This post was originally published on Forbes May 18, 2015
The Tax Court decision in the case of Coastal Heart Medical Group, Inc and Doctor Anil V. Shah is a tax geek's dream covering complicated issues combined in a convoluted manner. It is not nearly as interesting as the related story which includes a physician being framed with a planted gun and drugs.That story is in a decision of the Fourth Appellate District of the State of California - Michael W. Fizgibbons V Integrated Healthcare Holdings Inc. The latter sheds some light on the non-tax issues that Doctor Shah was facing.
The dollars in the case were pretty substantial - just over $400,000 including penalty from Coastal for the years 2004 through 2007 and just shy of $400,000 for Doctor Shah and his spouse for the years 2004 through 2008. Doctor Shah and Coastal managed to come out on the wrong side of the lease purchase rules and the passive activity loss rules. There were issues with partnership basis. There was also a deemed dividend, although that was peanuts.
Lease Purchase Whatever
The lease purchase and basis problems related to a cardiac CT scanner leased from Siemens Medical Solutions USA Inc. with a bargain purchase provision at the end of the lease's 60 month term. Coastal Heart paid $4,000 to Zabala Custom Constructions to make alterations to accommodate the scanner. Dr. Shah formed Coastal Imaging a limited liability company to manage the scanner with two others. He claimed a $291,985 loss from Imaging on the theory that his guaranty of the lease gave him basis. The IRS disallowed the loss because they were not provided with a copy of the guaranty. They also dinged Dr. Shah with a $4,000 deemed dividend because of the construction work. Maybe Dr. Shah has a good reason for running his practice as a C corporation, but it cost him a few bucks there.
One of my mentors in public accountant once gave me some advice about the lease or buy issue. It is dated, because back in the day there was an investment credit. He said he once went through the analysis in depth considering all the factors. After that whenever a client called him to ask about a lease buy decision, he would tell him to buy and charge him a hundred dollars. (Back in the day a hundred dollars, was , you know, a hundred dollars.) When you lease you get to deduct whatever you pay throughout the term of the lease. When you buy you take depreciation deductions over the life of the property and deduct the interest payments as they occur. You don't deduct the principal payments (Although you do in a sense, because of your depreciation deductions). It ends up being about timing.
Dr. Shah, however, seems to have taken a unique view. He had Coastal Heart Medical deducting the lease payments while Coastal Imaging was taking depreciation deductions. It was very confusing and straightening it out would be like unscrambling an egg. It seems like the plan was to have a big bonus depreciation pass to Dr. Shah in 2004. It ended up not working out because of a violation of Reilly's Fourth Law of Tax Planning - Execution isn't everything but it's a lot. It was Coastal Heart Medical that entered into the lease not Imaging.
It would seem that the way to straighten this out would be to just forget about Imaging, which never seems to have done anything other than claim a depreciation deduction it was not entitled to, but instead it seems that all the operating expenses claimed by Coastal Heart are also being disallowed. Since Imaging never received the scanner it would seem that the constructive dividend for the construction should not have stuck, but it did.
It really seems that Dr. Shah and Coastal got whipsawed on the scanner. [See Note] The lesson here is to have your transactions follow the structure that you have set up.
Integrated Healthcare Holdings Inc
This is the part of the case that is much more interesting, more because of the surrounding circumstances than the tax issue. In 2004 Tenet Healthcare decided to sell four hospitals in Santa Ana (The Tax Court has it as "Tenant" rather than "Tenet"). Physicians in the area were very concerned about a Dr. Kali Chaudhuri who was going to be one of the lead investors, so, as described in the story, they organized under Dr. Shah's leadership to participate in the deal through Orange County Physicians Investment Network LLC.
Dr. Anil Shah said his group, Orange County Physicians Network, would at least match the $20-million pledged by Dr. Kali P. Chaudhuri toward buying the hospitals, which are considered critical to the county's emergency healthcare system. The facilities handle a quarter of the county's emergency room visits and house one of its three trauma centers.
There ended up being a lot of drama as Dr. Shah found himself at odds with Bruce Mogel, the CEO of Integrated Healthcare Holdings Inc., the acquiring entity that Dr. Shah's physicians group had a stake in. Doctor William Fitzgibbons who had been critical of IHHI sued Bruce Mogel and IHHI for attempting to frame him
The infectious disease specialist was arrested and handcuffed in the employee parking lot at Western Medical Center – Santa Ana after police found a handgun and a pair of black gloves in his car. Police questioned him and searched his car after receiving two anonymous 911 calls claiming that a man driving Fitzgibbons' car had waved a gun in traffic.
In the trial testimony Mogel was quoted as having been capable of having someone do extremely nasty things to Dr. Shah. Nasty enough that I'm going to have to make you go read the decision in the Fitzgibbons case if you really want to know.
IHHI deregistered with the SEC in January 2014. According to its last 10-K for the year ended March 31, 2013 Doctors Shah and Chaudhuri and Dr. Shah's group Orange County Physicians Investment Network LLC were all still major shareholders. Because of a previous favorable ruling, BDO Seidman let the company reverse the contingent liability of five million plus to Doctor Fitzgibbons. Oops.
Doctor Shah The Real Estate Professional
When the hospital operations were acquired from Tenet by IHHI, the real estate was carved out into a different entity - Pacific Coast Holdings Investment LLC. Dr. Shah and the other physicians participated in that entity through West Coast Holdings LLC. Dr. Shah managed West Coast and comanaged Pacific Coast.
Thereafter, PCHI leased the hospital properties purchased from Tenant to several different hospitals. Because the leases to these hospitals were “triple-net leases”, the hospitals themselves were responsible for routine maintenance and repairs, not PCHI. Instead, Dr. Shah's duties as a comanager for PCHI during the years at issue were negotiating leases with the other hospitals, dealing with lawsuits pertaining to the transactions, and avoiding bankruptcy. Dr. Shah also spent time finding investors for the hospitals, refinancing loans used for the purchase of the hospitals, and obtaining guaranties on two properties that PCHI rented instead of owned.
"Avoiding bankruptcy" - that's generally a good thing.
Dr. Shah also managed RPS, LLC where Coastal Medical operated. The Court also concluded that since IHHI was engaged in hospital acquisition and management it qualified as a real property trade or business.
In order not have real estate losses suspended, Dr. Shah needed to establish himself as a real estate professional, which means he had to spend more time on his real property businesses than his other businesses - you know, like being a physician. At this point he strikes me as the proverbial one-armed paper hanger. God bless him. The Tax Court did not have as much sympathy for him. Like countless would-be real estate professionals before him his lack of detailed time records proved fatal with the court not crediting his "ballpark guesstimates".
At trial Dr. Shah testified that he spent 14 to 16 hours a day, seven days a week in 2004 on negotiating the purchase of several hospitals. He further testified that he worked over 1,000 hours in 2005 and 2006 negotiating leases for the hospitals, finding investors for PCHI, West Coast, and IHHI, and refinancing loans related to the purchase of the hospitals. Although the regulations permit some flexibility concerning the records to be maintained by taxpayers, the Court is not required to accept a postevent “ballpark guesstimate” or the unverified, undocumented testimony of taxpayers. Dr. Shah's testimony appears to be exaggerated and self-serving. On the basis of that testimony we cannot determine with any clarity how many hours Dr. Shah devoted to each entity for which he performed personal services. Dr. Shah did not distinguish the number of hours he spent finding investors for West Coast, a non-real-property trade or business, from the total number of hours he claimed. Furthermore, the Shahs did not describe with any specificity the number of hours they spent performing services for RPS, a legitimate rental real estate trade or business. We decline to accept Dr. Shah's vague testimony regarding the maze of businesses he performed personal services for without adequate documentary support.
I think Dr. Shah may have gotten a really raw deal on the CT scanner, but the lesson there is probably that C corporations are not a good way to run professional practices anymore. The real estate pro argument was probably hopeless although I was surprised that IHHI would qualify as a real estate company. At least those deductions are not lost forever.
The drama reminds me that I have never seen it work out well when professional services are run through the mechanisms of finance capitalism. It also gives me a little more insight into what prevents people from achieving really good execution on their tax plans. Other things on their minds.
I picked up on the related story of Dr. Fitzgibbons from an editorial by Dr. Lawrence Huntoon in the Journal of American Physicians and Surgeons. Dr. Huntoon was kind enough to point me to the recent appellate decision.
Lew Taishoff focused on the lease purchase aspect of the case. I should mention here that Lew Taishoff's blog is very underappreciated. He pretty much exclusively covers the Tax Court decisions and is pretty thorough. I've gotten over my resentment of him always getting to the cases before I do and have turned that into a feature rather than a bug.
Eric Kroh at Law360 focused on the passive activity loss aspect of the case.
Joseph Wilson, one of the lead attorneys in the case wrote to me to clarify some of the issues that I had not quite gotten right in my reading of the decision.
Essentially, you are correct in terms of the harsh position taken by the IRS, and “forgetting” about Imaging was a position pursued by the taxpayer and rejected by the IRS. Ultimately, the IRS was not settling for anything less than a whipsaw. However, the article is incorrect as to all the operating expenses claimed by Coastal Heart being disallowed. The Tax Court held that Coastal Heart, not Imaging, should have been allowed to claim the depreciation on the CT scanner. This was Coastal Heart’s position throughout the audit and the case proceeded to trial in large part on the IRS’s failure to allow the depreciation expense to be moved to Coastal Heart.
In trial and trial briefing, it was Coastal Heart that sought the finding that the CT scanner had not been contributed to Imaging and that the depreciation expense should be moved to Coastal Heart. With the Tax Court’s holding, the depreciation of the CT Scanner by Coastal Heart will have to be included in the Rule 155 computation in determining the ultimate tax liability of Coastal Heart, which amount will be significantly less than proposed by the IRS. Thus, though it may not appear so on first glance, the outcome of this case is a victory for Coastal Heart on a primary issue.
I was pleased to learn that the Tax Court had not been as harsh with Dr. Shah as it appeared. Mr. Wilson also gave some more insight about IHHI.
You further wrote “Dr. Shah found himself at odds with Bruce Mogel, the CEO of Integrated Healthcare Holdings Inc.,” which is certainly all true. It should further be noted that Dr. Shah won the lawsuit involving these parties and settled for extremely favorable terms in his favor in 2014.