice intangibles to SMF and claiming charitable contribution

deductions for their values.

     Mr. Grant recommended that petitioners structure the

transfers of the intangibles as donations because that technique

had been used in connection with an acquisition of a group

medical practice by a nonprofit medical foundation (Friendly

Hills Healthcare Foundation), for which Mr. Grant had served as

an adviser.   Mr. Grant had received a written determination in

the form of a determination letter granting section 501(c)(3)

tax-exempt status to Friendly Hills Healthcare Foundation, where

it had been represented that the medical group physicians would

make donations of an aggregate portion of the transferred assets
                                 - 18 -

(including intangible assets) to the foundation and claim

charitable contribution deductions for proportionate amounts of

the aggregate donation (Friendly Hills determination letter).   In

addition, Mr. Grant was familiar with the annual Exempt

Organizations Continuing Professional Education Technical

Instruction Program manuals, including the manual for 1994, which

expressly contemplated a "charitable donation" as one method by

which a nonprofit corporation might acquire assets from an

existing group medical practice in connection with its

acquisition of the practice.13

     C.   Acquisition Transaction

          1.   In General

     To effect Sutter Health's acquisition of the medical

practices of the UHMG physicians, including petitioners, who

wished to affiliate with it, a number of steps were taken, as

discussed below.

     First, Sutter Health and the affiliating physicians arranged

for an appraisal of the "business enterprise value" of the to-be-

formed medical group, as well as a separate appraisal of the

tangible assets that would be transferred to SMF as part of the

acquisition.   In April 1994, Sutter Health retained an investment

banking firm, Houlihan Lokey Howard & Zukin (Houlihan), to

     13
        See "Exempt Organizations Continuing Professional
Education Technical Instruction Program for FY 1994", Dept. of
Treasury, Internal Revenue Service, Training 4277-045, at 215-217
(7-93).
                               - 19 -

perform an analysis of the "Davis Medical Group * * * , a group

medical practice (currently being formed) comprised of thirty-

five primary care physicians" and to render an opinion regarding

"the fair market value of the aggregate assets of * * * [the

Davis Medical Group] exclusive of any benefit or element of value

conferred upon Sutter [Health] as a consequence of its current or

proposed relationship with * * * [Davis Medical Group], and with

consideration of proposed posttransaction compensation and

benefits to the physician group."    Houlihan also agreed to

"allocate the appraised value of * * * [Davis Medical Group] to

each of its physician/shareholders" using a method to be agreed

upon in consultation with the UHMG steering committee, but the

agreed-upon method "[had to] be acceptable" to Houlihan.     The

retainer agreement further provided that Houlihan would arrange

for an appraisal of the hard assets by a qualified third party,

for a separate fee.

       Second, shortly after Houlihan was retained, a corporation

was formed to serve as the entity for the medical group to be

formed by certain of the UHMG physicians, including petitioners,

for purposes of the acquisition of their medical practices by

SMF.    On April 19, 1994, the Community Health Associates

Multispecialty Medical Group, Inc. (d.b.a. Sutter West Medical

Group), was incorporated as a California professional medical

corporation (SWMG).
                              - 20 -

          2.   Professional Services Agreement (PSA)

     SWMG thereupon entered into a Professional Services

Agreement (PSA) with SMF on August 12, 1994, to become effective

on November 1, 1994, subject to the conditions precedent that at

least 25 primary care physicians associated with the UHMG IPA

would become shareholder-employees of SWMG and sell their medical

practices to SMF under prescribed asset purchase agreements.    The

PSA had a 2-year term, subject to renewal.   Pursuant to the PSA,

SWMG agreed to provide professional services through its member

physicians exclusively to the patients of SMF's group practice

program in a prescribed service area, generally the Davis,

California, region, so as to become part of a comprehensive

health care delivery system involving SMG, SWMG, and Sutter

Health's hospitals and other health care facilities.   The

physicians rendering the professional services on behalf of SWMG

were to be under contract with SWMG pursuant to agreements

complying with the terms of the PSA, which included the proviso

that the physicians would provide professional services solely to

SMF (through SWMG), with an exception for reasonable amounts of

unpaid volunteer work.   SMF agreed to provide and maintain clinic

locations and equipment, all necessary nonphysician personnel,

professional liability insurance coverage, and accounting and

billing services, as well as maintenance of patient records.

Under the PSA, all patients seen by the SWMG shareholder
                             - 21 -

physicians were deemed to be the patients of SMF's group practice

program, and all income from the rendering of professional

services to these patients was to accrue to SMF.

     The PSA contained a noncompete provision, under which SWMG

and its physician shareholder/employees were prohibited from

participating in the ownership, management, operation, or control

of any business or person providing health care services within

the service area covered by the agreement.   However, specifically

exempted from this prohibition was any SWMG physician who left

the employment of SWMG.

     Pursuant to the PSA, SWMG would receive compensation for its

provision of professional services equal to a percentage of net14

revenues from patients, as follows:   57.75 percent15 of fee-for-

service revenue; 47 to 53 percent of capitation revenue,

depending on average monthly levels; and a sliding scale from 90




     14
       For this purpose, "net" revenue consisted, in the case of
fee-for-service revenues, of gross revenues less an estimated
percentage to account for contractual discounts and bad debts
and, in the case of capitation revenue, of gross revenue less
amounts equal to the cost of third-party administration, cost of
ancillary services, and other miscellaneous costs. "Net"
revenues for this purpose were not offset by SMF's expenses of
providing clinic locations, nonphysician personnel, or
administrative services such as billing or maintaining patient
records.
     15
       The parties amended the PSA, wherein the fee-for-service
percentage was initially set at 54.5 percent, to reflect the
percentage noted above on Dec. 1, 1994, retroactive to Nov. 1,
1994.
                                - 22 -

to 60 percent for the first $800,000 of "risk pool revenue",16

with a 55 percent17 share of amounts above $800,000.    SWMG agreed

to compensate its physician members, including petitioners, from

the foregoing share of revenues.    In addition, the PSA provided a

guaranty, or floor, on the annual compensation that SWMG (and

through SWMG, its member physicians) would receive, generally

equal to 98 percent of the total designated annual compensation

amounts for SWMG's member physicians.    (The designated annual

compensation amounts were set individually for each member, and

ranged (for full-time practitioners) from a high of $348,859 for

petitioner Elise R. Smith-Hoefer to a low of $110,076 for

petitioner James W. Eusebio.)    Finally, the PSA provided for the

payment of a "Physician Access Bonus" described as follows:    "A

critical element necessary to maintain an integrated health

system is physician access.    To provide an incentive to SWMG to

form and sustain a group, SMF will pay SWMG a Physician Access

Bonus."    The PSA nowhere provided, or required that the

employment agreement between SWMG and each SWMG physician

provide, that SWMG physicians maintain "open" practices; i.e.,

accept new patients notwithstanding existing patient loads.

Provisions governing the assignment of patients to SWMG


     16
          The record does not define "risk pool revenue".
     17
       As with capitation revenues, the share of risk pool
revenues noted above was the product of a subsequent amendment,
having been initially set at a flat 50 percent.
                               - 23 -

physicians were contained in the employment agreements between

SWMG and each SWMG physician, discussed below.

       The "Physician Access Bonus" was $35,000 for each of SWMG's

full-time physicians, plus a prorated portion of $35,000 for each

of up to five part-time physicians.     Forty-four percent of the

amount so calculated was payable 2.5 months after the November 1,

1994, effective date of the PSA (January 15, 1995), with the

balance payable in two 28-percent installments on the first and

second anniversaries of the PSA's effective date.     When the PSA

was renegotiated for the period after its initial 2-year term,

there was no comparable provision for a "Physician Access Bonus".

SMF did not pay physician access bonuses in connection with its

acquisition of any other physician practices.

       The PSA also secured for SWMG a role in the governance of

SMF.    Pursuant to the PSA, SWMG was entitled to designate one of

its member physicians to serve as a voting member of SMF's board

of directors during the first year of the agreement, and one to

serve as a nonvoting member for the term of the agreement.18    SWMG

was also entitled to designate representatives on various

management and planning committees of SMF and Sutter Health.     In

addition, as one of SMF's contracting medical groups, SWMG was

entitled to nominate three of the seven members of SMF's Area


       18
       SMF also agreed to "facilitate discussions" between SWMG
and Sutter Health to evaluate and restructure provisions
regarding permanent physician members of SMF's board of
directors.
                               - 24 -

Governance Council, the function of which was to oversee the day-

to-day operations of the group medical practices in SWMG's

service area and to provide advice to SMF's board of directors

with respect to all policy matters affecting that service area.

Finally, SMF agreed under the PSA to include the SWMG member

physicians' clinic locations among its clinic locations and to

refrain from making changes in clinic locations during the term

of the agreement without the approval of SWMG.

          3.   Physician Employment Agreements (PEAs) and Asset
               Purchase Agreements (APAs)

     The concluding steps of the affiliation of the UHMG

physicians with Sutter Health were effected during the latter

half of October 1994 and consisted of the purchase of a share of

SWMG's stock by each affiliating physician (including

petitioners) coupled with his or her execution, effective

November 1, 1994, of a Physician Employment Agreement (PEA) with

SWMG and an Asset Purchase Agreement (APA) with SMF.    SMF's

obligation to purchase, and each affiliating physician's

obligation to sell, his or her medical practice pursuant to an

APA was preconditioned upon the physician's having become a

shareholder and employee of SWMG, and the PSA between SWMG and

SMF having become effective.

     As noted, a precondition to the PSA's becoming effective was

the requirement that at least 25 of the UHMG physicians become

shareholders of SWMG.   This had occurred by the end of October
                              - 25 -

1994, by which time 36 UHMG physicians had done so.    Accordingly,

the SWMG shareholder physicians sold their practices pursuant to

the APAs and became employees of SWMG pursuant to the PEAs, on

November 1, 1994.

     The PEAs between SWMG and the affiliating physicians,

including petitioners, were substantially identical except for

the compensation and benefit amounts to be paid to the physicians

under the agreements, and were effective November 1, 1994, for a

term of 1 year, renewable annually.    Each petitioner agreed to

practice medicine full time and exclusively for SWMG (except for

reasonable amounts of unpaid volunteer work) and to provide

medical services solely to SMF and its group practice patients.

SWMG was given "the exclusive right to allocate patients among

its employees with due regard to the source of the patients, the

patient's preference with respect to choice of physicians, the

specialty and skills of its employees, and their workload";

however, SMF was given "final authority over acceptance or

refusal of any patient".   The PEAs provided that persons treated

by physicians pursuant to the agreement were patients of SMF and

that SMF was solely entitled to all fees for the services

rendered by the physicians.   Upon the termination of a

physician's employment under the PEA, the physician was not

entitled to take or use any confidential or proprietary
                              - 26 -

information of SWMG, including "patient lists" and "patient

medical records".   The PEAs provided in addition that

     the Physician shall not use any information obtained in
     the course of his or her employment with * * * [SWMG]
     for the purpose of notifying patients of * * * [SWMG]
     of the termination of his or her employment, or of his
     or her willingness to provide medical services;
     provided, however, the departing Physician may give
     written notice to the Departing Physician's patients
     named in the Departing Physician's patient list
     furnished to SMF on or before the [November 1, 1994]
     Effective Date [of the PEA], announcing the Departing
     Physician's separation from * * * SWMG and his or her
     new practice location, and offering the patient an
     opportunity to choose whether his or her patient
     records should remain with SMF or be transferred to the
     Departing Physician.

We shall hereinafter refer to the foregoing patient notification

right, together with the PSA's exemption from its noncompete

provision for SWMG physicians who ceased employment with SWMG, as

the free-to-compete provision.

     Each affiliating UHMG physician (or partnership), including

petitioners, agreed to sell his/her (or its) medical practice

assets to SMF pursuant to an APA.   Although each seller entered

into a separate APA with SMF, the APAs were virtually identical.19

Pursuant to article 1 of those agreements, SMF agreed to purchase

from each seller "all of the fixtures and personal property of

every kind and description, whether tangible or intangible and

wherever located, * * * used in the operation of [the seller's]

business."   Those assets included the seller's fixed assets

     19
       The APAs were prepared from master agreements that were
customized for each seller.
                               - 27 -

(equipment, furniture, fixtures), inventory and supplies, records

(excluding patient records), licenses and permits to the extent

transferrable under applicable law, and any intangibles which

were part of the seller's medical practice.    Each seller retained

his/her (or its) cash and accounts receivable.    Each seller was

given "an equal and joint ownership interest" with SMF "in all

patient lists and patient medical records used in [the seller's

business]".    SMF agreed to assume contractual and lease

liabilities.

     Article 1.04 of each APA provided:

          Seller and Buyer believe that the purchase price
     of the Assets is less than their fair market value.
     The difference between the purchase price and the fair
     market value of the Assets is referred to as the
     "contribution". At the closing, Seller will
     irrevocably and unconditionally donate the Contribution
     to Buyer to be used in furtherance of its charitable
     purposes. If Seller chooses to claim a charitable
     contribution deduction for the Contribution, then,
     subject to the following conditions, Buyer, upon the
     written request of Seller, agrees to acknowledge
     receipt of the contributed property by executing Part
     IV (Donee Acknowledgment) of a properly completed IRS
     Form 8283 (Noncash Charitable Contribution) supplied by
     Seller: (a) Seller must obtain from a duly qualified
     independent third-party appraiser an appraisal (the
     "Appraisal") of the value of the Seller's Business that
     complies with the standards of Rev. Rul. 59-60,
     including its later modification and amplifications;
     (b) the Appraisal must be made as of a date no more
     than sixty (60) days prior to the Closing Date (as
     defined in Section 7.01); (c) the claimed fair market
     value of Seller's charitable contribution must not
     exceed the Contribution, as determined by the
     Appraisal.
                                 - 28 -

     The APA further provided that each seller was required "to

use Seller's best efforts * * * to preserve Seller's present

business relationship with suppliers, patients and others having

business relationships with Seller" and "to cooperate with * * *

[SMF's] attempts to retain the services of the employees of

Seller's Business following the Closing to the extent that * * *

[SMF] decides to attempt to employ any such employees."

             4.   Houlihan and Narvco Appraisals

     Houlihan issued its appraisal (Houlihan appraisal) on April

7, 1995.20    The Houlihan appraisal described SWMG as "a newly

formed group of thirty-eight physicians who have practiced in the

City of Davis for many years."     Using a discounted cashflow

approach, the Houlihan appraisal concluded that, "as of November

1, 1994 and currently, the fair market value of the fixed and

intangible assets, excluding working capital, of * * * [SWMG] is

reasonably stated as $4 million."

     The tangible assets of the affiliating physicians' practices

were valued separately by Narvco Enterprises, Inc. (Narvco).      The

standard used by Narvco in valuing the tangible assets, namely,

"value in use", was directed by SMF and the SWMG physicians after

they had agreed that it was appropriate.      Under the APAs, each


     20
       Respondent contends, and we agree, that the Houlihan
appraisal is hearsay. It was not offered as an expert report
under Rule 143(f). Nonetheless, it was the appraisal relied on
by petitioners in the 1994 returns, and it is relevant for
various nonhearsay purposes.
                               - 29 -

SWMG physician received payment for the tangible assets of his or

her medical practice equal to the appraised value determined by

Narvco.   The aggregate amount paid by SMF for the tangible assets

of the SWMG physicians' practices was $1,156,733.

           5.   Allocation of Value of Intangibles

     SWMG entered into a further retainer agreement with Houlihan

on June 14, 1995, pursuant to which Houlihan would provide an

opinion "with respect to the appropriateness of the allocation of

the intangible value [of SWMG] among the individual shareholders

of SWMG pursuant to * * * the Asset Purchase Agreement [APA]

between SWMG and Sutter Health."   No such opinion is in the

record.   Earlier, in an October 11, 1994, letter, Houlihan had

advised Dr. Silva (chairman of the SWMG steering committee) that

an allocation could be made upon one, or a combination, of the

following three methods:   On the basis of each physician's

contribution to revenue, on the basis of each physician's

contribution to income, or on the basis of each physician's

roster of active patients.

     The formula for allocating each SWMG physician's

proportionate share of the estimated intangible value of SWMG was

devised, however, not by Houlihan but by one of petitioners;

namely, Dr. Levin.   Dr. Levin described his allocation, to be

used by each SWMG physician for purposes of calculating his or

her charitable contribution deduction arising from the "bargain
                               - 30 -

sale" of his or her medical practice to SMF, in a July 11, 1995,

letter.    Dr. Levin calculated that the aggregate value of the

intangible assets that had been "contributed" by the SWMG

physicians to SMF was equal to the "business enterprise

valuation" of SWMG as determined by Houlihan ($4 million), less

the aggregate value of the amount paid by SMF to the SWMG

physicians for the fixed assets of their practices, as determined

by Narvco ($1,156,733), less the aggregate accounts receivable

estimated to be collectible by the SWMG physicians as of November

1, 1994 (the transfer date) ($1,210,890).    The residual

($1,632,377) was assumed to represent "the value of the

intangible donation to * * * [SMF]."    This aggregate value was

then allocated among the 29 SWMG physicians who sold their

medical practices to SMF, pursuant to a formula devised by Dr.

Levin.    That formula allocated (i) 50 percent of the aggregate

value on the basis of each physician's share of gross revenues

generated in the year preceding the transfer to SMF; (ii) 25

percent on the basis of each physician's "years in the

community", with up to a maximum of 5 years being counted; and

(iii) 25 percent on the basis of each physician's share of the

aggregate fixed assets transferred to SMF by the SWMG physicians.

V.   Petitioners' and SMF's 1994 Returns

      On their 1994 returns, petitioners claimed charitable

contribution deductions for the transfer to SMF of the intangible
                                - 31 -

assets associated with their medical practices in amounts

consistent with Dr. Levin's allocations, as follows:

                                                  Deduction
    Docket No.          Petitioner                 Claimed
                                                  1
     10930-02            Derby                      $65,006
     10931-02            Droubay                      73,592
     10932-02            Eusebio                      35,978
     10933-02            Harris                       38,839
     10934-02            Hirsch                       28,619
     10935-02            Smith-Hoefer                 81,769
                                                     2
     10936-02            Kennedy                       40,884
     10937-02            Levin                      104,255
     10939-02            Smith-MacLean                47,427
     10941-02            Patterson                    83,405
     10942-02            Silva                        76,045
                                                  3
     10943-02            Women's Health Assoc.      162,926
     10945-02            Watts-White                  40,475

     1
       Because the charitable contribution deduction claimed
     on Schedule A, Itemized Deductions, of the Derbys' 1994
     return ($8,913 in cash contributions plus the $65,006
     noncash portion at issue in this case) exceeded 50
     percent of adjusted gross income, the Derbys' 1994
     charitable contribution deduction was limited to
     $60,212. Respondent denied a deduction for "any amount
     in excess of $8913" and increased the Derbys' income by
     $51,409, although it appears that the deduction
     disallowance should not have exceeded $51,299 (the
     difference between $60,212 and $8,913).
     2
         Claimed on an amended return.
     3
       This is the aggregate amount of the charitable contribution
     deduction related to the SMF transaction that the
     partnership allocated to the two partners (Dr. Schimmel
     ($77,277); and Dr. Conrad-Forest ($85,699)) on the
     partnership return. The Forms 8283 provided for each
     partner list a charitable contribution deduction of $96,896
     for each. There is no evidence in the record that accounts
     for the discrepancy.
                              - 32 -

      Attached to each petitioner's 1994 return was a Form 8283,

Noncash Charitable Contributions, in support of the charitable

contribution deduction claimed for the transfer of intangible

assets to SMF.   Part III, Certification of Appraiser, of Section

B of the Form 8283 was executed by Houlihan and dated April 7,

1995, the date of the Houlihan appraisal.   Part IV, Donee

Acknowledgment, of Section B of the Form 8283 was executed on

behalf of SMF by Karl Silberstein, "VP", and dated July 18, 1995.

      On its 1994 return, Form 990, Return of Organization Exempt

From Income Tax, SMF did not report as contributions received any

donations of intangible assets or goodwill from petitioners or

any other SWMG physician.

VI.   Dutcher Appraisal

      After respondent commenced an examination of petitioners'

1994 returns, petitioners' counsel in this case retained another

appraiser, Ernest E. Dutcher, managing member of National

Business Appraisers, L.L.C., to "independently determine the

market value of the intangible assets of SWMG as of * * *

November 1, 1994, assuming a sale to a qualified buyer who could

either be a for-profit entity or a 501(c)(3) corporation."   Mr.

Dutcher's appraisal (Dutcher appraisal) postulated that the value

of the aggregate intangibles of the SWMG physicians was equal to
                              - 33 -

SWMG's "business enterprise value" less SWMG's (i)"implied

working capital" and (ii) fixed assets.21

     Mr. Dutcher derived the business enterprise value of SWMG by

taking the weighted average of what he computed to be SWMG's

value based on an income method (50 percent), an asset method (40

percent), and a market method (10 percent).   The income value was

based upon a discounted future distributable earnings approach

whereby an estimate of SWMG physicians' aggregate revenues for

199422 was projected forward, and the future after-tax

distributable earnings then discounted to present value,

producing a business enterprise value on November 1, 1994, of

$4,112,500.   In calculating what SWMG's future distributable

earnings would be, Mr. Dutcher assumed that the expense of

physician compensation would equal the national median for the




     21
       The Dutcher appraisal treated the fixed assets of SWMG as
equal to the fixed assets of the medical practices of each of the
SWMG physicians (or partnership) who transferred his or her (or
its) practice to SMF.
     22
       SWMG did not exist as an operating entity until Nov. 1,
1994. Mr. Dutcher treated as SWMG's 1994 revenues the estimated
1994 aggregate revenues of the 29 UHMG physicians who transferred
their practices to SMF, plus the 1994 revenues of 5 of the 7
"hired" physicians in SWMG who did not have ownership interests
in a medical practice when the affiliation with SMF consummated.
                              - 34 -

"Western Region"23 for a weighted average of the medical

specialties comprising SWMG, or 45.18 percent.

     The asset value was based upon a capitalization of excess

earnings approach.   In making his computations under the excess

earnings approach, Mr. Dutcher used the Narvco appraised value of

the tangible assets of the medical practices of the UHMG

physicians who transferred their practices to SMG (namely,

$1,156,733), as the value of SWMG's fixed assets.   Mr. Dutcher's

estimate of the business enterprise value of SWMG computed under

the excess earnings approach was $4,061,400.

     Finally, Mr. Dutcher used a market approach whereby he

derived a business enterprise value for SWMG based on a

comparison with price/earnings ratios of publicly traded health

care companies, with a 23.1-percent discount for SWMG's smaller

size, a 35-percent premium reflecting control, and a discount for

lack of marketability of 10 percent, resulting in an indicated

value of $4,076,400.   Weighting the three values in the manner

previously noted produced a business enterprise value of

$4,088,450.

     As noted, Mr. Dutcher treated the value of SWMG's intangible

assets as SWMG's business enterprise value ($4,088,450), less (i)


     23
       Mr. Dutcher's figures were taken from a "Physician
Compensation Survey", based on data from a report by the Center
for Research in Ambulatory Health Care Administration, "Physician
Compensation and Production Survey: 1994 Report Based on 1993
Data".
                              - 35 -

"implied working capital" (estimated as 4 percent of net revenue,

in accordance with industry standards, or $416,46224) and (ii)

fixed assets (Narvco's $1,156,733 appraised value), producing an

estimated value for SWMG's intangible assets of $2,515,255.    Mr.

Dutcher further opined that SWMG's intangible value represented a

"bundle" of intangible assets, including "assembled workforce,

patient records, provider contracts, trademarks and tradename,

and practice goodwill".25

     For purpose of allocating the $2,515,255 value for SWMG's

intangible assets to the 29 SWMG physicians, Mr. Dutcher simply

adopted the same formula devised by Dr. Levin.   The Dutcher

appraisal offered no analysis of the appropriateness of Dr.

Levin's formula.

     The business enterprise value of SWMG as estimated in the

Houlihan and Dutcher appraisals differed by only 2 percent


     24
       In Mr. Dutcher's view, substituting an amount for
"implied working capital", based on industry standards, instead
of measuring actual current assets and liabilities, provided a
more accurate measure of the business enterprise value of a going
concern, since the level of current assets and liabilities
fluctuates greatly.
     25
       In Mr. Dutcher's view, the goodwill of a medical or other
professional practice consists of "practice goodwill", which is
associated with the entity, and "professional goodwill", which is
associated with the individual. According to Mr. Dutcher, the
practice goodwill of a medical practice generally consists of
such items of value as patient records, provider contracts,
assembled workforce, trademarks and tradenames, and going concern
value. Professional goodwill, in his view, "results from the
charisma, knowledge, skill, and reputation of a specific
practitioner", is not transferable, and has no economic value.
                              - 36 -

($4,000,000 and $4,088,450, respectively).   However, the

aggregate value of SWMG's intangible assets estimated by the

Dutcher appraisal ($2,515,255) differed markedly from the amount

postulated by Dr. Levin through the use of his formula

($1,632,377).   Since the Dutcher appraisal and Dr. Levin's

formula both started with substantially the same figure for

SWMG's business enterprise value, and both subtracted an

identical figure for fixed assets ($1,156,733), the marked

difference in their outcomes is attributable to the fact that Dr.

Levin believed that the SWMG physicians' accounts receivable

($1,210,890 as of November 1, 1994) also needed to be subtracted

(and that no adjustment needed to be made for working capital),

whereas the Dutcher appraisal postulated that all current assets

and liabilities (i.e., including accounts receivable) were best

accounted for by subtracting an amount for implied working

capital, which was estimated as $416,462.    The difference between

the Dutcher appraisal's working capital figure and Dr. Levin's

accounts receivable figure, when added to the approximately 2-

percent difference in the Dutcher and Houlihan estimates of

SWMG's business enterprise value, accounts for the discrepancy in

the estimates of SWMG's aggregate intangible value by Dr. Levin

and the Dutcher appraisal.

     In his appraisal, Mr. Dutcher also asserted that "it is my

opinion the physician compensation offered SWMG shareholders by
                                - 37 -

Sutter had no market value beyond the value of their professional

medical services".     The Dutcher appraisal contains no further

discussion or analysis purporting to support this proposition.

The Dutcher appraisal does, however, contain a "Physician

Compensation Survey", which sets forth the national median ratios

(for the "Western Region") of physician compensation to net

revenues for listed medical specialties.     Using a weighted

average of those published ratios, the Dutcher appraisal's

Physician Compensation Survey shows that the weighted average of

the national median ratios of "compensation to revenue" for the

specialties mix of the SWMG physicians was 45.18 percent.       As

previously noted, the PSA entered into between SWMG and SMF

provided for compensation to SWMG equal to 57.75 percent of fee-

for-service revenue, 47 to 53 percent of capitation revenue, and

at least 55 percent of risk pool revenue.

VII.    Issues Related to Specific Petitioners

        A.   The Kennedys

       On Schedule C of the Kennedys' 1994 return, they reported

$195,709 of gross receipts from Dr. Kennedy's medical practice.

The notice of deficiency issued to the Kennedys increased

reported Schedule C gross receipts by $3,760 to $199,469.

        B.   The Derbys

       On Schedule E, Supplemental Income and Loss, Part II, Income

or Loss From Partnerships and S Corporations, of the Derbys' 1994
                               - 38 -

return, they reported $4,209 of nonpassive income from Schedule

K-1, Shareholder's Share of Income, Credits, Deductions, etc.,

attached to the 1994 Form 1120S, U.S. Income Tax Return for an S

Corporation, filed by Dr. Derby's wholly owned professional

corporation, Charles A. Derby, M.D., Inc.    The referenced

Schedule K-1 states that Dr. Derby's share of his S corporation's

1994 ordinary income from business activities was $7,874.     The

notice of deficiency issued to the Derbys increased their 1994

income by $3,665, the difference between the foregoing figures on

the Schedules K-1 and E.

                               OPINION

I.   Petitioners' Entitlement to Charitable Contribution
     Deductions for Their Transfers of Intangible Assets to SMF

     A.   Transfer Without Adequate Consideration

      Petitioners contend that as part of the transfer of their

medical practices to SMF they each made a charitable contribution

to that entity of the intangible assets of the practices.

Respondent determined that the deductions petitioners claimed on

account of the charitable contributions are not allowable, and we

must decide the extent, if any, to which they may be deducted.

Petitioners bear the burden of proving their entitlement to those

deductions.    See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial
                                - 39 -

Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); see also Rule

142(a)(1).26

     Section 170(a) generally allows a taxpayer a deduction for

any charitable contribution, as defined in section 170(c), made

during the taxable year.    Section 170(c) defines the term

"charitable contribution" as "a contribution or gift" to or for

the use of certain specified organizations.    Respondent has not

disputed that SMF was a qualified recipient of a charitable

contribution as required by section 170(c).

     If a charitable contribution is made in property other than

money, the amount of the contribution is generally the fair

market value of the property at the time of the contribution.

Sec. 1.170A-1(c)(1), Income Tax Regs.    "[F]air market value" for

this purpose "is the price at which the property would change

hands between a willing buyer and a willing seller, neither being

under any compulsion to buy or sell and both having reasonable

knowledge of relevant facts."    Sec. 1.170A-1(c)(2), Income Tax

Regs.     A charitable contribution is allowable as a deduction only

if verified under regulations prescribed by the Secretary, sec.

170(a)(1), including certain substantiation requirements provided

in section 1.170A-13(c)(2), Income Tax Regs.    In addition, no

deduction for any contribution in excess of $250 is allowed



     26
       Petitioners concede that sec. 7491(a) does not apply in
this proceeding.
                              - 40 -

unless the taxpayer substantiates it by a contemporaneous written

acknowledgment by the donee organization.   Sec. 170(f)(8).

     The question of what constitutes a "contribution or gift"

for purposes of section 170 has been the subject of considerable

caselaw.   Some 5 years before the transaction at issue in this

case, the Supreme Court provided the following guidance:

          The legislative history of the "contribution or
     gift" limitation [of section 170], though sparse,
     reveals that Congress intended to differentiate between
     unrequited payments to qualified recipients and
     payments made to such recipients in return for goods or
     services. Only the former were deemed deductible. The
     House and Senate Reports on the 1954 tax bill, for
     example, both define "gifts" as payments "made with no
     expectation of a financial return commensurate with the
     amount of the gift." * * * Using payments to hospitals
     as an example, both Reports state that the gift
     characterization should not apply to "a payment by an
     individual to a hospital in consideration of a binding
     obligation to provide medical treatment for the
     individual's employees. It would apply only if there
     were no expectation of any quid pro quo from the
     hospital." * * * [Hernandez v. Commissioner, 490 U.S.
     680, 690 (1989); citations omitted.]

Thus, "A payment of money [or transfer of property] generally

cannot constitute a charitable contribution if the contributor

expects a substantial benefit in return."   United States v. Am.

Bar Endowment, 477 U.S. 105, 116 (1986); see also Transamerica

Corp. v. United States, 902 F.2d 1540, 1543 (Fed. Cir. 1990);

Singer Co. v. United States, 196 Ct. Cl. 90, 449 F.2d 413 (1971)

(sewing machine manufacturer not entitled to charitable

contribution deduction for sale of sewing machines to public

schools at discount, given the expectation that students' use
                              - 41 -

would result in future increases in sales); Murphy v.

Commissioner, 54 T.C. 249, 254 (1970) (no charitable contribution

deduction for payment to effect adoption of child).

     The Supreme Court has further instructed that in

ascertaining whether a given payment or property transfer was

made with the expectation of any return benefit or quid pro quo,

we are to examine the external, structural features of the

transaction, which obviates the need for imprecise inquiries into

the motivations of individual taxpayers.   Hernandez v.

Commissioner, supra at 690-691.   In Hernandez, where the Supreme

Court found a lack of donative intent in the taxpayers' payments

to the Church of Scientology for certain "auditing" and training

sessions, the external features cited by the Court included the

church's establishment of fixed price schedules for the sessions,

calibrated to length and level of sophistication; the provision

of refunds if session services went unperformed; and the

categorical prohibition on providing the sessions for free.

These external features revealed the "inherently reciprocal

nature of the exchange" involving the payments and the services

provided by the church.   A taxpayer who receives or expects to

receive a benefit in return for a purported contribution may

nonetheless be allowed a deduction if the money or property

transferred clearly exceeds the benefit received and the excess

is given with the intent to make a gift.
                               - 42 -

     Where the size of the payment is clearly out of
     proportion to the benefit received, it would not serve
     the purposes of §170 to deny a deduction altogether. A
     taxpayer may therefore claim a deduction for the
     difference between a payment to a charitable
     organization and the market value of the benefit
     received in return, on the theory that the payment has
     the "dual character" of a purchase and a contribution.
     See, e.g., Rev. Rul. 67-246, 1967-2 Cum. Bull. 104
     (price of ticket to charity ball deductible to extent it
     exceeds market value of admission) * * * . [United
     States v. Am. Bar Endowment, supra at 117.]

A taxpayer claiming a charitable contribution deduction under the

"dual character" theory, however, "must at a minimum demonstrate

that he purposely contributed money or property in excess of the

value of any benefit he received in return."   Id. at 118; see also

Sklar v. Commissioner, 282 F.3d 610, 621-622 (9th Cir. 2002),

affg. T.C. Memo. 2000-118.

     Petitioners argue that they transferred their medical

practices to SMF, a section 501(c)(3) organization, in a

transaction in which they agreed to accept a cash payment equal to

the value of the tangible assets of their respective practices and

no consideration for the intangible assets, because a payment for

goodwill would have violated Federal law.   Because they received

no consideration for the intangible assets, they made a

contribution thereof with the requisite donative intent,

petitioners contend.   In petitioners' view, the value of that

contribution is equal to each petitioner's allocable share of the

fair market value of the intangible assets of the medical group,

SWMG, formed when the transfers were made (as estimated by expert
                               - 43 -

appraisal).   The allocation to each petitioner of a share of the

value of the intangible assets of the newly-formed medical group,

though performed by a nonexpert (Dr. Levin, one of petitioners),

was reasonable, petitioners argue, and was ratified by expert

opinion.   In addition, petitioners argue, the Commissioner

indicated in a determination letter and in certain training

manuals that a charitable contribution deduction was available in

similar circumstances for the transfer of medical practice

intangible assets in connection with the acquisition of a group

medical practice by a section 501(c)(3) organization.

Consequently, petitioners contend, respondent has a duty of

consistency with the foregoing in his litigating position in this

case.

     Respondent disputes all of petitioners' arguments.

Respondent contends that petitioners have failed to show that the

value of the assets they transferred to SMF, including any

intangible assets of their medical practices, exceeded the values

of the consideration each received in exchange therefor.

Consequently, respondent argues, petitioners have failed to

satisfy the test outlined in United States v. Am. Bar Endowment,

supra.   Respondent further argues, relying on United States v. Am.

Bar Endowment, supra, and Hernandez v. Commissioner, supra, that

petitioners lacked donative intent in light of the substantial

benefits that they expected to, and did in fact, receive in return
                                - 44 -

for the transfers of their medical practice intangibles.

Respondent also takes issue with numerous aspects of the valuation

of the intangible assets purportedly transferred by petitioners to

SMF.    Finally, respondent argues that petitioners have failed to

satisfy the substantiation requirements of section 1.170A-13,

Income Tax Regs., and section 170(f)(8).

       We agree that petitioners have failed to satisfy the

requirements for a charitable contribution deduction.    While

petitioners seek to characterize the transaction between

themselves and SMF as the sale of the tangible assets of their

medical practices for cash equal to their value, coupled with the

transfer of their medical practice intangibles to SMF for no

consideration, that characterization ignores a significant

additional element of consideration they received; namely, future

employment with SMF on carefully delineated terms.    The agreements

securing the terms of petitioners' future employment (i.e., the

PSA between SWMG and SMF, and the PEAs between SWMG and each SWMG

physician) were integral to and legally interdependent with the

agreements under which petitioners transferred their medical

practice assets to SMF (i.e, the APAs).    Each of the foregoing

agreements was contingent upon the other.    Thus, the transfer of

petitioners' intangible assets to SMF was part of an integrated

transaction in which petitioners also agreed to provide future

services (through SWMG) and transfer tangible assets to SMF in
                                - 45 -

exchange for SMF's agreement to pay them cash and to employ them

(through SWMG27) pursuant to specified terms.

      The transaction had an "inherently reciprocal nature".

Hernandez v. Commissioner, 490 U.S. at 692.     The record

demonstrates that Sutter Health clearly wanted the SWMG

physicians' intangible assets, a significant portion of which

consisted in their patient roster and the expectation of continued

patronage from those patients.28   Sutter was engaged in a strategy

of expansion into the Davis area by means of acquiring existing

medical practices to become part of an integrated delivery system

with its hospitals.   Sutter also had a nearly completed hospital

in Davis for which it needed to ensure an adequate patient base.

Another portion of petitioners' goodwill, their established

reputation as efficient, cost-effective practitioners, increased

their desirability to Sutter.   The negotiations over the terms of

the acquisition transactions were protracted and sometimes


     27
       Under the integrated and legally interdependent
agreements, petitioners were obligated to form SWMG and to enter
into contracts to provide their medical services exclusively to
SWMG under stated terms, and SMF was obligated to contract with
SWMG for the medical services provided by petitioners and the
other SWMG physicians. The obligation of SMF to purchase, and
petitioners' obligation to sell, the tangible and intangible
assets of their medical practices was contingent on the
foregoing.
     28
       We note that the PSA provided that once the transaction
was consummated, all patients treated by the SWMG physicians were
deemed to be the patients of SMF (subject to the physicians'
rights to reclaim patients under the "free to compete"
provision). In addition, the APA obligated the SWMG physicians
to use their best efforts to retain existing patients.
                               - 46 -

acrimonious, according to the testimony of participants.   It is

clear from this testimony that the SWMG physicians negotiated

aggressively for the best terms they could get.   The intensity of

the negotiations is reflected in the written agreements, which

were amended late in the discussions to increase the percentages

of net revenue that were to be paid to the SWMG physicians for

given categories of revenue.   Significantly, an official of SMF

who participated in the negotiations testified that SMF not only

"could not" pay anything for the SWMG physicians' intangibles but

"would not", explaining that SMF's refusal to pay any cash for the

intangibles was based both on the possible legal proscriptions and

on SMF's unwillingness to pay anything for the intangibles

because, according to SMF's financial projections, to do so would

render the transaction financially infeasible for SMF.   In sum,

the SWMG physicians extracted from SMF all that SMF believed it

could provide if the affiliation with the physicians were to

remain economically viable.

     The consideration received in the transaction by petitioners

and the other SWMG physicians included:   (1) Employment, with

compensation to their medical group set at a minimum of 47 to

57.75 percent of net revenues with a guaranteed floor, (2) a

$35,000 "Physician Access Bonus" for each physician, (3) rights to

participate in the management of SMF; (4) greater professional

autonomy than was perceived to be available from other potential
                               - 47 -

acquirers of their medical practices; and (5) rather than a

noncompete agreement, the "free to compete" provision, which

secured for each petitioner the express right, upon his or her

termination of employment with SWMG/SMF, to have his or her

patients as of the date of affiliation with SMF notified of the

departure and given the option of having the patient's medical

records transferred to the departing physician.   In addition, when

petitioners' circumstances before the transaction are considered,

a second tier of benefits they secured in the transaction with SMF

becomes apparent.   First, petitioners solved their core economic

problem arising from the advent of managed care; namely, the risk

of loss from having patients requiring extraordinary care.    After

the transaction, by virtue of the minimum compensation guaranties,

this risk was largely transferred to SMF, which could better

manage it given SMF's greater patient population and resources.

Second, as a result of their affiliation with a relatively large

health care organization, petitioners secured the benefits of

greater leverage in negotiating contracts with HMO's and greater

efficiencies in providing care, with any resulting enhancement in

revenues inuring to their benefit by virtue of SWMG's compensation

being determined as a percentage of net revenues.   In sum, by

transferring their practices to SMF in the transaction at issue,

petitioners ensured for themselves the continued ability to

maintain or improve their accustomed level of earnings from the
                                - 48 -

practice of medicine-– something they had concluded was not likely

to be possible had they continued to maintain solo or small group

practices.

       The linchpin of petitioners' claim of entitlement to a

charitable contribution deduction is their argument that none of

the foregoing consideration was received in exchange for the

intangible assets of their medical practices, which consisted

essentially of goodwill or going concern value.    Petitioners

contend that they received no consideration for their goodwill

from SMF because any payment for goodwill by SMF was proscribed by

law.    Clearly none of the consideration from SMF was denominated

as a direct payment for the intangible assets of petitioners'

medical practices.    However, given the integrated nature of the

transaction, Sutter Health's desire to obtain petitioners' patient

roster and other goodwill, and the intensity of the negotiations,

we are persuaded that petitioners' intangible assets functioned as

leverage in the negotiations and that their transfer to SMF

resulted in an increase in the total consideration petitioners

received in the transaction.    Thus, the claim that petitioners

received no consideration for their intangible assets is

contradicted by the substantive evidence.29

       29
       We are aware that the parties to the transaction went to
some lengths in the APAs to memorialize that each SWMG physician
as seller and SMF as buyer "believed" that the purchase price for
the medical practice assets was less than their fair market value
and that the seller was therefore donating to the buyer the
                                                    (continued...)
                               - 49 -

     Since petitioners received consideration for their

intangibles, their charitable contribution deductions fail unless

they can show, pursuant to the theory approved in United States v.

Am. Bar Endowment, 477 U.S. 105 (1986), that the transfer of their

intangibles to SMF had a "dual character" as both a transfer for

consideration30 and a contribution.     To do so, however, petitioners

"must at a minimum demonstrate that * * * [they] purposely

contributed money or property in excess of the value of any

benefit * * * [they] received in return."     Id. at 118; see also

Sklar v. Commissioner, 282 F.3d at 620-622.

     Petitioners have not shown that the value of what they

transferred to SMF exceeded the value of the benefits they

received in return.   As noted above, those benefits included, in

     29
      (...continued)
excess of fair market value over the (purported) purchase price.
In our view, this provision is a self-serving attempt to support
the claim for a charitable deduction contribution. As discussed
hereinafter, the SWMG physicians received many other kinds of
consideration in connection with the integrated transaction. The
effort in the APAs to allocate any consideration away from the
intangible assets was self-serving for the SWMG physicians and a
matter of indifference for SMF. Notably, notwithstanding the
APAs' characterization of a contribution of intangible assets,
SMF did not report the receipt of any such contributions on its
Form 990 for 1994.
     30
       United States v. Am. Bar Endowment, 477 U.S. 105 (1986),
and the revenue ruling therein approved by the Supreme Court
(Rev. Rul. 67-246, 1967-2 C.B. 104) both involved transfers of
cash for goods or services that purportedly had dual characters
as purchases and contributions. The same principle applies,
however, to a transfer of property for consideration, see, e.g.,
Transamerica Corp. v. United States, 902 F.2d 1540, 1543-1546
(Fed. Cir. 1990), such as the transfer of the assets of
petitioners' medical practices at issue.
                              - 50 -

the first instance, employment that was compensated with shares of

revenue (47 to 57.75 percent) that significantly exceeded the

median share of revenue (45.18 percent) devoted to physician

compensation in petitioners' specialties; a $35,000 "Physician

Access Bonus" for each SWMG physician, including petitioners;31 an

absence of restrictions on establishing a competing medical

practice in the event of cessation of employment with SMF; and

greater economic security in the managed care environment.    Other

     31
       Petitioners strenuously argue that the "Physician Access
Bonuses" were consideration for the SWMG physicians' agreement to
maintain "open" practices; i.e., to accept new patients
notwithstanding existing patient loads. Accordingly, petitioners
contend, the "Physician Access Bonuses" could not have served as
consideration for the SWMG physicians' transfer of their medical
practice intangibles.
     Petitioners' argument is unpersuasive. As with petitioners'
broader claim that no consideration was paid for their intangible
assets, the argument depends upon segregating elements of
consideration that were part of an integrated, and intensely
negotiated, agreement. The extensive and otherwise detailed
written agreements governing the transaction with SMF do not
mention any open practice requirement. Even if the transaction
documents had expressly allocated the $35,000 bonuses to the
physicians' agreements to maintain open practices, we would
remain unpersuaded, because there is no evidence in the record
that a $35,000 payment was customary for a physician-employee's
agreement to maintain an open practice. In fact, one SMF
official who testified conceded that no such bonuses had been
paid to other physician groups that affiliated with SMF, and the
Dutcher appraisal does not address the bonuses. Tellingly, when
the PSA was renegotiated to cover the period after its initial 2-
year term, there was no comparable provision for "Physician
Access Bonuses" to secure the SWMG physicians' open practice
commitments. After respondent noted this apparent inconsistency
on brief, petitioners offered no explanation to account for it.
Consequently, we find that the $35,000 "Physician Access Bonuses"
are not fully allocable to open practice agreements and instead
were part of the consideration package received by the SWMG
physicians in exchange for the transfer of their medical
practices.
                               - 51 -

benefits received included greater professional autonomy than was

perceived to be available from competing acquirers and a role in

management.

     Petitioners rely on the Dutcher appraisal to establish that

they contributed property worth more that any benefits received in

return.32   Petitioners' position is that they transferred property

with a value in excess of what they received back from SMF because

the Dutcher appraisal estimated the value of their intangible

assets at $2,515,255,33 whereas they received back from SMF only a

$1,156,733 payment in the aggregate.    There are a number of

problems in the Dutcher appraisal's estimate of the fair market

value of SWMG's intangible assets and each petitioner's allocable

share thereof.34   However, even if it is assumed for argument's sake

     32
       Although petitioners used the Houlihan appraisal, coupled
with Dr. Levin's allocation formula, for purposes of claiming on
their returns the deductions at issue, they abandoned the
Houlihan appraisal for purposes of trial and rely instead on the
Dutcher appraisal, prepared for them after respondent commenced
examinations of the returns.
     33
       The Dutcher appraisal treats as the value of each
petitioner's intangible assets an allocable share of the value of
the intangible assets of SWMG, a medical group petitioners formed
simultaneously with the consummation of the transaction with SMF,
as required by the terms of the transaction. Respondent argues
that because SWMG did not exist before the transaction,
petitioners could not have transferred any portion of SWMG's
intangible value to SMF as part of the transaction. We find it
unnecessary to resolve this issue for purposes of deciding
whether petitioners are entitled to the charitable contribution
deductions claimed.
     34
       Some of the more salient problems with the Dutcher
appraisal include:
                                                    (continued...)
                              - 52 -


     34
          (...continued)

     (1) There is no allocation of any value to the professional
goodwill of the SWMG physicians. Mr. Dutcher distinguishes, in
the case of the goodwill of a professional practice, between
"practice" goodwill and "professional" goodwill, the former
attributable to characteristics of the practice entity such as
patient records, provider contracts, and workforce in place; and
the latter attributable to the personal attributes of the
individual practitioner, such as charisma, skill, and reputation.
Mr. Dutcher further acknowledges that professional goodwill is
not transferable. The intangible asset value attributed by Mr.
Dutcher to SWMG was derived to a substantial degree from the
discounted present value of the distributable earnings stream
that would be generated by the SWMG physicians in the 5 years
after the affiliation with SMF. (That is, Mr. Dutcher treated
the value of SWMG's intangible assets as equal to the present
value of its future distributable earnings, less implied working
capital and tangible assets.) Yet those distributable earnings
were undoubtedly generated in part by patients who continued to
see a physician because of that physician's charisma, skill,
and/or reputation--his or her professional goodwill. Several
petitioners testified that they understood the goodwill that they
transferred to SMF to consist of the foregoing elements. We
believe that some portion of the earnings from which Mr. Dutcher
derived his intangible value estimate were generated as a result
of professional goodwill. However, Mr. Dutcher made no
adjustment to his intangible value estimate to account for any
portion attributable to the professional goodwill that he
concedes is nontransferable. To that extent, his estimate of
value of the intangible assets transferred by the SWMG physicians
to SMF is inflated and unreliable.

     (2) There is no adjustment for the fact that the SWMG
physicians were not required to execute noncompete agreements.
Mr. Dutcher treated each SWMG physician as transferring an
allocable share of SWMG's intangibles, including goodwill, which
was not treated as diminished in any way by the physicians' not
having executed noncompete agreements with respect to SWMG or
SMF. However, in Norwalk v. Commissioner, T.C. Memo. 1998-279,
we found that there is no transferable or salable goodwill where
a company's business depends on its employees' personal
relationships with clients and the employees have not provided
covenants not to compete. We acknowledged, distinguishing
Schilbach v. Commissioner, T.C. Memo. 1991-556, that some of the
goodwill of a medical practice is inherent in the operating
                                                    (continued...)
                               - 53 -

that each petitioner transferred intangible assets with some value

to SMF, petitioners would still have failed to show that the value

of what they transferred exceeded the value of what they received

in return.   As previously outlined, the consideration petitioners


     34
      (...continued)
entity. Norwalk v. Commissioner, supra. We also believe that,
under the willing buyer/willing seller standard of fair market
value enunciated in Rev. Proc. 59-60, 1959-1 C.B. 237, to which
Mr. Dutcher purportedly adhered, a willing buyer of SWMG on the
transaction date would have insisted on a significant discount
with respect to the value of the entity's intangible assets,
precisely on account of the absence of noncompete agreements from
the SWMG physicians. Indeed, the SWMG physicians not only did
not execute noncompete agreements; they had the benefit of the
"free to compete" provision in the PSA which facilitated their
reclaiming their patients in the event they decided to cease
working for SWMG/SMF. Mr. Dutcher's failure to account for the
risk to his estimated 5-year stream of earnings posed by SWMG
physicians' departing with their patients is contrary to well-
established valuation principles and common sense, and results in
an inflated value for the SWMG physicians' goodwill.

     (3) The Dutcher appraisal adopts the formula devised by Dr.
Levin, a nonexpert, for allocating the purported value of SWMG's
intangible assets among the SWMG physicians, without providing
any reasons or analysis to support or justify that choice. See
Mid-State Fertilizer Co. v. Exch. Natl. Bank, 877 F.2d 1333, 1340
(7th Cir. 1989); Estate of Jann v. Commissioner, T.C. Memo. 1990-
333. To the extent petitioners may not be relying on the Dutcher
appraisal to support the allocation formula used, the allocation
underlying the claimed charitable contribution deductions is not
the product of expert appraisal and should be rejected on that
account.

     (4) The Dutcher appraisal takes no account of the $35,000
"Physician Access Bonus" payable to each SWMG physician over the
initial 2 years of the affiliation. Ignoring these payments when
computing distributable earnings that SWMG would generate results
in a overstatement of those earnings and a corresponding
overstatement of the value of SWMG's intangible assets (since,
under Mr. Dutcher's analysis, intangible asset value equals
present value of future distributable earnings, less tangible
assets and implied working capital).
                               - 54 -

received was not confined to the cash payment for their tangible

assets.   They in addition received a package of valuable benefits

(above-median compensation, $35,000 "Physician Access Bonuses",

working conditions they preferred, etc.) that were not merely

incidental or akin to the benefits that inure to the general

public as a result of a charitable transfer.   See, e.g., Ottawa

Silica Co. v. United States, 699 F.2d 1124 (Fed. Cir. 1983);

Singer Co. v. United States, 196 Ct. Cl. 90, 449 F.2d 413 (1971).

Concededly, some elements of the consideration petitioners

received may have been difficult to quantify, but this does not

mean these benefits can be disregarded in determining whether a

quid pro quo existed that defeats donative intent.   See, e.g.,

Transamerica Corp. v. United States, 902 F.2d 1540 (Fed. Cir.

1990) (donor-taxpayer's receipt back from donee of commercial

access rights to donated motion picture film negatives defeats

charitable deduction for value of negatives transferred); Singer

Co. v. United States, supra (benefit of possible increase in

future customers defeats charitable deduction for the value of

discounts given to public schools purchasing taxpayer's sewing

machines).

     Petitioners argue that any consideration they purportedly

received in the transaction representing the "value of their post-

contribution employment relationship" with SMF must be disregarded

because "that value is already taken into consideration in the
                                - 55 -

valuation process."   In petitioners' view, because the Dutcher

appraisal computed the value of petitioners' intangible assets as

being essentially the discounted present value of SWMG's "future

distributable earnings" (less the value of tangible assets and an

amount for implied working capital), and those future earnings

were net of physician compensation expense and all other

operational expenses, the amount claimed as a contribution for

intangible assets should not be offset by physician salaries or

any other benefit petitioners received in connection with their

providing services to SMF.   The "value of the physicians' future

salaries is already netted out of the value of the contribution",

petitioners argue.

     We disagree.    First, we do not believe the Dutcher appraisal

fully accounts for petitioners' compensation from SMF.   Presumably

because SWMG was newly formed and there existed no historical data

on its physician compensation expense, Mr. Dutcher assumed when

computing future distributable earnings that SWMG's physician

compensation expense (computed as a percentage of revenue) would

be equal to the median physician compensation expense for the

medical specialties comprising SWMG, or 45.18 percent of revenue.

In fact, SMF agreed to pay compensation to the SWMG physicians of

at least 47 to 55.75 percent of revenue.   Moreover, because Mr.

Dutcher treated SWMG's physician compensation expense as equal to

the 45.18 percent median, his computation of physician
                              - 56 -

compensation expense takes no account whatsoever of the $35,000

"Physician Access Bonus" that each SWMG physician received.    More

fundamentally, the Dutcher appraisal takes no account of the

various contractual rights and other intangible benefits that

petitioners and the other SWMG physicians sought and obtained in

the transaction with SMF, such as avoiding signing noncompete

agreements and obtaining preferred working conditions.   Because it

does not fully account for the benefits that petitioners received

in the transaction with SMF, the Dutcher appraisal does not

establish that petitioners contributed property to SMF that

exceeded the values of the benefits they received in return.35

     The quid pro quo nature of the transfer of petitioners'

medical practices (including both the tangible and intangible

assets) in exchange for the package of cash and contractual rights

     35
       Undoubtedly, some portion of the compensation and
benefits provided to the SWMG physicians in connection with their
posttransaction employment (through SWMG) with SMF is
attributable to the posttransaction services performed. However,
petitioners have not demonstrated what portion is attributable to
the services they provided, such as by showing what the fair
market values of those services were. The fair market values of
the services petitioners provided to SMF might be shown, for
example, by a comparison to the compensation paid to similarly
experienced physician-employees of an integrated delivery system
health care provider where the physician-employees had not
transferred existing medical practices to the employer. Whether
such an arrangement would have exhibited compensation comparable
to petitioners' in terms of salaries, initial $35,000 bonuses, no
requirements to execute noncompete agreements, etc. is a matter
of speculation on this record. Although Mr. Dutcher stated in
his appraisal that "it is my opinion the physician compensation
offered SWMG shareholders by Sutter had no market value beyond
the value of their professional medical services", there is no
data or analysis to support this conclusion.
                               - 57 -

that they received from SMF is also demonstrated by petitioners'

rejection of the proposed transaction with Foundation (wherein

they would have sold their practices to, and entered into an

agreement to provide future services for, Foundation).

Petitioners make much of the fact that Foundation, as a for-profit

entity, was willing to pay substantial sums for petitioners'

intangible assets because it was not constrained by the Federal

proscriptions on such payments applicable to nonprofit, tax-exempt

entities.   But when petitioners were offered the opportunity to

affiliate with Foundation (and receive an outright cash payment

for their intangibles), they collectively rejected the prospect in

favor of an acquirer that offered them working conditions they

preferred, greater economic security through multiple sources of

payment, a "free to compete" provision whereby any of them could

essentially "unwind" the transaction and retrieve his or her

patients if he or she desired to terminate the relationship with

the acquirer, a role in management, and other intangible benefits

that were negotiated between the SWMG physicians and SMF.    Viewed

in this light, it is apparent that the intangible benefits that

petitioners received in the transaction with SMF were of

substantial value to them.   Petitioners spurned a cash payment for

their medical practice intangibles in order to obtain these

benefits in a different transaction.    On this record, petitioners

have not shown that the value of what they received in the
                               - 58 -

transaction with SMF was less than the value of what they

transferred.   Thus they have not shown that the transfers of the

intangible assets of their medical practices were without adequate

consideration.   "The sine qua non of a charitable contribution is

a transfer of money or property without adequate consideration."

United States v. Am. Bar Endowment, 477 U.S. at 118; see also

Transamerica Corp. v. United States, 902 F.2d at 1545-1546.36

     B.   Respondent's Duty of Consistency

     Petitioners also argue that the Commissioner has previously

taken the position in rulings and other guidance covering similar

transfers of group medical practice assets to nonprofit health

care organizations that charitable contribution deductions for the

transferors are appropriate and that respondent is therefore bound

to follow that position in this case.   Petitioners cite the

Friendly Hills determination letter and several of the

Commissioner's annual Exempt Organizations Continuing Professional

Education Technical Instruction Program manuals (instruction

manuals) wherein the Commissioner indicated that a section

501(c)(3) organization could acquire the assets of a group medical

practice through purchase or through a charitable donation by the

group's physicians without jeopardizing the acquiring


     36
       Because we conclude that petitioners have failed to
demonstrate that they transferred property worth more than what
they received in return, we do not decide whether the claimed
deductions should be denied because petitioners failed to comply
with the requirements of sec. 1.170A-13, Income Tax Regs., and
sec. 170(f)(8).
                                - 59 -

organization's tax-exempt status.    Since in the foregoing

materials the Commissioner specifically contemplated a charitable

contribution under section 170 and did not put it into issue or

otherwise treat the matter as problematic, petitioners argue that

the Commissioner has thereby indicated that donative intent in

such transactions is presumed or is not a significant issue.

Thus, petitioners conclude, by challenging petitioners' donative

intent in a virtually identical transaction, respondent has

violated his duty of consistency between his rulings and

litigation position, contrary to our holding in Rauenhorst v.

Commissioner, 119 T.C. 157 (2002).

     Respondent argues that:   (1) The transaction considered in

the Friendly Hills determination letter is materially

distinguishable from the transaction in this case, (2) neither

that letter nor the instruction manuals address the section 170

deduction issue, and (3) in any event, neither may be cited as

precedent.    Therefore, respondent considers Rauenhorst to be

inapposite.

     We agree with respondent that, under Rauenhorst, neither the

Friendly Hills determination letter nor the instruction manuals

limit the position respondent may take in these cases.

     The Friendly Hills determination letter did concern the

acquisition of the assets (including "intangible assets") of a

physicians' medical group by a nonprofit medical foundation in
                                 - 60 -

which it was represented that the foundation would pay $110

million and the transferring physicians would "make charitable

donations in an aggregate amount, and deduct from their income

taxes proportionate amounts of that aggregate, which, when

combined with the [$110 million] cash purchase price, will not

total more than $125 million."    However, the issue addressed in

the determination letter was the tax-exempt status of the

acquiring foundation (which was granted).   The determination

letter thus had no occasion to consider the issue of donative

intent (much less rule on deductibility), observing only that

"Donors may deduct contributions to you as provided in section 170

of the Code."    Respondent also argues, and we agree, that there

are significant distinctions between the facts as represented in

the Friendly Hills determination letter and petitioners'

circumstances.   In the Friendly Hills transaction, unlike the

cases at issue, the transferring physicians had executed

noncompete agreements, there were no signing bonuses (i.e.,

"Physician Access Bonuses"), and the donations represented

approximately 12 percent of the transfer ($15 million/$125

million), whereas petitioners claim that approximately 61.5

percent of the "business enterprise value" of SWMG was given away

($2,515,255 intangibles/$4,088,450 "business enterprise value"37).


     37
       The figures above are taken from the Dutcher appraisal's
estimate of the intangible assets purportedly contributed by the
SWMG physicians, on which petitioners currently rely. On the
                                                    (continued...)
                                - 61 -

Most importantly, the Friendly Hills determination letter, as

petitioners concede on brief, pursuant to section 6110(j)(3)38 "may

not be used or cited as precedent."

     Similarly, although the instruction manuals generally

describe methods by which an integrated delivery system may be

formed, including acquisition of medical group assets "by

donation, fair market value purchase, lease, license, stock

transfer or a combination thereof" (emphasis added), those

publications also focus on mergers of nonprofit hospitals or

medical foundations with physician groups from the standpoint of

the former entities' qualification for tax-exempt status under

section 501(c)(3).    Similar to the Friendly Hills determination

letter, the instruction manuals do not specifically address the

charitable contribution issue, which accounts for their failure to

emphasize the requirement of donative intent in connection with

any "donation" of assets by the physicians.        Moreover, the

introduction to each annual edition of the instruction manuals

contains the following statement:     "The text is for educational

purposes only.    It is not authority, and may not be cited as

such."


     37
      (...continued)
basis of the Houlihan appraisal used by petitioners for purposes
of filing their 1994 returns (but now abandoned by them), the
claimed donations would constitute approximately 41 percent of
the value of SWMG ($1,632,377 intangibles/$4 million business
enterprise value).
     38
          Currently codified as sec. 6110(k)(3).
                                    - 62 -

      In Rauenhorst v. Commissioner, supra at 183, we held that the

Commissioner may not take a litigating position contrary to his

own revenue rulings, which constitute public guidance.       Neither

the Friendly Hills determination letter nor the instruction

manuals are revenue rulings or are intended by the Commissioner to

constitute public guidance.       Therefore, even if they could be

viewed as supporting petitioners' claim that the Commissioner has

minimized the significance of donative intent in some transfers of

medical practice assets, since the cited materials are not revenue

rulings or similar public guidance they do not, under Rauenhurst,

constrain the position that respondent may take in these cases.

II.   Issues Involving Individual Petitioners

      A.     The Kennedys

             1.   Background

      Respondent bases his $3,760 increase in Dr. Kennedy's 1994

Schedule C gross receipts on three documents, all of which are

stipulated exhibits:        (1) The examining agent's summary of certain

bank deposits of Dr. Kennedy's, totaling $23,797.26, that is

described as a schedule of Dr. Kennedy's 1994 accounts receivable

after sale of practice (agent's report); (2) a letter from Dr.

Kennedy to his accountant dated February 27, 1994,39 (sic)

(letter), in which he advises his accountant:       "I have collected



      39
           Given its contents, the letter was necessarily drafted in
1995.
                                - 63 -

$23,037.00 for November and December and I have included that on

my business income for 1994"; and (3) Dr. Kennedy's profit and

loss statement for October, 1994 (P & L statement), which shows

total year-to-date patient fees, as of October 31, 1994, of

$176,002.44.    On the basis of these documents, respondent posits

that Dr. Kennedy's total reported 1994 gross receipts from patient

fees (earned before he became an employee of SWMG as of November

1, 1994) were understated by $3,760.     Therefore, they must be

increased from $195,709 as reported to $199,469 as determined

after examination.   The Kennedys offer no documentary rebuttal.

They merely state, on brief, that the adjustment is 9 years old,

the records are "impossible to trace", and it is "Dr. Kennedy's

recollection" that the $195,709 reported on his return "is the

accurate dollar amount that he received as gross sales for his

medical practice."

          2.    Discussion

     Although the stipulated exhibits (in particular, the letter)

generally support respondent's determination, his numbers do not

quite add up.    Whether the $176,002 representing Dr. Kennedy's

1994 gross receipts through October 31, 1994, is increased by

$23,797 (per the agent's report) or $23,037 (per the letter), the

result differs slightly from the total 1994 Schedule C gross

receipts of $199,469 respondent determined.     On cross-examination
                                - 64 -

by respondent's counsel, Dr. Kennedy testified as follows

regarding the contents of the letter and the P & L statement:

     Q      Would you look at Exhibit 629-J please? Do you
            recognize this?
     A      I think it's a letter I wrote to my accountant it
            looks like, at least the first of it.
     Q      Okay. And then there's a lengthy paragraph on the
            bottom of the page, which you know, as we get two-thirds
            of the way down it states, "I have collected 23,037 for
            November and December." Do you see that?
     A      Yes.
     Q      Okay. And then would you look at Exhibit 631-J
            please?
     A      Yes.
     Q      Which is your profit and loss statement through the
            end of October '94?
     A      Um-hmm.
     Q      So it says, "Income Patient Fees Year To Date $176,002.”
            That would have been what you collected through that
            point in time?
     A      (No audible response).
     Q      So then if we add the 176,000 to the 23,000, we get
            about 199,000. So that would have been your income for
            the year?
     A      I suppose.

     We accept the foregoing exchange as a concession by Dr.

Kennedy that his November and December 1994 collections totaled

at least $23,000 and a concession by respondent that Dr. Kennedy's

total 1994 Schedule C gross receipts totaled $199,000, not

$199,469, an increase of $3,291 over the $195,709 Dr. Kennedy

reported.   Therefore, we sustain respondent's proposed increase in

Dr. Kennedy's 1994 Schedule C income to the extent of $3,291.

     B.   The Derbys

          1.   Background
                                - 65 -

     There appears to be no dispute between the parties that there

is a $3,665 discrepancy between the amount reported as Schedule K-

1 nonpassive income from Dr. Derby's wholly owned professional (S)

corporation, Charles A. Derby, M.D., Inc. (the corporation), on

the Derbys' 1994 Schedule E ($4,209) and the amount of ordinary

income actually listed on the corporation's 1994 Schedule K-1

($7,874). During the trial, Dr. Derby testified as follows

regarding the discrepancy:

          At the close of the year, I had -- I was in the
     process of dissolving the "S" corporation, and one of
     the reconciliations that was necessary was there were a
     -- I had a petty cash drawer and in it there were
     receipts. And there was one principal receipt that was
     for the -- my computer that I had purchased earlier in
     the year. It was around 2,600 -- 2,700. And then
     around a thousand dollars of petty cash receipts that
     were money from my own personal pocket that had been
     utilized by the "S" corporation, and in dissolving the
     "S" corporation, I think that's where the discrepancy.
          Now, I tried to get in touch with my accountant,
     Mr. Kramer, to go over this with him, and I just wasn't
     able to do that, and I don't have specific receipts for
     this at this particular time, but that's my best
     recollection of the -- what the discrepancy was.


Dr. Derby further testified that the corporation reimbursed him

for the computer and the other items at the time of its

dissolution in late 1994.    Thus, it is Dr. Derby's position that

he, in effect, made a constructive loan to the corporation of the

amount in question by personally incurring expenses deemed to be

incurred by the corporation with the constructively borrowed funds

(which were reimbursed to Dr. Derby upon dissolution of the
                               - 66 -

corporation), and that the corporation's 1994 return mistakenly

overstated the corporation's net ordinary income by the amount of

those deductible expenses.   Respondent simply points to the

discrepancy between the two returns and argues that Dr. Derby

understated his 1994 ordinary income from the corporation by

$3,665.

          2.   Discussion

     The dispute between the Derbys and respondent raises three

issues:   (1) A factual issue as to whether Dr. Derby incurred the

expenses in question in 1994, (2) whether the expenses were

currently deductible business expenses under section 162(a), and

(3) assuming he did incur the expenses and that they were

currently deductible, whether they resulted in a constructive loan

and corporate purchase of the items in question or a capital

contribution of the purchased items by Dr. Derby to the

corporation.

     At trial, Dr. Derby admitted that he had no "specific

receipts" that would substantiate the alleged expenditures or

their deductibility and that his oral testimony constituted his

"best recollection of * * * what the discrepancy was."    Assuming

arguendo that the Derbys are not required to satisfy the

substantiation requirements of section 274(d) in support of the

alleged expenditures, they were nonetheless required to maintain

records sufficient to substantiate the claimed deductions, in this
                                 - 67 -

case, on behalf of the corporation.       See sec. 6001; sec. 1.6001-

1(a), Income Tax Regs.   Moreover, they have failed to provide even

the minimal substantiation that would permit us to estimate the

allowable deduction under Cohan v. Commissioner, 39 F.2d 540, 543-

544 (2d Cir. 1930).   Even under Cohan, there must be sufficient

evidence in the record to provide a basis upon which an estimate

may be made.   Vanicek v. Commissioner, 85 T.C. 731, 742-743

(1985).   Here, there is none.   By failing to provide any

substantiation that would corroborate Dr. Derby's somewhat

uncertain testimony, the Derbys have failed to sustain their

burden of proof under Rule 142(a) as to either the existence or

deductibility of the alleged expenditures.

     Moreover, assuming arguendo that Dr. Derby actually incurred

the alleged expenditures and that they were of a type that would

be currently deductible by the corporation, the evidence does not

establish whether Dr. Derby incurred them on behalf of the

corporation with an expectation of reimbursement or intended that

they constitute a capital contribution to the corporation.      Dr.

Derby's oral testimony is consistent with either approach.40      The

Derbys' failure to prove the existence of a constructive loan

provides an additional basis for respondent's $3,665 adjustment.


     40
       Although Dr. Derby testified that he was reimbursed by
the corporation when the corporation was dissolved, that
"reimbursement" distribution is consistent with either a debt
repayment or a final cash distribution in connection with the
dissolution.
                                - 68 -

             3.   Conclusion

       The Derbys understated Dr. Derby's 1994 income from the

corporation to the extent of $3,665.

III.    Penalties

        A.   Introduction

       The notices of deficiency issued to petitioners contain the

following explanation for respondent's denial of a charitable

contribution deduction for each petitioner's alleged contribution

of practice intangibles to SMF:

       The contribution claimed with respect to * * * [SMF] is
       not allowable because it has not been established that
       the fair market value of the assets sold exceeded the
       sales price received by you or that the intangible
       assets donated had any fair market value.

       Based upon petitioners' alleged failure to establish that

their intangible assets had any fair market value, respondent

alleges, in his answers to the petitions, that "petitioners are

liable for the accuracy related penalty under [section] 6662(a) in

the amount of 40 [percent] of the deficiency for a gross valuation

misstatement under * * * [section] 6662(h), or in the alternative

are liable for a penalty in the amount 20 [percent] of the

deficiency for a substantial valuation misstatement under * * *

section 6662(e)" (sometimes, the overvaluation penalty).    Because

respondent raises the penalty issue in his answers, the issue

constitutes a "new matter" under Rule 142(a), and the burden of

proof with respect to that issue is upon respondent.    See Rule
                               - 69 -

142(a); see also Am. Ideal Cleaning Co. v. Commissioner, 30 B.T.A.

529, 531 (1934); Burnett v. Commissioner, T.C. Memo. 2002-181,

affd. 67 Fed. Appx. 248 (5th Cir. 2003).

     Respondent argues, on the evidence in the record, that "the

allegedly donated goodwill had no value to SMF."   Therefore, the

values petitioners claimed as the bases for their section 170

deductions "were 400 percent or more of the correct value, zero."

Respondent further argues that petitioners may not rely upon the

"reasonable cause", "good faith" exception of section 6664(c)(1)

because:   (1) The valuation of their intangible assets transferred

to SMF was not "based on a qualified appraisal made by a qualified

appraiser" as required by section 6664(c)(2)(A), and (2)

petitioners failed to make "a good faith investigation of the

value of the contributed property" as required by section

6664(c)(2)(B).   See also sec. 1.6664-4(h), Income Tax Regs.41

Petitioners argue that the advice received from Mr. Grant and his

partners and, for several of petitioners, from their own

accountants furnished a "reasonable basis" for their charitable

contribution deductions and that the seeking of and reliance upon

that advice constituted a "good faith investigation of the value

of the contributed property" within the meaning of section

6664(c)(2)(B).



     41
       As applicable in 1994, the regulation was codified as
1.6664-4(e), Income Tax Regs.
                              - 70 -

     B.   Analysis

     On brief, respondent specifically acknowledges that, if we

deny petitioners' charitable contribution deductions for reasons

other than their overvaluation of the transferred intangibles,

"the penalty is not applicable", citing Gainer v. Commissioner,

893 F.2d 225 (9th Cir. 1990), affg. T.C. Memo. 1988-416.

     In Gainer, the issue was whether the taxpayer was liable for

the overstatement penalty under circumstances in which his

depreciation deduction and investment tax credit with respect to

an equipment purchase were denied because:   (1) The equipment was

not placed in service during the taxable year, (2) the equipment

was overvalued, and (3) the promissory note given in connection

with the purchase was nonrecourse so that he was not at risk.    We

refused to apply the penalty on the ground that the deduction and

credit were disallowed because the equipment had not been placed

in service during the tax year.   Therefore, the underpayments were

not "attributable to" any overstatement of value.42   The Court of

Appeals for the Ninth Circuit affirmed, reasoning as follows:

     Even if Gainer had correctly valued the container, the
     underpayment of tax would be the same because the
     container was not placed in service. Thus, Gainer's
     actual tax liability, after adjusting for failure to
     place the container in service, was no different from


     42
       Sec. 6662(b)(3), like its predecessor provision (sec.
6659) considered in Gainer, imposes an addition to tax on
underpayments "attributable to" any "substantial valuation
misstatement" (referred to, in sec. 6659, as "a valuation
overstatement").
                                - 71 -

     his liability after adjusting for any overvaluation.
     [Id. at 228.]

The Court stated that "no * * * [overvaluation] penalty * * * [may

be imposed] when there is some other ground for disallowing the

entire portion of a deduction that otherwise might be disallowed

for overvaluation."    Id.; see also Scoville v. Commissioner, 108

F.3d 1386 (9th Cir. 1997), affg. in part and revg. in part without

published opinion T.C. Memo. 1995-376; Todd v. Commissioner, 862

F.2d 540, 543 (5th Cir. 1988), affg. 89 T.C. 912 (1987).

     We have denied petitioners' charitable contribution

deductions, in their entirety, on the ground that petitioners

received a commensurate quid pro quo.    Therefore, under Gainer,

because there is a separate, independent ground for disallowing

those deductions, the overvaluation penalty may not be imposed

against petitioners.   See also 885 Inv. Co. v. Commissioner, 95

T.C. 156, 163 (1990).43

     C.   Conclusion

     Petitioners are not liable for either a 40-percent or 20-

percent addition to tax under section 6662.




     43
      In light of our conclusion that the overvaluation penalty
may not be imposed, we need not address whether petitioners had
"reasonable cause" with the meaning of sec. 6664(c).
                            - 72 -

To reflect the foregoing,

                                 Decisions will be entered

                            under Rule 155.
