Caracci v. Commissioner of Internal Revenue

The Caracci family (plaintiffs) owned three tax-exempt healthcare agencies (Sta-Home) (plaintiffs). Sta-Home depended almost entirely on Medicare reimbursement payments for its revenue, and compliance with Medicare rules to receive those payments dictated Sta-Home’s operational activities. For example, to avoid a reduction in reimbursement payments, Sta-Home structured wages so as to defer payments for an employee’s first month to be payable as a bonus upon the employee’s departure from the company. Sta-Home had accumulated operating losses over several years, and its cash flows were, in general, precarious. An anticipated change to Medicare rules jeopardized Sta-Home’s ability to continue operating at all. In response, the Caraccis, under advice from their attorney, sought to convert the three agencies into for-profit entities, which would be able to access lines of credit from private lenders unavailable to tax-exempt companies. Sta-Home hired appraisers, who, because of Sta-Home’s substantial liabilities and lack of capital assets, determined that Sta-Home had a negative net market value. Accordingly, the conversion was structured so that three newly created, nontax-exempt entities would pay zero cash to acquire the old companies’ assets and would assume the old companies’ liabilities. The new entities issued equity shares to members of the Caracci family. On audit, the Internal Revenue Service (IRS) (defendant) determined that the old entities had been undervalued and issued substantial deficiency notices against the new entities and the Caraccis. The Caraccis filed a petition with the United States Tax Court. During the proceedings before the Tax Court, it was revealed that the IRS’s appraisal relied on valuation methods appropriate only for companies with substantial invested capital and current profit-generating capabilities, neither of which described Sta-Home. The Tax Court adopted its own valuation methodology by cobbling together arguments from both the IRS’s and the Caraccis’ experts, ultimately finding that the agencies and the Caraccis owed millions in additional taxes. The Cararccis appealed.