Third Circuit addresses burden of proof in valuing intangibles.

• Author: Magin, Elizabeth

In Capital Blue Cross, 3d Cir., 12/5/05, rev'g in part and remd'g 122 TC 224 (2004), the Third Circuit held that the Tax Court erred in assigning a zero basis in hundreds of terminated insurance contracts issued by Capital Blue Cross (Capital).The appellate court concluded that minor flaws in a taxpayer's valuation were insufficient to reject the valuation completely.

Valuing Intangibles

Although this case arose because of facts related to the 1986 statutory transition of Blue Cross Blue Shield (BCBS) organizations from tax free to taxable, the decision has consequences beyond such entities and their insurance contracts. The Third Circuit's discussion applies more broadly, to the valuation of intangible assets in general and the taxpayer's burden of proving valuation. The court addresses the issue in light of Newark Morning Ledger Co., 507 US 546 (1993), in which the Supreme Court allowed depreciation deductions for a newspaper company's paid subscriber base.

This item discusses the facts of Capital Blue Cross and the decision's significance as to the broader valuation issue. Accordingly, the facts discussed are only those needed for a full understanding of that issue.

Facts

BCBS organizations were not subject to Federal income tax until 1987. The Tax Reform Act of 1986, Section 1012, eliminated their tax exemption and provided that such organizations could take a stepped-up basis in their assets based on each asset's fair market value (FMV) on Jan. 1,1987 (the fresh-start basis rule).

On that date, Capital had more than 23,000 group health insurance contracts outstanding, covering more than 12,000 insured groups. The contracts automatically renewed on a month-to-month or annual basis, unless cancelled. At that time, Capital was the leading health insurance provider in its geographical area; alternatives to BCBS (such as health maintenance and other organizations) were not yet widespread, but were developing in importance.

Capital did not apply the fresh-start basis rule to its insurance contracts in 1987. In 1995, however, it obtained a valuation of the contracts it had as of Jan. 1, 1987, and on its 1994 tax return claimed a $2.6 million loss deduction under Sec. 165 for group contracts cancelled in 1994. Capital also filed amended returns for 1991-1993, claiming loss deductions for the contracts cancelled during those years.

The IRS disallowed the claimed deductions in full, determining that Capital failed to establish that it incurred...