Anclote Psychiatric Ctr. v. Commissioner

T.C. Memo. 1998-273

UNITED STATES TAX COURT

ANCLOTE PSYCHIATRIC CENTER, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4810-92. Filed July 27, 1998.

Robert Williams and V. Jean Owens, for petitioner.

Julie M. T. Foster, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WRIGHT, Judge: Respondent revoked recognition of

petitioner's status as an organization exempt from income tax

under section 501(a) effective October 1, 1982, and determined

the following deficiencies in Federal income tax:
 - 2 -

Taxable Year Ended1 Deficiency

Sept. 30, 1984 $159,008
Sept. 30, 1985 110,623
Sept. 30, 1986 75,490
Sept. 30, 1987 45,444
Sept. 30, 1988 62,041

Unless otherwise stated, all section references are to the

Internal Revenue Code, as in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

The primary issue for decision is whether petitioner's tax-

exempt status should be revoked. This issue turns on the

question whether petitioner's sale of its hospital in May 1983

was for less than fair market value, resulting in prohibited

inurement within the meaning of section 501(c)(3). If we decide

that there was no such inurement, we must decide whether

petitioner's tax-exempt status should be revoked for failure to

conduct exempt activities for its fiscal years ended

September 30, 1985, and 1986.

If we decide petitioner's tax-exempt status was properly

revoked, then we must decide whether petitioner is entitled to

deduct certain amounts as ordinary and necessary business

expenses during the years for which its income is no longer tax-

exempt.

1
The issuance of a notice of deficiency for the taxable
year ended Sept. 30, 1983, is barred by the period of
limitations.
 - 3 -

If petitioner's tax-exempt status is revoked effective

October 1, 1982, we must decide whether petitioner is entitled to

a net operating loss carryover from its fiscal year ended

September 30, 1983.

FINDINGS OF FACT

Some of the facts have been stipulated and are found

accordingly. The stipulation of facts and the attached exhibits

are incorporated herein by this reference.

Petitioner had its principal place of business in Tarpon

Springs, Florida, at the time it filed its petition. Petitioner

filed its Federal Returns of Organization Exempt From Income Tax

Under section 501(c) of the Internal Revenue Code (Forms 990) for

the years in issue with the Atlanta Service Center, Atlanta,

Georgia. For all relevant periods, petitioner used a fiscal year

ending September 30. Its reports on Form 990 reflected that

petitioner utilized the accrual method of accounting.

Petitioner is a Florida corporation, organized under chapter

617 of Florida Statutes as a corporation not-for-profit.

Petitioner was originally incorporated in 1951, as a for-profit

corporation and, in December 1953, began operation of Anclote

Manor Hospital (the hospital). In 1958, petitioner became a

nonprofit corporation and received a determination letter that it

qualified as a Federal tax-exempt corporation under section

501(c)(3).
 - 4 -

When the hospital opened, it provided every type of

psychiatric treatment. Although the hospital began as a short-

term treatment facility with an average length of stay of 1 to 2

weeks, by 1968, it had become a long-term treatment facility with

an average length of stay of 430 days. The hospital operated as

a "closed" medical hospital in that its medical staff did not

have independent outside medical practices.

By 1980, petitioner operated a 99-bed facility with a high

occupancy rate. The hospital was one of only five to seven long-

term facilities at that time. Referrals came from short-term

psychiatric hospitals nationwide. By 1981, its beds were full

and it was turning down patients for admission. On November 19,

1982, petitioner obtained a certificate of need from the State of

Florida Department of Health and Rehabilitative Services allowing

it to increase its number of beds by 31.

Dr. Walter H. Wellborn, Jr. (Dr. Wellborn), became

petitioner's president and chief executive officer in 1980. He

began working for petitioner in 1953, prior to the hospital's

opening. Petitioner was governed by a board of 12 directors (the

board) consisting of medical doctors and business persons from

the local community and southeastern United States.

During the 1950's and 1960's, petitioner's patients

generally paid for their own treatment. During the 1970's and

1980's, petitioner had patients whose private health insurance
 - 5 -

paid for their treatment and those who paid themselves. However,

petitioner never admitted Medicare or Medicaid patients.

The hospital is situated on about 20 acres. In addition,

petitioner owned two nonadjacent unimproved parcels known as the

Belcher Road property (approximately 4.2 acres) and the County

Road #77 property (approximately 76 acres) and two waterfront

lots across the street from the hospital. Blanton Realty

appraised the Belcher Road property for $210,000 as of March 5,

1981. As of July 8, 1982, Blanton Realty appraised the County

Road #77 property at $836,000 and the two lots at $60,000.

The Sale of the Hospital

In or about 1980, Dr. Wellborn and a few board members

attended several meetings of the National Association of Private

Psychiatric Hospitals where information was given about

restructuring psychiatric hospitals; hospitals were changing from

not-for-profit to for-profit organizations. Dr. Wellborn and the

other board members were looking for ways to generate funds to

expand the hospital and, at the same time, support petitioner's

research and educational goals. Dr. Wellborn wished to continue

running the hospital, and the board supported that relationship.

Sometime in the first half of 1981, the board engaged James

O'Donnell (Mr. O'Donnell), a Jacksonville, Florida, tax attorney,

to advise them regarding converting to a for-profit entity, with

the possible sale of the hospital to an entity to be formed by
 - 6 -

some or all of the board members, and the tax effects of such a

transaction on petitioner's tax-exempt status. It became clear

to Mr. O'Donnell that the board did not want to relinquish

control of the hospital and that petitioner needed access to the

hospital in order to conduct research; these factors limited the

options and effectively prevented selling to a third party. Mr.

O'Donnell advised the board on the choice of purchasing entity

(e.g., partnership or S corporation) and the associated liability

and tax implications for the purchasers.

On November 30, 1981, Mr. O'Donnell, on behalf of

petitioner, requested a private letter ruling (PLR) from the

Internal Revenue Service (IRS) as to the income tax consequences

of a sale of the hospital to a private entity (the request),

namely: (1) Whether petitioner would retain its charitable

qualification under section 501(c)(3); (2) whether any unrelated

business income would result; and (3) whether the proposed

transaction was prohibited by any Code provision, rule, or

regulation. Under "Statement of Facts", the request states:

7. Because of the highly specialized nature of the
hospital's facilities there is a very limited market
for its sale. Further, the risks and uncertainties
related to the operation of the hospital are best
understood and therefore subject to evaluation by the
Board of Directors of APC [petitioner]. For these
reasons, APC has decided to sell the hospital at its
appraised value, to its Board of Directors, or an
entity which they propose to form, probably a limited
partnership.

Under "Description of Proposed Transaction", the request states:
 - 7 -

1. An independent appraisal by a qualified
competent appraiser will be obtained, which
determination will be the basis of the price and terms
upon which the hospital will be sold.

2. All documents necessary for the closing of the
proposed sale and related consents will be negotiated
and prepared by separate counsel for APC and the
purchasing entity.

* * * * * * *

Following Mr. O'Donnell's recommendation, the board hired

Ray J. Sheldrick (Mr. Sheldrick), a business appraiser, to

determine the fair market value of the hospital. On March 5,

1982, Mr. Sheldrick submitted to petitioner his Summary Valuation

Report, effective as of September 30, 1981. Using the asset-

based approach, Mr. Sheldrick determined the fair market value

for the hospital as of September 30, 1981, to be in the range

between $3,500,000 and $4,300,000. Mr. Sheldrick's appraisal did

not include the Belcher Road property or County Road #77

property.

On May 27, 1982, the IRS issued a PLR to petitioner. After

reiterating the facts as submitted by petitioner and presenting

the applicable law, the PLR states:

As noted, arms-length standards will prevail
during the negotiations and sale, as you will certify
by maintaining appropriate records, attesting to the
fact that the price was set at fair market value and
that no loan abatements or other special concessions
will be afforded to the present directors in their
capacity as purchasers and/or operators of the
 - 8 -

hospital. Thus, the proposed sale as described will
not benefit those in a controlling position with
respect to you by virtue of the ability of such persons
to unfairly manipulate the transaction. The sale will
not jeopardize your tax exempt status under section
501(c)(3) of the Code.

On or about February 1983, Mr. O'Donnell assisted in forming

Anclote Manor Hospital, Inc. (AMH), a Florida for-profit

corporation whose stock was owned by petitioner's board members

individually, to purchase petitioner's assets.

On February 8, 1983, petitioner hired Stanley W. Rosenkranz

(Mr. Rosenkranz), a partner in the law firm of Holland and

Knight, to negotiate the sale of the hospital. In these

negotiations, Mr. O'Donnell represented AMH as buyer and Mr.

Rosenkranz represented petitioner as seller. Both lawyers knew

the sale had to be for fair market value. Both relied in part on

Mr. Sheldrick's appraisal in setting the purchase price. Both

knew Mr. Sheldrick's appraisal did not include the Belcher Road

or County Road #77 properties. Negotiations between Mr.

Rosenkranz and Mr. O'Donnell continued between February 1983 and

April 1983, with the parties exchanging several drafts of a

purchase and sale agreement. Mr. Rosenkranz insisted that AMH

assume petitioner's liabilities including the liability for

contributions to the pension plans. He also required that a bank

hold the paper and foreclose on the mortgage if the payments were

not made.
 - 9 -

On April 18, 1983, petitioner's board of directors passed a

resolution authorizing the sale of the hospital as negotiated by

Mr. O'Donnell and Mr. Rosenkranz. The purchase and sale

agreement was executed on April 25, 1983. The property to be

exchanged included "all of the * * * [petitioner's] properties,

assets, and business as a going concern", but not petitioner's

license to conduct or maintain a hospital or those assets

considered as restricted funds; i.e., the research, education,

and children's psychiatric development funds. In addition, the

buyer agreed to lease to petitioner 1,000 square feet of space

and allow petitioner access to the premises of the hospital for

conducting its research, educational, and charitable functions.

At this time, petitioner had not made the renovations necessary

for the additional 31 beds approved by the certificate of need.

The agreed purchase price was an amount equal to: (1)

$4,500,000, plus (2) the amounts of (a) the liabilities shown on

the March 31, 1983, balance sheet then outstanding and (b) those

outstanding liabilities incurred in the normal course of business

between the date of the March 31, 1983, balance sheet and the

closing date, plus (3) to the extent required, the amount to be

contributed to petitioner's pension plans of the excess of the

plans' actuarial present value of accrued benefits over the

assets of the plans. The agreement provided that the liabilities

assumed included petitioner's liability for the Florida Patient's
 - 10 -

Compensation Fund assessments, but such liability was limited to

$114,815, the amount of the liability assessed as of the time of

the agreement. The purchase price was to be paid at closing as

follows: An executed "Assumption of Liabilities" agreement, a

check for $450,000, plus a note for $4,050,000. Closing was held

on May 9, 1983, effective May 1, 1983.

The February 28, 1983, Statement of Liabilities attached to

the purchase and sale agreement included an accrued expense for

"Retirement Fund for Employees (Funding by June 15, 83 [sic],

subject to adjustment by actuarial report)" in the amount of

$291,320. The attached March 31, 1983, balance sheet showed

liabilities of $1,701,786. Petitioner's April 30, 1983 balance

sheet showed liabilities of $1,711,549.20.

On June 6, 1983, AMH made a contribution to the pension

trust of $171,640 for the plan year ended September 30, 1982. On

June 7, 1984, AMH made a contribution of $162,168 for the plan

year ended September 30, 1983. AMH terminated one of its defined

benefit pension plans effective September 30, 1983, replacing it

with a defined contribution plan, and received in excess of

$425,000 due to the termination.

In early 1985, AMH sold the Belcher Road property for

$375,000 and the County Road #77 property for $1,500,000.

During May and June of 1985, AMH received several preliminary

offers to buy the hospital; offers ranged from $12 to $26
 - 11 -

million. On July 23, 1985, AMH entered into a contract for the

sale of the hospital's operating assets for $29,587,000 to AMISUB

(Anclote), Inc., a subsidiary of American Medical International,

Inc. (AMI), a large health care provider. At this time, the

hospital was operating at 130 beds and had a certificate of need

for an additional 36 beds. Of the total purchase price, the

parties agreed that $3,500,000 was to be placed in escrow to be

used for expenses related to the transfer of the 36-bed

certificate of need, and that the remaining balance would be

released to AMH only if a certificate of need for all 36 beds

were approved, otherwise the remaining amount would be prorated

based on the number of beds approved. The closing date was

October 21, 1985. In 1990, AMI sold the hospital for about

$4,276,000.

Regulatory Environment

The State of Florida Department of Health and Rehabilitative

Services was the granting authority for the license to operate

the hospital and the certificates of need. The hospital's

patient revenue and cost charges were subject to review by the

State's Hospital Cost Containment Board.

On September 3, 1982, Congress enacted the Tax Equity and

Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. 97-248, 96

Stat. 324. TEFRA sec. 101(b)(3), 96 Stat. 335, provided in part:

The Secretary [of Health and Human Services] shall
develop, in consultation with the Senate Committee on
 - 12 -

Finance and the Committee on Ways and Means of the
House of Representatives, proposals for legislation
which would provide that hospitals, skilled nursing
facilities, and, to the extent feasible, other
providers, would be reimbursed under title XVIII of
this [the Social Security] Act on a prospective basis.
The Secretary shall report such proposals to such
committees not later than December 31, 1982.

On April 20, 1983, Congress enacted the Social Security

Amendments of 1983 (SSA), Pub. L. 98-21, 97 Stat. 63, replacing

Medicare's reasonable cost basis payment system for hospital

inpatient services with the Diagnosis Related Group (DRG)

prospective pay system to be phased-in over a 4-year period with

reporting periods beginning after October 1, 1983. SSA, tit. VI,

97 Stat. 149. Under the DRG system, hospitals would receive

Medicare payments for inpatient services for each discharge at a

specific rate to be determined by the Secretary of Health and

Human Services based on DRG's. SSA at sec. 601(e), 97 Stat. 152;

see 48 Fed. Reg. 39752, 39754 (Sept. 1, 1983). Congress excluded

psychiatric hospitals and distinct psychiatric units from the DRG

system. SSA at sec. 601(e), 97 Stat. 152. As a result, hospital

care providers increased their interest in providing psychiatric

care.

Florida Patient's Compensation Fund

In 1975, the Florida legislature enacted the Medical

Malpractice Reform Act of 1975, which was designed to (1) limit

liability of medical providers and (2) fund valid claims. The

Medical Malpractice Reform Act established the Florida Patient's
 - 13 -

Compensation Fund (FPCF) to provide liability coverage in excess

of basic policy limits for its participant members. Each

hospital was required to pay a yearly fee and assessments.

Petitioner first became a participant in FPCF sometime

during the fund year 1977-78. Pursuant to the FPCF statute, as

in effect in the 1977-78 time frame, petitioner was self-insured

for the first $100,000 per claim of liability and any excess

liability was to be paid by FPCF. As of November 30, 1979,

petitioner had established a reserve fund of $345,000 for this

purpose. Subsequent to June 30, 1982, petitioner was insured for

medical malpractice with a commercial insurance carrier, and the

reserve fund reverted to working capital.

FPCF made a series of assessments against its members to

cover the deficits arising from the costs of the claims exceeding

the membership fees it had collected with respect to a fund year.

These assessments represented a proration of the fund deficits

among the members based on a formula composed of factors such as

type of provider, net fees, and number of providers in each

class. As of September 30, 1982, petitioner had been assessed

$58,594 for coverage provided for the fund years 1977-78, 1978-

79, and 1981-82, and $56,221 for the fund year 1979-80, for a

total of $114,815.

Member hospitals, including petitioner, filed a law suit

against the State of Florida Department of Insurance and FPCF in
 - 14 -

attempting to prevent collection of the assessments. On June 9,

1983, the Florida Supreme Court issued its order and, on

September 15, 1983, rendered its opinion that the statute

governing the FPCF's imposition of fees and assessments was

constitutional both on its face and as applied. Department of

Ins. v. Southeast Volusia Hosp. Dist., 438 So. 2d 815 (Fla.

1983).

As of September 30, 1983, the unpaid assessments against

petitioner for the fund years 1977-78 through 1981-82 totaled

$460,384. Of this total amount, AMH had assumed liability for

$114,815 upon purchase of the hospital. As of September 30,

1984, the unpaid assessments by FPCF against petitioner for those

years totaled $401,709, of which AMH was liable for $56,221. In

addition, petitioner owed interest on these amounts. On June 20,

1985, petitioner entered a settlement agreement with the FPCP and

the State of Florida Department of Insurance for the payment of

petitioner's FPCF obligation. Petitioner made all payments to

FPCF in accordance with the settlement agreement.

The total amounts petitioner paid to FPCF during the years

in issue were as follows:

Year Total Paid

1984 $71,976.76
1985 638,806.22
1986 284,330.46
1987 0
1988 29,764.26

$1,024,877.70
 - 15 -

All amounts are attributable to assessments stemming from claims

related to the years when petitioner operated the hospital.

Grants to Organizations and for Patient Care

Petitioner gave grants for education, research, and other

charitable purposes, and for indigent patient care at the

hospital. For 1979 through 1982, petitioner's financial

statements reflected the following amounts as "charity,

discounts, and provisions for uncollectible accounts" arising

from patient care:

Year Amounts

1979 $212,922
1980 309,862
1981 161,056
1982 116,477

Following the sale of the hospital, petitioner made grants

totaling the following annual amounts:

Year To Organizations For Patient Care

1984 $186,817.00 $184,526.00
1985 700.00 138,521.97
1986 47,500.00 92,565.00
1987 53,500.00 1,500.00
1988 145,784.00 0

All of the amounts paid for patient care were paid only for the

benefit of the patients, none of whom were related to or

connected in any way personally with anyone on petitioner's

board.
 - 16 -

Petitioner's Returns

Petitioner timely filed Forms 990, on the basis of a

September 30 fiscal year, for 1982 through 1988 using the accrual

method of accounting. On its fiscal 1983 Form 990, petitioner

reported the sale of the hospital for a net loss of $1,427,297.

Petitioner calculated this loss as follows:

Sale Price $4,500,000

Basis of Assets sold:

Cash $1,268,319
Treasury bills 1,231,499
Patients accounts receivable 1,023,141
Other receivables 7,428
Supplies 88,517
Prepaid expenses 61,011
Property, plant, equipment 4,022,764
and other non-current assets
$7,702,679

Liabilities assumed by buyer 1,838,120
Net assets sold 5,864,559

(1,364,559)
Sales expenses 62,738

Loss (1,427,297)

For 1983, petitioner reported total revenue of $3,622,160 and

total expenses of $4,289,241. Included in the accrued expenses

were $1,550 for grants, $20,809 for assistance to individuals,

and $354,580 for FPCF assessments. Of the amount accrued for

FPCF assessments, $345,000 was unpaid in the year 1983.

Included in the expenses reported by petitioner for the

years in issue were the following:
 - 17 -

Assistance to
Year Grants Individuals FPCF

1984 $180,817 $184,526 $0
1985 145,073 550 560,257
1986 47,500 92,565 862
1987 53,500 1,500 0
1988 145,784 0 3,606

Revocation and Notice of Deficiency

On December 12, 1991, respondent issued the notice of

deficiency and, on the same date, issued the final adverse

determination letter revoking petitioner's tax-exempt status

effective for all years beginning on or after October 1, 1982.

The reasons given for the revocation were that the sale of the

hospital resulted in "inurement of your earnings to the benefit

of private shareholders or individuals, contrary to the

provisions of Code section 501(c)(3)" and

Additionally, during examination of the Forms 990 which
you filed for the taxable years ended September 30,
1985 and 1986, you did not establish that you conducted
the charitable, educational, research program which was
represented as having been the altruistic goal
motivating the sale of your hospital facility.
Payments made by you for the provision of patient
services, although substantial, were generally
restricted to patients of Anclote Manor Hospital who
were not shown to have been members of a charitable
class. Research and education programs were minimal
and poorly documented. There was no evidence that
donations made to a variety of public charities,
schools, hospitals, and foundations were subjected to
any direction or expenditure responsibility.

Based on the revocation of petitioner's tax-exempt status,

respondent determined the deficiencies in the Federal income tax.
 - 18 -

In the notice of deficiency, respondent calculated petitioner's

taxable income as follows:
1984 1985 1986 1987 1988

Gross income $592,299 $453,356 $308,705 $245,814 $329,843
Operating expense (159,309) (137,236) (77,449) (83,021) (105,367)
Charitable (43,299) (31,612) (23,126) (16,279) (22,448)
contributions
Total $389,691 $284,508 $208,130 $146,514 $202,028

In determining petitioner's taxable income, respondent disallowed

the deductions reflected on petitioner's Forms 990 for assistance

to individuals and payments to the FPCF. Respondent treated

petitioner's grants to organizations as charitable contributions

but limited those deductions to 10 percent of taxable income.

OPINION

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

organization be operated exclusively for one or more specified

purposes and that no part of the net earnings of the organization

"inures to the benefit of any private shareholder or individual".

See also sec. 1.501(c)(3)-1(c)(1), Income Tax Regs. An

organization is not operated exclusively for an exempt purpose

unless it serves a public rather than a private interest. Sec.

1.501(c)(3)-1(d)(1)(ii), Income Tax Regs. An organization is not

operated exclusively for one or more exempt purposes if its net

earnings inure in whole or in part to the benefit of private

shareholders or individuals. Sec. 1.501(c)(3)-1(c)(2), Income

Tax Regs. The words "private shareholder or individual" refer to
 - 19 -

persons having a personal and private interest in the activities

of the organization. Sec. 1.501(a)-1(c), Income Tax Regs.

The presence of a single substantial nonexempt purpose

destroys the exemption regardless of the number or importance of

the exempt purposes. Better Bus. Bureau v. United States, 326

U.S. 279, 283 (1945); American Campaign Academy v. Commissioner,

92 T.C. 1053, 1065 (1989). When an organization operates for the

benefit of private interests, the organization by definition does

not operate exclusively for exempt purposes. American Campaign

Academy v. Commissioner, supra at 1065. Prohibited benefits may

include advantage, profit, or gain. Id. at 1065-1066.

Fair Market Value

If petitioner sold the hospital to AMH, a corporation whose

shareholders were directors of both petitioner and AMH, for less

than fair market value, such an advantage to the shareholders of

AMH would be a prohibited benefit constituting private inurement.

Fair market value has been defined as the price at which

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. United

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

Commissioner, 98 T.C. 554, 562 (1992); see sec. 1.170A-1(c)(2),

Income Tax Regs. The determination of the fair market value of

property is a question of fact which must be resolved after
 - 20 -

consideration of all of the evidence in the record. Morris v.

Commissioner, 761 F.2d 1195, 1200 (6th Cir. 1985), affg. T.C.

Memo. 1982-508; Estate of Newhouse v. Commissioner, 94 T.C. 193,

217 (1990).

In 1958, respondent determined that petitioner was exempt

from Federal income tax as an organization described in section

501(c)(3). The principal question before us is whether the

circumstances of the 1983 sale by petitioner to AMH were such as

to confer a prohibited benefit, i.e., inurement, on AMH and

therefore on its shareholders, who were directors of both

petitioner and AMH, with the result that petitioner should lose

its exemption. At the outset, we think it important to keep in

mind the context in which the question arises and the role of

fair market value in determining whether such inurement occurred.

This is not an estate or gift tax case where it is necessary

to determine a precise amount representing the fair market value

of the property transferred in order to determine the amount, if

any, subject to tax. Rather, the question to be resolved is

whether the sale was the product of an arm's-length transaction

which produced a sale price that is sufficiently close to the

fair market value of the property at the time of the sale, so

that one can fairly conclude that there was no prohibited

inurement. Or to put it another way, recognizing that what is

fair market value presents an inherently imprecise issue (which
 - 21 -

even respondent admits), we see our task as one of determining

whether the sale price was within a reasonable range of what

could be considered fair market values.

In this respect, our task is not unlike that which we face

when inurement depends upon a determination whether payments of

compensation are excessive or reasonable. See Church of

Scientology v. Commissioner, 823 F.2d 1310, 1317 (9th Cir. 1987)

("the payments in this case, cross the line between reasonable

and excessive"), affg. 83 T.C. 381 (1984); United Cancer Council,

Inc. v. Commissioner, 109 T.C. 326, 396 (1997).2 The foregoing

frame of reference is to be sharply distinguished from the

situation involving the issue whether a section 501(c)(3)

organization loses its exemption where there is inurement but it

is de minimis. See Carter v. United States, 973 F.2d 1479, 1486

n.5 (9th Cir. 1992) (majority opinion), 1489-1490 (Tang, J.,

concurring in part and dissenting in part); Orange County Agric.

Socy., Inc. v. Commissioner, 893 F.2d 529, 534 (2d Cir. 1990),

affg. T.C. Memo. 1988-380; Church of Scientology v. Commissioner,

supra.

2
Compare also the manner in which the courts have dealt
with the relationship between the sales price and fair market
value in determining the bona fides of a sale-leaseback
transaction. See Brown v. Commissioner, 37 T.C. 461, 486
(1961)(the price "was within a reasonable range"), affd. 325 F.2d
313 (9th Cir. 1963), affd. 380 U.S. 563 (1965); see also Brekke
v. Commissioner, 40 T.C. 789, 800 n.5 (1963) and cases cited
thereat.
 - 22 -

Thus, fair market value plays an important role but is not

determinative herein. As a consequence, we reject respondent's

insistence that we should determine a definite figure for fair

market value which should then be compared with the sale price

and automatically measure inurement. Such an approach would

accord that value a preciseness it simply does not have. See

Messing v. Commissioner, 48 T.C. 502, 512 (1967). On the other

hand, we are not prepared to minimize, as petitioner would have

us do, the influence of the fair market value element in

determining whether the sale price should be treated as the

product of arm's-length negotiations, with the absence of

inurement the result.

Burden of Proof and Evidentiary Matters

There is one further preliminary matter. In an earlier

proceeding in this case, we decided that petitioner had made a

proper request for a determination in respect of its exemption

under section 501(c)(3), within the meaning of section

7428(b)(2), that respondent had failed to make a determination

with respect to such request, and that petitioner had filed a

proper and timely petition for a declaratory judgment so that all

the jurisdictional requirements prescribed by section 7428 had

been satisfied. Anclote Psychiatric Ctr., Inc. v. Commissioner,

98 T.C. 374 (1992) (docket No. 19530-91X). Given our conclusion

that respondent had not made the required determination, the
 - 23 -

burden of proof is on respondent with respect to the issue of

whether petitioner is entitled to an exemption under section

501(c)(3).3 Rule 217(c)(2)(B); see also infra pp. 29-30. As to

all other issues raised by the deficiency notice, petitioner has

that burden. Rule 142(a).

It is against the foregoing background that we proceed to

examine the various elements of the 1983 sale, in order to

determine whether fair market value of petitioner's assets as

compared to the sales price "cross[es] the line between

reasonable and excessive". See Church of Scientology v.

Commissioner, supra.

We see no purpose to be served by setting forth in detail

the various steps in the negotiations between petitioner and AMH

which culminated in the 1983 sale. Both parties were represented

by counsel who, as far as the legal as distinguished from the

financial aspects of the sale were concerned, acted independently

and in good faith and sought to protect the interests of his

3
Respondent has accepted this burden and proceeded
accordingly at trial but has reserved the right to reassert its
position that we were without jurisdiction in Anclote Psychiatric
Center v. Commissioner, 98 T.C. 374 (1992) (docket No. 19530-
91X). We also note that there are two other docketed cases
involving the revocation of petitioner's sec. 501(c)(3) status;
i.e., docket Nos. 4833-92X (petition for declaratory judgment
after revocation letter issued) and 27403-92X (petition for
declaratory judgment that petitioner qualifies as tax-exempt in
years subsequent to the sale). None of the cases referred to in
this footnote have been consolidated with the instant case. See
Fazi v. Commissioner, 102 T.C. 695, 696 n.1 (1994).
 - 24 -

client. As will subsequently appear, however, there are serious

questions as to the extent to which the negotiations adequately

took into account certain financial aspects of the transaction

which may cause the negotiations and the resulting sale price to

be categorized as not being at arm's length and therefore giving

rise to inurement. Among the elements involved are consideration

or lack of consideration given to the changes in values of items

reflected in petitioner's balance sheet between September 30,

1981, and May 8, 1983, the proper valuations of the Belcher Road

and County Road #77 parcels, the measure of petitioner's

obligations under its pension plan, the value, if any, of the

certificate of need for 31 additional beds, and the impact of

changes in methods of reimbursement in respect of Medicare

reimbursements and of the sales of the hospital in 1985 and 1990.

These elements bear directly on the determination of the range of

fair market values and consequent inurement, if any.

An element in resolving the question of fair market value,

and therefore inurement, is the extent to which evidence as to

events and actions occurring after the date of the 1983 sale can

be taken into account. Petitioner has raised a number of

objections to such evidence, particularly the evidence relating

to the 1985 sale of the property and the circumstances

surrounding such sale, on the ground of relevancy.
 - 25 -

Rule 402 of the Federal Rules of Evidence, rules that apply

to this Court under Rule 143(a), Tax Court Rules of Practice and

Procedures, provides generally that all relevant evidence is

admissible and that evidence which is not relevant is not

admissible. Rule 401 of the Federal Rules of Evidence defines

relevant evidence as "evidence having any tendency to make the

existence of any fact that is of consequence to the determination

of the action more probable or less probable than it would be

without the evidence."

In examining all the facts and circumstances involved in

determining fair market value, events occurring subsequent to the

valuation date are not considered, except to the extent that such

events were reasonably foreseeable on the valuation date. First

Natl. Bank of Kenosha v. United States, 763 F.2d 891, 894 (7th

Cir. 1985); Estate of Spruill v. Commissioner, 88 T.C. 1197, 1228

(1987). However, the price set by a freely negotiated agreement

made reasonably close to the valuation date is persuasive

evidence of fair market value, except where a material change in

circumstances occurs between the valuation date and the date of

sale. First Natl. Bank of Kenosha v. United States, supra at

894; Estate of Spruill v. Commissioner, supra at 1233. A useful

distinction may be drawn between later events which affect fair

market value as of the valuation date, and later events which may

be taken into account as evidence of fair market value as of the
 - 26 -

valuation date. Estate of Jung v. Commissioner, 101 T.C. 412,

431 (1993). In short, evidence as to latter category of events

may be admitted because of its potential relevance even though it

may ultimately be determined that such evidence does not have an

impact on the determination of fair market value.

Here again, we see no purpose to be served by analyzing each

stipulation, exhibit, or testimony relating to post-May 1983

events. These items include matters not only relating to the

1985 and 1990 sales of the hospital, but also the payments made

to and from petitioner's pension plan which was transferred as

part of the 1983 sale, sales of the Belcher Road and County Road

#77 parcels, and the AMH 1984 audit report. We think it

sufficient to observe that the evidence to which petitioner

objects may be relevant to our determination herein, i.e., to the

extent that other evidence could provide a basis for concluding

that the elements which impacted the 1985 sale may have been

sufficiently known or anticipated at the time of the 1983 sale.

We previously ruled twice that such evidence was admissible,

reserving to petitioner the right to reargue its position on

brief. This petitioner has done, but we remain unpersuaded.

Accordingly, petitioner's objections to evidence relating to

post-1983 events are overruled. We likewise overrule

petitioner's objections to the other described material on the
 - 27 -

ground that such material may provide information relevant to our

determination of whether there was inurement.

The parties primarily rely upon their experts' testimony and

reports to support their respective positions regarding the fair

market value of the hospital. Expert opinion sometimes aids the

Court in determining valuation; other times, it does not. See

Laureys v. Commissioner, 92 T.C. 101, 129 (1989). We evaluate

such opinions in light of the demonstrated qualifications of the

expert and all other evidence of value in the record. Estate of

Newhouse v. Commissioner, 94 T.C. at 217. We are not bound,

however, by the opinion of any expert witness when that opinion

contravenes our judgment. Id. We may accept the opinion of an

expert in its entirety, Buffalo Tool & Die Manufacturing Co. v.

Commissioner, 74 T.C. 441, 452 (1980), or we may be selective in

the use of any portion thereof, Parker v. Commissioner, 86 T.C.

547, 562 (1986).

Initially, we deal with petitioner's objection to the

admission of the report of respondent's expert, Mr. Shelton, on

the ground that he assumed the role of an advocate. See Laureys

v. Commissioner, supra. Petitioner points to Mr. Shelton's use

of terms such as "collusion", "in secrecy", "the closed and

secret sale", and "inside knowledge", when describing the

appraisal of Mr. Sheldrick and AMH's purchase of the hospital.

That appraisal was utilized by Messrs. O'Donnell and Rosenkranz
 - 28 -

in their negotiations which culminated in the 1983 sale.

Additionally, when analyzing petitioner's revenues and expenses

for purposes of the income approach to valuation set forth in his

appraisal, Mr. Shelton states:

Prior to the sale, and at the time when the hospital
was owned by a not-for-profit organization, maximizing
patient revenues per patient day and net income were
not priority matters as they were consumed with their
"totally in-secret plans" to purchase the hospital.
However, the Board did not want to do anything to make
the contemplated sale suspect as the members of the
board covertly made preparations to sell the hospital
to themselves. Thus expenses in the years immediately
prior to and in the year of sale were higher than
normal because of fees and costs related to the
preparation and the related sale expenses.

Finally, in his overall conclusion, Mr. Shelton states that the

Board of Directors of petitioner "covertly schemed and planned

the successful purchase of the hospital to their inurement and at

the expense of this 501(c)(3) corporation".

We think that Mr. Shelton's report is more characteristic of

the work of a revenue agent than of an impartial, disinterested

appraiser. In this connection, we note that Mr. Shelton's report

was received and adjusted by respondent's National Office. We

reject respondent's suggestion that we exclude Mr. Shelton's

objectionable comments and admit the balance of his report.

Those comments impart a pervasive negative impact on the report.

We conclude that petitioner's objection based on bias is well
 - 29 -

founded and accordingly rule that Mr. Shelton's report should not

be received in evidence. Cf. Laureys v. Commissioner, supra.

Our conclusion makes it unnecessary for us to rule on

petitioner's further objection to the admission of Mr. Shelton's

report on the ground that it is significantly inadequate,

particularly in respect of his use of comparables. We are

constrained to add that, even if we had decided to overrule

petitioner's objections and admit Mr. Shelton's report into

evidence, we would have given it minimal weight because of Mr.

Shelton's inexperience at the time of his appraisal, the defects

in the report, such as listing a claimed comparable sale as

having taken place in 1983 instead of 1985, the value he ascribes

to the impact of the change in the Medicare system in 1983, the

failure to take into account the impact of income taxes on his

projected income stream (only partially corrected by the

subsequent adjustment of the report by respondent's National

Office), the internal contradictions reflected in his analysis of

projected profitability, and the seeming excessive value for

goodwill. See Furman v. Commissioner, T.C. Memo. 1998-157.

Mr. Shelton's report represented the bulk of respondent's

case, and its exclusion raises the question of the impact of its

inadmissibility on respondent's burden of proof. The case law is

clear that the determination whether that burden has been

satisfied is not limited to respondent's affirmative evidence but
 - 30 -

can be made on the basis of the whole record. See Clark v.

Commissioner, 266 F.2d 698, 717 (9th Cir. 1959), remanding on

other grounds T.C. Memo. 1957-129; Coleman v. Commissioner, 87

T.C. 178, 200 (1986), affd. without published opinion 833 F.2d

303 (3d Cir. 1987); Imburgia v. Commissioner, 22 T.C. 1002, 1014

(1954). Accordingly, we proceed with our task on the basis of

the record herein in its entirety.

Inurement

We first address the question of how much AMH paid

petitioner for the assets which petitioner sold to it in May

1983. The agreement of sale provided:

2. Purchase Price.

Buyer and Seller agree that the total purchase price
(the "Purchase Price") to be paid for all property, assets
and business being acquired hereunder shall be an amount
equal to the sum of (i) $4,500,000 and (ii) the sum of (x)
the amount of all liabilities shown on the 1983 Balance
Sheet and not heretofore paid or discharged, (y) the amount
of all liabilities incurred by the Seller in the ordinary
course of its business, between the date of the 1983 Balance
Sheet and the Closing Date, and not heretofore paid or
discharged, and (iii) to the extent the same is required to
be contributed to said plans, the excess of total actuarial
present value of accrued benefits over the assets of the
Seller's pension plans, (the amounts referred to in (ii) and
(iii) being sometimes hereinafter collectively referred to
as the "Assumed Liabilities"). Anything herein contained to
the contrary notwithstanding, there shall be deemed included
within the amount of Assumed Liabilities, the Seller's
liability for Florida Patient's Compensation Fund
Assessments; provided, however, that Buyer shall not be
deemed to have assumed, and therefore the same is not deemed
within the Assumed Liabilities, liability for Florida
Patient's Compensation Fund assessments to the extent the
same exceed $114,815.
 - 31 -

The parties appear to be in agreement that the purchase

price was at least $6,338,120 consisting of $4.5 million payable

by way of cash and a promissory note plus $1,838,120 of assumed

liabilities. They differ on whether the latter amount includes

some $300,000 claimed to represent petitioner's liability to its

pension funds as of May 8, 1983, in respect of the excess of

vested benefits over net assets in the funds. Petitioner asserts

that such amount should not be so included but rather should be

added to the foregoing amount of assumed liabilities.

Petitioner's position finds support in the separate treatment

accorded this item in the above-quoted excerpt from the sale

agreement. Further support for petitioner's position can be

found in Mr. Sheldrick's report4 which clearly indicates that

this liability is an off-the-balance-sheet item, and in footnote

G to petitioner's September 30, 1982, audit report. On the other

hand, petitioner's Form 990 for the fiscal year ended September

30, 1983, shows liabilities of $1,838,120 as part of the basis

used in computing the claimed loss from the sale to AMH. It is

difficult to reconcile this figure with the figure of $1,711,549

which is the updated total amount of liabilities shown on

4
We note that, since Mr. Sheldrick was deceased at the
time of trial, his report was not admitted as an expert report
but is part of the record because it was utilized by Messrs.
O'Donnell and Rosenkranz as a basis for their negotiations.
 - 32 -

petitioner's April 30, 1983, balance sheet.5 Additional

difficulties arise when one takes into account that AMH, on

June 4, 1983, paid $171,640 in respect of September 30, 1982,

plan year and on June 7, 1984, paid $162,168 in respect of

September 30, 1983, plan year. To be sure, as petitioner points

out, neither of these figures was available on May 8, 1983 (the

closing date of the purchase and sale agreement), but the

$171,640 figure was available when petitioner's Form 990 for its

September 30, 1983, fiscal year was filed and presumably could

have been included in the amount of assumed liabilities; had this

been done, the amount of such liabilities would have exceeded the

amount shown on the Form 990 ($1,883,188 without taking into

account the net increase, if any, of liabilities incurred between

April 30, 1983, and the May 8, 1983, closing date). As will

subsequently appear, whether or not the $6,338,120, which

respondent appears to accept as the purchase price, is increased

by the amount of the liability in question will not be critical

in deciding the inurement question. We reject respondent's

argument that there was an overfunding of the pension plans and

therefore there is no liability to be taken into account. The

overfunding, upon which respondent relies, appears to relate to

the calculations applicable when a plan is being terminated which

5
The comparable figure in the Mar. 31, 1983, balance sheet
annexed to the purchase and sale agreement was $1,701,702.
 - 33 -

are different from those which determine the liability for

contributions. In any event, there is insufficient evidence in

the record to satisfy respondent's burden of proof in this aspect

of the inurement issue. On this basis, we accept the testimony

of Messrs. O'Donnell and Rosenkranz that they thought the figure

was approximately $300,000 and that this was the figure they used

in the negotiations.6 As a result, we conclude that the purchase

price should be $6,638,120.

The next question is what was the value of the assets

transferred by petitioner to AMH. We think that the best way to

approach this question is to take the September 30, 1981, balance

sheet which was Mr. Sheldrick's starting point and make three

adjustments to reflect: (1) The increase in the amount of cash

and Treasury bills; (2) Mr. Sheldrick's adjustment of $280,000 to

reflect an increase in the value of the hospital land; and (3)

the values of the Belcher Road and County Road #77 real estate

above the value of $581,153 at which they were carried on

petitioner's books.7 If these three adjustments produce an

6
This round figure is quite close to the actual payments
by AMH; i.e., $171,640 for fiscal 1982 and $97,945 (the pro rata
portion of fiscal 1983 payment for the period prior to sale -
220/365 x $162,168), or $269,583.
7
We have concluded that $60,000 attributable to the value
of two vacant lots should not be a separate item because it may
well be that these lots were included in Mr. Shelton's valuation
of the hospital's land, buildings, and improvements.
 - 34 -

excess of asset values over the purchase price which falls

outside a reasonable range of values as related to purchase

price, the conclusion that there was inurement will follow and no

further analysis will be necessary.

In respect of the first adjustment, the following figures

(in thousands of dollars rounded) are revealing:

Cash and Increase Book Value Increase
Date Treasury bills Over 9/30/81 Assets Over 9/30/81

9/30/81 $823 $6,092
9/30/82 1,538 $715 6,559 $467
3/31/83 2,206 1,383 7,090 998
4/30/83 2,499 1,676 7,237 1,145

It is apparent that between September 30, 1981, and the

May 8, 1983, closing date, there was an increase of approximately

$1.1 million in assets (or $1 million if one is guided by the

March 31, 1983, value reflected in the purchase and sale

agreement), assets as to which there can be no question as to

their values as of the pertinent dates and their liquidity at

those values. The significance of these increases is confirmed

when one takes into account that balance sheet liabilities (in

thousands of dollars rounded) remained relatively unchanged:

Date Amount

9/30/81 $1,502
9/30/82 1,831
3/31/83 1,702
4/30/83 1,712
 - 35 -

The second adjustment is an increase over book value of

$280,000 as of September 30, 1981, which Mr. Sheldrick made in

order to reflect what he considered to be the fair market value

of the land, buildings, and improvements of the central hospital

complex. In this connection, we note that there is insufficient

evidence in the record for us to arrive at any additional amount

of such adjustment as of the closing date.

Finally, we note that Mr. Sheldrick excluded from his

valuation of petitioner any consideration of the real estate not

in use and the $581,153 reflected for such real estate on

petitioner's books. This fact was apparently inadequately

considered, by Messrs. O'Donnell and Rosenkranz in their

negotiations and by petitioner's officers and directors, a defect

which is significant in light of the availability of the

appraisals dated March 2, 1981, and July 8, 1982, made for

petitioner by Herbert Blanton which valued such land as follows:

Property Amount

County Road #77 $ 836,000
Belcher Road 210,000

Total $1,046,000

If one adds the increase of $464,847 ($1,046,000 less

$581,153 reflected for such real estate on petitioner's
 - 36 -

September 30, 1981, balance sheet)8 and the $280,000 adjustment

made by Mr. Sheldrick in respect of the value of the hospital

complex, or a total of approximately $745,000, to the asset

values as of March 31, 1983, see supra p. 33, which reflected the

changes in the values of the cash and Treasury bills, one arrives

at a figure of $7,835,000 as the indicated fair market value of

the assets transferred.

Comparing this figure with the $6,638,120 purchase price,

see supra p. 33, it is apparent that the sale price was almost

$1,200,000 less than the fair market value of the assets

acquired. This is a substantial amount in relation to the

purchase price and causes us to conclude that the $7,835,000

falls outside the upper limit of any reasonable range of fair

market values.9 We reach the same conclusion when one compares

the increase in the net worth of petitioner adjusted to take into

account the $300,000 additional liability to the pension funds,

with the similarly adjusted net worth reflected in petitioner's

September 30, 1981 balance sheet. This increase is $798,000 (not

8
We note that the Belcher Road property was sold on Feb.
15, 1985, for $375,000 and County Road #77 property on Mar. 15,
1985, for $1,500,000, or a total of $1,875,000. This would
indicate that our use of $1,046,000, which is over $800,000 less,
may unduly favor petitioner.
9
We note that the gap between sale price and asset value
would have been even greater if we had not resolved the $300,000
pension liability question in petitioner's favor.
 - 37 -

taking into account the further increase attributable to the

month ending April 30, 1983)10 which when added to the

aforementioned increase of $745,000 related to petitioner's real

estate produces a net increase of $1,543,000. Finally, we note

that, in addition to the likelihood of increased values for the

hospital complex land and the unimproved real estate, see supra

notes 7 and 8, we have not sought to include the values, if any,

attaching to the certificate of need for an additional 31 beds,

the enhanced value, if any, of petitioner, as a long-term

psychiatric hospital facility, attaching to the exemption of

psychiatric hospitals from the anticipated changes in Medicare

reimbursement standards which occurred later in 1983 but stemmed

from legislation antedating the May 1983 sale, or to the fact

that the hospital was resold in 1985 for some $29 million. We

also find it unnecessary to attempt to consider the impact of a

prohibition against sale for a 2-year period, which was present

10
Adjusted Net Worth (in thousands):

Adjusted Increase
Date Net Worth Over 9/30/81

9/30/81 $4,290
9/30/82 4,428 $138
3/31/83 5,088 798
4/30/83 5,225 935
 - 38 -

in the drafts but somehow was omitted in the final purchase and

sale agreement.

Under the foregoing circumstances, we find it unnecessary to

engage in any detailed analysis of the report of petitioner's

expert, Mr. Mard, who arrived at a fair market value of

$6,588,000, approximately $200,000 more than petitioner reported

as the purchase price on its Form 990 for the fiscal year ended

September 30, 1983. We think it appropriate to note, however,

that we examined his report and testimony sufficiently to

conclude that his analysis would probably require adjustment

which would produce a fair market value of at least $7 million,

an amount not insignificantly in excess of the $6.638 million

purchase price we have accepted and an even greater excess over

the $6.338 million figure shown on petitioner's above-mentioned

Form 990.

The long and the short of the matter is that the

negotiations between Mr. O'Donnell and Mr. Rosenkranz were

fatally flawed because of their apparent failure to take into

account the obvious and substantial adjustments to Mr.

Sheldrick's appraisal as of September 30, 1981, in respect of

changes between that date and March 31, 1983.11 Petitioner's

11
The record contains numerous indications of such failure
either directly or inferentially from their inability to recall
significant aspects of the May 1983 sale. One example is
(continued...)
 - 39 -

effort to avoid this consequence by arguing that Mr. Sheldrick's

report satisfied the independent appraisal condition of

respondent's private letter ruling, see supra p. 7, is clearly

without merit. Nothing in that condition can be construed as

validating an appraisal which was more than 18 months old at the

time of the closing of the transaction to which the ruling

relates.

We hold that respondent has satisfied the burden of proving

that the May 1983 sale by petitioner to AMH resulted in a

prohibited inurement and that petitioner was not an exempt

organization under section 501(c)(3) during the years at issue.

Exempt Activities for 1985 and 1986

Our holding makes it unnecessary to consider respondent's

alternative argument that, even if petitioner continued to be

exempt after October 1, 1982, it lost its exemption in fiscal

11
(...continued)
reflected in the following testimony of Mr. Rosenkranz with
respect to the Belcher Road and County #77 Road properties:

Q. Mr. Rosenkranz, did -- by the conclusion of this
transaction, did you satisfy yourself that the two parcels
of land, that component of this entire transaction, was
subsumed within the purchase price that was ultimately
agreed upon?

A. I have no recollection.

Q. One way or the other?

A. I have no recollection one way or the other.
 - 40 -

1985 and 1986 because the major portion of its expenditures

during those years, namely, payments to FPCF and to AMH for

patient care, constituted prohibited inurement to the board

members. Petitioner also treats respondent's argument as an

alternative and does not ask us to grant it exempt status during

the aforesaid years if we conclude, as we do, that it lost such

status at an earlier date. In this connection, petitioner points

out that this issue is subsumed in the issues involved in docket

No. 27403-92X wherein petitioner filed a petition, in response to

respondent's action in respect of its request for exempt status

after October 1, 1983, seeking a declaratory judgment that it was

exempt in the years after the sale.

We now turn to the question of whether petitioner, as a

taxable entity during the years at issue herein, is entitled to

certain deductions in computing its taxable income. These

deductions are for amounts due FPCF, for grants to organizations

and patient care and for a claimed net operating loss

carryforward from its 1983 fiscal year.

FPCF

Petitioner had contingent liabilities to the FPCF at various

times during its fiscal year 1983 and subsequent taxable years

with respect to its hospital activities prior to the May 1983

sale. The deductibility of those liabilities to the extent that

they became fixed or paid during the years is at issue herein.
 - 41 -

First, respondent seems to argue that petitioner is not

entitled to any deduction because it was no longer in the

hospital business to which the expenses attached at the time of

payment or accrual. This position is without merit. It has long

been established that, if an expense relates to a trade or

business, a taxpayer is still entitled to a deduction for payment

in a later year even though the taxpayer is no longer engaged in

that trade or business. Dowd v. Commissioner, 68 T.C. 294, 301

(1977); Burrows v. Commissioner, 38 B.T.A. 236, 238 (1938).

Second, given that the FPCF payments related back to

petitioner's hospital business prior to May 1983, what is the

impact of the fact that, at that time, petitioner was exempt

under section 501(c)(3)? Respondent argues that this exempt

status precludes petitioner from claiming the deductions under

section 162(a) because such deductions are precluded by section

265(1),12 which denies deductions allocable to tax-exempt income

and, as provided in sections 161 and 261, has priority over

section 162(a). Petitioner's argument fails to take into account

12
Sec. 265(1) (now sec. 265(a)(1)) provides:

No deduction shall be allowed for--

(1) Expenses.--Any amount otherwise
allowable as a deduction which is allocable to one
or more classes of income other than interest
(whether or not any amount of income of that class
or classes is received or accrued) wholly exempt
from the taxes imposed by this subtitle * * *
 - 42 -

the tax-exempt status of petitioner during the periods to which

the FPCF expenses relate and completely ignores section 265(1).

Petitioner's position is, to say the least, curious. On the

one hand, it utilizes the relation-back argument in order to

relate the FPCF liabilities to its earlier income-producing

hospital activities since its activities during the years at

issue could not be considered a trade or business within the

meaning of section 162(a). On the other hand, it rejects any

relation back to take into account that the income produced by

its hospital activities was exempt from tax because of its

section 501(c)(3) status. This it may not do.

We are satisfied that the FPCF liabilities are allocable to

petitioner's hospital income in the periods prior to the sale of

the hospital and that section 265(1) applies. That being the

case, the fact that those payments might have been deductible

under section 162(a) had petitioner's hospital business produced

taxable income becomes irrelevant since section 265(1) prevails

over section 162(a) by disallowing deductions falling within its

ambit which are "otherwise allowable". See supra note 12; see

also Stroud v. United States, 906 F. Supp. 990, 996 (D.S.C.

1995), affd. in part and vacated in part without published

opinion 94 F.3d 642 (4th Cir. 1996); Rickard v. Commissioner, 88

T.C. 188, 193-194 (1987). The fact that the nontaxability of the

hospital income derived from petitioner's status rather than from
 - 43 -

the character of the income as such does not prevent the

application of section 265(1). As we stated in Rickard v.

Commissioner, supra at 193-194, where the tax exemption attaching

to the taxpayer's farm income derived from his status as an

Indian and the location of the farm on Indian land:

The legislative purpose behind section 265 is
abundantly clear: Congress sought to prevent taxpayers
from reaping a double tax benefit by using expenses
attributable to tax-exempt income to offset other
sources of taxable income. Manocchio v. Commissioner,
78 T.C. 989, 997 (1982), affd. 710 F.2d 1400 (9th Cir.
1983). More importantly, the Supreme Court has
concluded that Congress intended to limit deductions to
those expenses related to taxed income. Rockford Life
Insurance Co. v. Commissioner, 292 U.S. 382 (1934).
* * * [Fn. refs. omitted.]

Nor is it relevant that the tax-exempt income to which FPCF

relates was earned by petitioner in an earlier year. In Stroud

v. United States, supra, the taxpayer was denied a deduction for

amounts paid in the taxable year because of a breach of contract

to provide medical service in return for a tax-exempt scholarship

received in an earlier year.

We hold that the FPCF payments in question are not

deductible.

Grants to Organizations and for Patient Care

Respondent disallowed further deductions for petitioner's

grants to charitable organizations because of the limit contained

in section 170(b)(2), which provides that a corporation's

deductions for charitable contributions may not exceed 10 percent
 - 44 -

of the taxpayer's taxable income. Petitioner does not dispute

the 10-percent limitation if we sustain the revocation of its

tax-exempt status. Respondent also disallowed the grants for

patient care on the basis that the patients were not eligible

donees as specified in section 170(c). We agree with respondent

that the grants for patient care are not eligible charitable

contributions. Petitioner's reference to Rev. Rul. 56-304, 1956-

2 C.B. 306, which provides the basis for allowing section

501(c)(3) organizations to distribute funds to individuals, is

misplaced. That ruling assumes that the taxpayer is tax exempt,

which is not the case during the taxable years involved herein.

Thus, we sustain respondent's determination of the amounts

allowed for charitable deductions.13

Net Operating Loss Carryover From 1983

At the outset, we note the facts that the taxable year 1983

is not before us or that it may be a barred year do not preclude

us from considering that year for carryforward to the taxable

years at issue herein. See Hill v. Commissioner, 95 T.C. 437,

440 (1990).

13
For 1985, petitioner reported grants to organizations as
$145,073 and to individuals as $550, whereas the parties agree
that petitioner gave $700 to organizations and $138,521.97 for
patient care. Since respondent has not requested an increase in
the deficiency, we sustain the amounts respondent originally
allowed.
 - 45 -

Petitioner argues that it should be allowed a net operating

loss carryforward from 1983 of $706,522. Respondent argues that

petitioner has no loss for 1983 because: (1) the $1,427,297 loss

reported on the sale of the hospital was a capital loss, the

deduction of which is limited to capital gain under section

1211(a), or zero in this case, and (2) the $354,580 FPCF expense

is not deductible. In the alternative, if any loss is allowable

on the hospital sale, respondent points out certain discrepancies

between the amounts used to calculate the loss on the sale as

reported on the return and those on petitioner's earlier

financial statements. Petitioner's response to respondent's

capital loss limitation argument is that the assets of the

hospital must be analyzed separately to determine their nature as

capital or ordinary items. Having made that analysis, petitioner

then allocates the sales price among those assets in order to

measure the extent of its deductible loss. Petitioner recognizes

that capital losses can only be carried forward against capital

gains. See sec. 1212(a)(1). As a result, petitioner will not

benefit from any portion of its claimed loss which is a capital

loss because it had no capital gains during the taxable years

before us.

The sale of a business involves the sale of its assets. The

nature of its assets determines the nature of the gain or loss.

The purchase price must be allocated among the assets sold based
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on their fair market value and then the gain or loss on the

individual assets determined. Other than the assets of cash and

Treasury bills, the record before us contains little information

with which to ascertain the fair market value of the individual

assets. In this connection, we note that any such allocation

would require us to determine specific fair market values in

contrast to the range standard which we were able to apply in

respect of the inurement issue.

Petitioner's allocation of the purchase price has several

defects, one of which is that it is based upon book values of

assets rather than fair market values. In any event, we have

increased the purchase price, and therefore decreased

petitioner's loss by $300,000 representing obligations to

petitioner's pension plans assumed by AMH. We have also

determined that the FPCF expenses are not deductible in the post-

1983 years, and the same reasoning applies to the $354,580

reported as an FPCF item on the Form 990 for fiscal 1983. These

two adjustments total $654,880 and reduce petitioner's claimed

loss to $51,942. We are satisfied that a sufficient portion of

the loss on the sale of the hospital would be capital so as to

eliminate any remaining loss, if there was a loss at all.

Regardless, petitioner has not met its burden of proving, see

supra p. 21, that it had a net operating loss for 1983.
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In keeping with the above holdings,

Decision will be entered

for respondent.