Court Opinion

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Opinions of the United
2005 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit

12-5-2005

Cap Blue Cross v. Commissioner IRS
Precedential or Non-Precedential: Precedential

Docket No. 04-2645

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                                          PRECEDENTIAL

          UNITED STATES COURT OF APPEALS
               FOR THE THIRD CIRCUIT

                         No. 04-2645

       CAPITAL BLUE CROSS AND SUBSIDIARIES,

                                       Appellant

                             v.

        COMMISSIONER OF INTERNAL REVENUE

         On Appeal from the United States Tax Court
                 (Agency No. 13322-01)
                  Judge Stephen J. Swift

                 Argued April 20, 2005
  Before: ROTH, FUENTES, and BECKER, Circuit Judges.

                  (Filed: December 5, 2005)

PETER H. WINSLOW (ARGUED)
SAMUEL A. MITCHELL
Scribner, Hall & Thompson, LLP
1875 Eye Street, N.W., Suite 1050
Washington, D.C. 20006-5409
Attorneys for Appellant

EILEEN J. O’CONNOR
Assistant Attorney General
JONATHAN S. COHEN

                              1
STEVEN W. PARKS (ARGUED)
Tax Division
United States Department of Justice
P.O. Box 502
Washington, D.C. 20044
Attorneys for Appellant

ALAN I. HOROWITZ
FREDERICK W. ROBINSON
MARIA O’TOOLE JONES
Miller & Chevalier, Chartered
Suite 900
655 15th Street, N.W.
Washington, D.C. 20005-5701
Attorneys for Amicus Curiae Blue Cross and Blue Shield
       Association

                             OPINION OF THE COURT

BECKER, Circuit Judge.

                                Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

II. Facts and Procedural History . . . . . . . . . . . . . . . . . . . . . . . . 4
        A. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
        B. Initial Taxation of Blue Cross Blue Shield Entities . . 5
        C. Capital’s Contracts in 1987 . . . . . . . . . . . . . . . . . . . . 6
                1. Premium structures . . . . . . . . . . . . . . . . . . . . . 6
                2. Renewals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
                3. Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
        D. The Present Controversy . . . . . . . . . . . . . . . . . . . . . . 8

III. Deductibility of Losses on Health Insurance Contracts . . . 10
       A. The Blue Cross Blue Shield Fresh Start Basis Rule

                                             2
                 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
         B. Deductibility of Non-Sale Losses by Blue Cross
               Blue Shield Organizations . . . . . . . . . . . . . . . . . 12
         C. Are the Insurance Contracts Mass Assets? . . . . . . . 13

IV. Burden of Proof of Deduction Amounts . . . . . . . . . . . . . . 16
      A. Who Bears the Burden of Proof? . . . . . . . . . . . . . . . 17
      B. Proof of Separate Valuation . . . . . . . . . . . . . . . . . . . 19

V. Capital’s Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       21
      A. The Reinsurance Model . . . . . . . . . . . . . . . . . . . . . .                 22
              1. Highest and best use . . . . . . . . . . . . . . . . . . .                22
              2. Separate values . . . . . . . . . . . . . . . . . . . . . . .             23
              3. The goodwill adjustment . . . . . . . . . . . . . . . .                   26
      B. Specific Contract Characteristics . . . . . . . . . . . . . . .                   27
      C. Lapse Rates and “Lifing Analysis” . . . . . . . . . . . . .                       30
              1. Prospective changes in the market . . . . . . . . .                       31
              2. Human factors . . . . . . . . . . . . . . . . . . . . . . . .             34
              3. The Commissioner’s lifing arguments . . . . . .                           35
      D. The Commissioner’s Objections . . . . . . . . . . . . . . .                       36
      E. Summary and Conclusions . . . . . . . . . . . . . . . . . . . .                   36

                                   I. Introduction

        Capital Blue Cross (“Capital”) appeals from a decision of
the United States Tax Court denying its request for a refund of
overpayment of taxes for tax year 1994. Capital claims that it
properly established a basis in hundreds of insurance contracts that
were terminated in that year, and that it is therefore entitled to take
a loss deduction under 26 U.S.C. § 165 to account for the
cancellation of those contracts. The Tax Court found that Capital
had not established its basis in those contracts; it therefore treated
Capital’s basis as zero and denied any deduction.
        We agree with Capital that the Tax Court improperly
discounted expert testimony that tended to establish Capital’s basis
in the disputed contracts, and that the zero basis found by the Court
was inconsistent with the facts and hence clearly erroneous. Capital
engaged in an extensive and professional valuation process in order
to calculate its basis in the lost contracts. While the Tax Court

                                              3
correctly found that the Commissioner of Internal Revenue (“the
Commissioner”) established several flaws in Capital’s valuation,
overall, we are convinced that Capital’s process was thorough and
professional, and that it arrived at an essentially reasonable
valuation for the cancelled contracts. Given these conclusions, we
are unwilling to affirm the Tax Court merely because we find some
flaws in Capital’s valuation process. Instead, we will reverse and
remand for further proceedings.
        We leave it to the Tax Court to find the correct valuation for
Capital’s contracts. On remand, the Commissioner may again press
his objections to Capital’s methods, and the Tax Court may
consider those objections in arriving at a final valuation. But the
existence of some problems in Capital’s valuation process will not
justify finding a zero basis in the lost contracts. Instead, the Tax
Court must do its best to calculate a reasonable and correct basis;
the Commissioner can best assist the Court by raising specific and
quantifiable objections to Capital’s valuation, and by proposing
alternative methods that will lead to what, in his submission, would
be a more reasonable valuation. Thus far, the Commissioner has
pointed to alleged flaws in the valuation methodology without
explaining or quantifying how they impacted the bottom-line
calculation, and without offering any alternatives. We conclude
that, on the facts before us, such a procedure is insufficient to reject
Capital’s claimed deductions.

                II. Facts and Procedural History

                           A. Introduction

        As suggested above, this case concerns the procedures under
which Blue Cross Blue Shield organizations may take loss
deductions for terminated subscriber contracts. Since Blue Cross
Blue Shield organizations became taxable in 1986, this issue has
slowly grown in importance. It has only recently reached the
attention of the courts and the Internal Revenue Service (“IRS” or
“the Service”). The Service has

       inform[ed] Blue Cross Blue Shield insurance
       organizations that the Service will challenge
       deductions for losses that relate to the termination of

                                   4
       individual customer, provider, or employee contracts
       or relationships associated with customer lists,
       provider networks, and workforce in place with
       respect to which the taxpayer claims an adjusted
       basis derived from section 1012(c)(3)(A)(iii) [sic] of
       the Tax Reform Act of 1986.

I.R.S. Notice 2000-34, 2000-2 C.B. 172.
        We are the second Article III court to consider the
deductibility of these losses. The first case was Trigon Insurance
Co. v. United States, 215 F. Supp. 2d 687 (E.D. Va. 2002), which
found for the Commissioner and disallowed the deductions. The
court ultimately held that the taxpayer—Trigon, a successor to two
Blue Cross Blue Shield insurers—had not established the 1987 fair
market value of its insurance and provider contracts and was
therefore not entitled to a deduction. The decision has not been
appealed, and our analysis will be guided in part by Judge Payne’s
thorough opinion. Since Trigon, the IRS has reaffirmed and
clarified the position of Notice 2000-34 in a Coordinated Issue
Paper dated May 27, 2005. See 2005 WL 1412148 (I.R.S.).

      B. Initial Taxation of Blue Cross Blue Shield Entities

        Capital Blue Cross is a Blue Cross Blue Shield organization
that sells health insurance to individuals and groups in central and
northeastern Pennsylvania. It was founded in 1938, became a Blue
Cross organization in 1972, and became a Blue Cross Blue Shield
licensee when Blue Cross and Blue Shield merged in 1982.
        Historically, Blue Cross Blue Shield organizations were not
subject to federal income taxes. In 1986, the Congress, concerned
that this gave Blue Cross Blue Shield organizations an unfair
competitive advantage over other for-profit insurers, eliminated the
tax exemption effective January 1, 1987. See Tax Reform Act of
1986, Pub. L. No. 99-514, § 1012, 100 Stat. 2085, 2390-94
(codified at 26 U.S.C. §§ 501(m) & 833). When Blue Cross Blue
Shield entities became taxable, they needed to have a way to
determine their tax basis in their assets. Congress therefore
provided that Blue Cross Blue Shield organizations could take a
basis step-up in their assets, so that their tax basis in each asset
would be its fair market value (“FMV”) on January 1, 1987. Tax

                                 5
Reform Act of 1986, § 1012(c)(3)(A)(ii). This basis step-up is
sometimes called the “Fresh Start Basis Rule,” see Trigon, 215 F.
Supp. 2d at 691.

                 C. Capital’s Contracts in 1987

        On January 1, 1987, when Capital became a taxable entity,
it had 23,526 group health insurance contracts outstanding, as well
as a number of individual contracts. Many groups had entered into
multiple contracts with Capital; the 23,526 group contracts
represented a total of 12,579 separate insured groups.
        Under each of these group health insurance contracts,
Capital agreed to provide health insurance coverage to the
individual members of each group (typically the employees of a
company), and the group agreed to pay premiums. Individual group
members could elect the type of insurance benefit (individual,
single parent with dependents, or family) and coverage (basic
medical, basic hospital, major medical, or comprehensive) that they
wanted to receive.

1. Premium structures

       Each group was charged a total annual premium; the group
decided what portion of the premium was to be paid by the
employer and what was to be paid by the individual group
members. The premium for a group was determined in one of three
ways.
       Groups with fewer than one hundred individual members
were community-rated. Under community rating, premiums for a
particular type of coverage and benefit were based on the
cumulative claims history of all of Capital’s community-rated
contracts for that coverage/benefit. Claims experience for all
community-rated contracts in one year would serve as the basis for
the premiums on community-rated contracts in the following year.
Some 90 percent of Capital’s group contracts were community-
rated.
       Groups of over one hundred members had their premiums
determined based on their own claims experience, rather than on
the shared claims experience of multiple contracts. Thus, premiums
for each such group would be unique. Capital had two ways of

                                6
setting these premiums.
        In experience-rated contracts, total claims received from the
members of a group in one year would form the basis for the
premiums charged to that group in the following year. If an
experience-rated group paid premiums in one year that were
excessive relative to its claims, it could receive a “retrospective
refund” (cash) or a “retrospective credit” (credited against the next
year’s premiums). Experience-rated contracts made up over 60
percent of the total value of Capital’s contracts.
        Cost-plus-rated contracts were a variation on experience-
rated contracts; premiums for the following year were calculated
based on claims in the previous year plus Capital’s administrative
costs related to the group. Cost-plus contracts also had a
retrospective adjustment feature that would adjust premiums in a
given year to more closely match claims and administrative costs in
that year.
        The experience-rated and cost-plus rated contracts are, for
our purposes, basically identical. For convenience, we will
sometimes refer to the experience-rated and cost-plus-rated
contracts together as “separately-rated” contracts, as distinguished
from community-rated contracts whose premiums are determined
collectively.

2. Renewals

       Capital’s community-rated contracts were automatically
renewed (unless cancelled) on a month-to-month basis; its
experience-rated and cost-plus contracts were automatically
renewed on an annual basis. The Tax Court found that groups could
cancel their contracts at will: the customer group could just stop
paying the premiums, which would cause Capital to cancel the
contract. Capital’s CEO testified, however, that few contracts were
cancelled for that reason, and opined that Capital might have a
cause of action against a customer who simply stopped paying
premiums while still under a contract.
       Because premiums were adjusted every year, Capital could
typically expect to make money on most of its contracts, since it
was not locked into premium rates that might prove inadequate. But
Capital was not guaranteed a profit. A separately-rated contract
could build up a retrospective deficit (i.e., claims could be higher

                                 7
than premiums in a given year). Premiums would then be increased,
but if claims continued to increase faster than premiums, the deficit
could constantly increase. Because groups could essentially cancel
their contracts at will, and because Capital seems to have had no
claim against the group for any accumulated claims-based deficit
that was not paid, Capital could in fact lose money on any contract.
The Tax Court cited one example: the Pennsylvania Farmer’s
Union had experience-rated, retrospective contracts with Capital
that had a cumulative deficit of $700,000 in January 1988. By 1994,
the deficit had reached $4 million. Anxious to recoup this loss,
Capital proposed a 48% rate increase for the following year.
Pennsylvania Farmer’s Union rejected the rate increase and
terminated its contracts, leaving Capital to bear the $4 million loss.
3. Valuation
        From 1938 through 1986, when Capital was a tax-exempt
entity, it had never valued its group insurance contracts for tax
purposes. It also did not compute a cost basis for the contracts in its
financial records, as the contracts were self-created assets. When it
became taxable in 1987, Capital did not make any adjustments in
its tax books and records to reflect the basis step-up allowed by the
1986 tax changes. In fact, it did not make any such adjustments
until 1994; prior to that, its records did not reflect any basis in the
group contracts, and it claimed no § 165 deductions for any losses
on those contracts until that year.
        As of January 1, 1987, Capital was the leading health
insurance provider in its geographical area. Alternatives to Blue
Cross Blue Shield—such as health maintenance organizations
(HMOs), preferred provider organizations (PPOs), and other health
insurance products—were not nearly as widespread or important as
they are today. But they were developing in importance, and by
1987 Capital was facing increased competition from HMOs and
PPOs. Capital’s management was aware of this increasing
competition, and the company’s weakening future prospects, in
1987.

                    D. The Present Controversy

        As noted above, Capital did not take any steps to apply the
fresh start basis rule when it came into effect in 1987: its tax books

                                  8
did not reflect the stepped-up basis of its insurance contracts.1 This
changed in September 1995, when Capital filed its 1994 tax return.
This return claimed $2,648,249 of loss deductions for subscriber
groups who cancelled their insurance contracts with Capital. The
$2.6 million loss was based on a 1995 valuation by Deloitte &
Touche. The losses came from the 1994 cancellation of 376 of the
over 12,000 group contracts that Capital had owned in 1987. At
roughly the same time, Capital filed amended tax returns for 1991-
1993, claiming loss deductions for contracts cancelled during those
years.
        The Commissioner disallowed the deductions in a notice of
deficiency dated August 16, 2001. The notice stated a number of
theories under which the Commissioner rejected the deductions,
including (1) that “it has not been established that any abandonment
occurred during the taxable year, or that any loss was sustained”;
(2) that the customer contracts were “components of intangible
assets which constitute single indivisible assets”; and (3) that the
basis step-up applies only to sale or exchange losses, not to
abandonment losses.
        On November 13, 2001, Capital filed a petition in the United
States Tax Court challenging the Commissioner’s deficiency
determination. The petition claimed contract loss deductions for
1994 totaling $3,342,944. As the Tax Court correctly noted, Capital
did not explain why it now claimed this amount, rather than the
some $2.65 million claimed on its tax return. In preparation for
trial, Capital retained a valuation expert, Daniel McCarthy, who is
a member of the actuarial consulting firm Milliman USA and a
highly credentialed actuary.2 McCarthy calculated that Capital’s
basis in the contracts cancelled in 1994 was $3,973,022.94.

        1
        The record also does not reflect whether or when Capital took
a stepped-up tax basis in its tangible assets.
        2
        McCarthy has been a Fellow of the Society of Actuaries and a
Member of the American Academy of Actuaries since 1965. He has
served on the Board of Governors of the Society of Actuaries, on the
Actuarial Standards Board, and as President of the American Academy
of Actuaries. He concentrates his practice in health and life insurance
consulting and appraisal, and he has participated in at least fifty actuarial
appraisals of health and life insurance businesses.

                                     9
McCarthy also calculated values for contracts cancelled in other
years. Capital now claims deductions totaling over $37 million for
tax years 1991-2000, including the roughly $4 million for the 1994
tax year. While this case directly concerns Capital’s $4 million
claimed deduction for 1994, it will affect at least $37 million in
deductions for Capital.
        A trial was held in March and April of 2003 before Judge
Stephen J. Swift. Expert testimony was taken from McCarthy and
other experts for Capital and for the Internal Revenue Service
(hereinafter the “Service” or “IRS”). After trial, Judge Swift
entered a decision for the Commissioner, dated March 12, 2004.
See Capital Blue Cross v. Comm’r, 122 T.C. 224 (2004). The court
rejected the third theory in the Commissioner’s notice of deficiency
(that the basis step-up does not apply to § 165 losses), was
equivocal on the second (that the contracts were part of “indivisible
assets”), but agreed with the Commissioner that Capital had not
established any loss, and therefore upheld the disallowance of the
entire deduction. Capital timely appealed.
        The Tax Court had jurisdiction over Capital’s petition under
26 U.S.C. §§ 6213, 6214, 6512, and 7442. We have appellate
jurisdiction under 26 U.S.C. § 7482(a)(1). We have plenary review
over the Tax Court’s legal conclusions, and may set aside findings
of fact if they are clearly erroneous. Neonatology Associates, P.A.
v. Comm’r, 299 F.3d 221, 227 (3d Cir. 2002).

 III. Deductibility of Losses on Health Insurance Contracts

     Loss deductions are governed by § 165 of the Internal
Revenue Code, which provides in relevant part:

       (a) General rule.—There shall be allowed as a
       deduction any loss sustained during the taxable year
       and not compensated for by insurance or otherwise.
       (b) Amount of deduction.—For purposes of
       subsection (a), the basis for determining the amount
       of the deduction for any loss shall be the adjusted
       basis provided in section 1011 for determining the
       loss from the sale or other disposition of the property.

26 U.S.C. (hereinafter “I.R.C.”) § 165(a)-(b).

                                 10
       The main dispute in this case concerns the value of Capital’s
lost contracts, and who bears the burden of proving that value. But
we begin with more fundamental questions. First, is the
cancellation of valuable contracts a “loss” under § 165(a), such that
Capital is entitled to a deduction? Second, if so, what was Capital’s
basis in those contracts under § 165(b)? It is useful to begin with
the second question.

      A. The Blue Cross Blue Shield Fresh Start Basis Rule

        Normally, a taxpayer’s basis in an asset is the taxpayer’s cost
of acquiring that asset. I.R.C. § 1012; see also id. § 1011. A
taxpayer’s basis in a self-created customer asset—e.g., an insurer’s
basis in an insurance contract with its customers—will normally be
zero. The taxpayer may generally deduct the costs of acquiring the
asset (advertising, underwriting, etc.) when those costs are incurred,
but does not capitalize them into a basis in the asset. On the other
hand, an insurance company might have a cost basis in insurance
contracts that it purchased from another insurer. Its basis in such
contracts would be the purchase price.
        With respect to contracts written after 1987, Capital follows
these principles. Thus, the parties have stipulated that “for tax
accounting purpo ses beginning in 1987, Petitioner
expensed/deducted the cost of securing customer insurance
contracts in the year such expenses were incurred.” Capital would
thus have zero basis in self-created contracts acquired after 1987:
it deducts the costs of acquiring those contracts, and so has no cost
basis.
        However, with respect to the assets that it possessed on
January 1, 1987, Capital’s basis is not a cost basis but the fair
market value of those assets on that date. The basis step-up
provision for Blue Cross Blue Shield organizations states that, “for
purposes of determining gain or loss, the adjusted basis of any asset
held on the 1st day of [the taxpayer’s first taxable year beginning
after December 31, 1986] shall be treated as equal to its fair market
value as of such day.” Tax Reform Act of 1986, § 1012(c)(3)(A),
Pub. L. No. 99-514, 100 Stat. 2085, 2394. Capital’s tax year is the
calendar year, meaning that its basis in its pre-1987 assets should
be determined based on their fair market value on January 1, 1987.
        The purpose of the basis step-up provision was, as the Tax

                                  11
Court noted, “to prevent Blue Cross Blue Shield organizations from
being taxed on appreciation in the value of assets that had occurred
in pre-1987 years when the organizations had not been subject to
Federal income tax.” 122 T.C. at 234 (citing H. Conf. Rep. 99-841,
at II-350 (1986), 1986-3 C.B. (vol. 4) 1, 350). A Blue Cross Blue
Shield organization that bought a building for $10,000 in 1980, saw
its value increase to $50,000 in 1987, and sold it for $65,000 in
1990, would have taxable income of only $15,000. A typical
taxpayer in the same situation would have $55,000 in taxable
income on the sale, but Congress did not want to tax the Blue Cross
Blue Shield organizations for unrealized appreciation that occurred
before they became taxable.
        This basic understanding of Capital’s basis in its assets
raises several further questions. To that end, in Part II.B, we inquire
whether the basis step-up applies to § 165 losses, and in Part II.C,
we discuss its application to intangible assets like the insurance
contracts at issue here.

       B. Deductibility of Non-Sale Losses by Blue Cross
                  Blue Shield Organizations

        Congress’s intent in passing the basis step-up seems
primarily to have been to provide tax relief for gains on sales. But
basis is also used to calculate deductible losses when a taxpayer
sells an asset for less than its basis. The basis found under §§ 1011
and 1012 is also used in calculating deductions when the asset is
“lost” under § 165. Losses of assets used in business are deductible
under that section, as detailed in the regulations:

       A loss incurred in a business or in a transaction
       entered into for profit and arising from the sudden
       termination of the usefulness in such business or
       transaction of any nondepreciable property, in a case
       where such business or transaction is discontinued or
       where such property is permanently discarded from
       use therein, shall be allowed as a deduction under
       section 165(a) for the taxable year in which the loss
       is actually sustained.

Treas. Reg. § 1.165-2(a).

                                  12
        In the Tax Court, and in the notice of deficiency, the
Commissioner reasoned that the Blue Cross Blue Shield basis step-
up applied only to sales transactions, and not to § 165 loss
situations like the one presented here. See 122 T.C. at 234-35. He
cited to the legislative history of the Tax Reform Act of 1986,
which includes the statement that “The basis step-up is provided
solely for the purposes of determining gain or loss upon sale or
exchange of the assets, not for purposes of determining amounts of
depreciation or for other purposes.” Id. at 235 (quoting H. Conf.
Rep. 99-841, at II-349 to 350, 1986-3 C.B. (vol. 4) 1, 349-50).
        The Tax Court rejected this contention. Judge Swift found
that the statutory language unambiguously provides a basis step-up
for the purposes of determining any gain or loss, and therefore
declined to look to the legislative history to change the meaning of
an unambiguous statute. Id. at 236. He also noted that the policy
rationale behind the step-up applies in cases of § 165 losses. See id.
at 237. The Commissioner has not appealed this conclusion, and we
accept it. We note that it is in accord with the only other reported
decision on the question, Trigon, 215 F. Supp. 2d at 699-701.

          C. Are the Insurance Contracts Mass Assets?

        Before we turn to Capital’s disputed valuation, we address
another issue that was raised in the Tax Court but not pursued with
clarity on appeal. That is the question whether the contracts at issue
here were actually assets subject to § 165 losses at all. While the
Commissioner does not clearly raise this argument here, its
assumptions underlie many of his objections to Capital’s valuation.
        It seems to be agreed that these contracts are in fact assets,
in that each contract constitutes the right to a continuing stream of
future payments. See Trigon, 215 F. Supp. 2d at 696; cf. Newark
Morning Ledger Co. v. United States, 507 U.S. 546 (1993) (holding
that a newspaper subscription list was a depreciable asset); Union
Bankers Ins. Co. v. Comm’r, 64 T.C. 807 (1975), acq., Rev. Rul.
76-411, 1976-2 C.B. 208. While the Commissioner believes that
client groups may cancel their contracts at will, even an at-will
relationship may constitute a valuable asset if it is reasonably likely
to continue into the future. “[I]n valuing a contractual relationship,
it is appropriate to determine the useful life of a contract by taking
into account the likelihood of its renewal.” Trigon, 215 F. Supp. 2d

                                  13
at 715 (citing Union Bankers, 64 T.C. at 807; Super Food Servs. v.
United States, 416 F.2d 1236 (7th Cir. 1969)); cf. Newark Morning
Ledger, 507 U.S. at 550 n.4.
        The more difficult question is whether the contracts are part
of one or more “mass assets” or (synonymously) “indivisible
assets.” In his notice of deficiency, the Commissioner alleged that
Capital’s “specific individual customer contracts are components
of intangible assets which constitute single indivisible assets,
including customer-based intangibles.” This theory relies on the
hoary “mass asset rule,” which limits a taxpayer’s ability to deduct
losses of some intangible assets that are treated as mere components
of a larger, indivisible asset.
        “The mass-asset rule prohibits the depreciation of certain
customer-based intangibles because they constitute self-
regenerating assets that may change but never waste.” Newark
Morning Ledger, 507 U.S. at 558. While the Newark Morning
Ledger Court discussed depreciation of the entire mass asset, the
rule also prevents taxpayers from deducting the loss of individual
components of the mass, as those deductions would for most
practical purposes be equivalent to depreciation deductions. See
Sunset Fuel Co. v. United States, 519 F.2d 781, 783-84 (9th Cir.
1975).
        In Newark Morning Ledger, the Supreme Court allowed the
taxpayer to take depreciation deductions for its subscriber base,
finding that these “paid subscribers” “constituted a finite set of
subscriptions” and were not “composed of constantly fluctuating
components.” 507 U.S. at 567. This distinguished them from a mass
asset. The Court also cited Ithaca Industries, Inc. v. Comm’r, 97
T.C. 253 (1991) (Ithaca I), which denied a deduction for
“assembled work force,” finding that this force was a
nondiminishing asset and that “new employees were trained in
order to keep the ‘assembled work force’ unchanged, and the cost
of training was a deductible expense.” Newark Morning Ledger,
507 U.S. at 560 (citing Ithaca I, 97 T.C. at 271).
        In the wake of Newark Morning Ledger, the mass asset rule
is on somewhat uncertain footing. Indeed, if the subscription lists
in that case were not a mass asset, it is arguably difficult to see
what would be. The leading post-Newark Morning Ledger mass
asset case is Ithaca Industries, Inc. v. Comm’r, 17 F.3d 684 (4th
Cir. 1994) (Ithaca II), which affirmed the Tax Court’s judgment in

                                 14
Ithaca I. The Fourth Circuit framed the issue as follows:

       As the Court suggested in Newark Morning Ledger
       . . . the distinguishing feature of a true mass asset is
       its ability to be regenerated without substantial effort
       on the part of its owner, that is, its ability to “self-
       regenerate.” When an asset is maintained only by
       significant affirmative efforts to add new elements,
       these additions are most naturally understood as
       comprising something new and distinct from the
       original asset.

Ithaca II, 17 F.3d at 688. This test has been adopted by the Tax
Court. See Hardware Plus, Inc. v. Comm’r, 67 T.C.M. (CCH) 3045,
1994 WL 237350.
        Although the question is not without its difficulties, it
appears that Capital’s contracts do not constitute part of a single
indivisible asset. The Commissioner does not even contend that
Capital’s contract base is able to “self-regenerate.” See Ithaca II, 17
F.3d at 688. Instead, Capital must make “significant affirmative
efforts” to acquire new group contracts, id., although the costs of
these efforts are generally deductible, see Ithaca I, 97 T.C. at 271.
Moreover, the insurance contracts seem to be distinct in fact: each
contract has a unique economic value based on its claims history,
rate structure, group size, and other characteristics. We thus are
satisfied that these contracts are not a mass asset.3

       3
         The Commissioner presses a related argument, claiming that
Capital’s loss deductions in this case are merely a subterfuge for
claiming amortization or depreciation deductions: “seriatim loss
deductions claimed as individual contracts terminate are the functional
equivalent of depreciation deductions.”
        Section 167 of the Code allows deductions for depreciation and
amortization of certain assets with a limited useful life. The
Commissioner notes, however, that Blue Cross Blue Shield organizations
are not allowed to use their basis step-up for depreciation purposes. See
Tax Reform Act of 1986, § 1012(c)(3)(A)(ii), 100 Stat. at 2394.
        Capital, however, claims loss deductions, not depreciation
deductions. While the Commissioner argues that these deductions are in
a sense equivalent, there is no support for the Commissioner’s contention
that Capital’s aging of customer contracts must be effected by means of

                                   15
           IV. Burden of Proof of Deduction Amounts
        It appears, thus far, that Capital has at least a theoretical
right to take § 165 loss deductions when its group insurance clients

depreciation rather than deduction of individual cancelled contracts. The
Commissioner’s argument has some intuitive appeal because there is a
certain economic equivalence between the two procedures: assuming that
the contracts will be cancelled in a predictable pattern, an amortization
schedule based on that pattern would lead to roughly the same deductions
as would deducting each cancelled contract individually. We note in
passing that the Commissioner uses the word “depreciation,” although it
would appear that the correct word is “amortization.” See Newark
Morning Ledger, 507 U.S. at 571 n.1 (Souter, J., dissenting) (“Black’s
Law Dictionary tells us that intangible assets are amortized, while
tangible assets are depreciated.”). We treat the terms as interchangeable.
         We cannot find any legal basis on which to accept the
Commissioner’s theory. To the extent that his depreciation argument rests
on a theory that Capital’s contracts are a single indivisible asset, we have
rejected that theory in the text. To the extent that it is a factual argument,
it clearly fails: Capital has not attempted to take a depreciation deduction
in order to approximate the average annual loss of contracts; instead, it
has gone through the extraordinarily laborious exercise of counting
cancelled contracts and valuing each one.
         To the extent that the Commissioner claims that a taxpayer may
never take loss deductions when those deductions are economically
similar to disallowed depreciation deductions, the argument is novel and
unsupported. Instead, the regulations specifically provide that taxpayers
may take a § 165 deduction for the loss of nondepreciable property. See
Treas. Reg. § 1.165-2(a). A § 165 loss is sustained where the loss is
“evidenced by closed and completed transactions, fixed by identifiable
events, and . . . actually sustained during the taxable year.” Treas. Reg.
§ 1.165-1(b). This requirement distinguishes § 165 losses from § 167
amortization: a § 165 loss requires “some step that irrevocably cuts ties
to the asset,” Corra Res., Ltd. v. Comm’r, 945 F.2d 224, 226-27 (7th Cir.
1991), and a § 165 “loss is not sustained and is not deductible because of
mere decline, diminution or shrinkage of the value of property,” A.J.
Indus., Inc. v. United States, 503 F.2d 660, 664 (9th Cir. 1974). Here, an
identifiable event—a customer’s cancellation decision—has severed
Capital’s control over each of its lost contracts. These losses are in form
and function § 165 abandonment losses, and may not be characterized as
mere amortization deductions.

                                     16
cancel contracts that were in force on January 1, 1987.
Furthermore, Capital’s basis in each of these contracts—and thus
the amount of each deduction—is equal to the fair market value of
each contract as of January 1, 1987. That said, the calculation of
this fair market value is difficult and hotly disputed, as is the
question who bears the burden of proof.

                A. Who Bears the Burden of Proof?

        The burden of proof in a Tax Court case is on the petitioner,
but the Commissioner bears the burden of proof “in respect of any
new matter.” Tax Ct. R. 142(a)(1). The Tax Court placed the
burden of proving the contracts’ value on Capital. See 122 T.C. at
246 n.11.
        Capital, however, contends that the Tax Court should have
shifted the burden of proof to the Commissioner, because “the
Notice of Deficiency did not raise the issue of Capital’s valuation,”
or in the alternative because the notice “was arbitrary for finding no
value.”
        The first of these contentions is based on the fact that the
notice denied that Capital had established “any” loss. Capital claims
that the dispute over its specific valuation is therefore “new matter”
within the meaning of Rule 142. The Tax Court found that the
notice’s “broad language relating to whether Petitioner sustained
‘any loss’ . . . includes the factual valuation issue.” 122 T.C. at 246
n.11. We agree with the Tax Court: the notice of deficiency
challenging Capital’s entire deduction necessarily raised the
valuation issue at the heart of that deduction.
        Capital’s more compelling contention is that the
Commissioner’s initial notice of deficiency denying any deduction
was per se unreasonable. In deficiency cases brought in Tax Court,
the petitioner may shift the burden of proof to the Commissioner if
it can prove that the Commissioner’s assessment is “arbitrary and
excessive.” Helvering v. Taylor, 293 U.S. 507, 515 (1935). Even
the Commissioner’s experts agree that these contracts had some
value. Therefore, Capital argues, it has demonstrated that the
Commissioner’s zero-deduction position is unreasonable, and so the
burden shifts to the Commissioner to prove the correct amount of
the deductions.
        Taylor, however, concerned the apportionment of income,

                                  17
not the calculation of deductions. Indeed, the Taylor Court stated
in dictum that “the burden is upon the taxpayer to establish the
amount of a deduction claimed,” even where the Commissioner’s
position is unreasonable. Id. at 514.
        We have applied Taylor to deduction claims in
circumstances closely analogous to this case. In R.M. Smith, Inc. v.
Comm’r, 591 F.2d 248 (3d Cir. 1979), the Commissioner disputed
the amount that the taxpayer could deduct for amortization of
certain patents. The taxpayer’s basis for deductions depended upon
the fair market value of the patents at the time they were acquired.
The taxpayer and the Commissioner put forward widely varying
calculations of this fair market value; the Tax Court, rather than
choosing one or the other, split the difference and entered a
judgment based on its own valuation. The taxpayer appealed,
arguing that (1) once it had proven that the Commissioner’s
valuation was “unduly pessimistic,” the burden shifted to the
Commisssioner, and (2) because the Tax Court rejected the
Commissioner’s valuation, it was required to accept Smith’s
valuation . We agreed with the first of these contentions:

       Smith states that it had the burden of proving that the
       Commissioner’s determination of the gross values,
       which initially amounted to $10,000, was arbitrary.
       Having established that the calculation was in error,
       Smith was not required to prove the correct figure.
       The Commissioner had the burden of establishing the
       proper valuation and thus the actual tax owed. This
       much is an accurate statement of the law.

Id. at 251 (citing Taylor, 293 U.S. 507; Fed. Nat’l Bank v. Comm’r,
180 F.2d 494, 497 (10th Cir. 1950)).
        But we rejected Smith’s second contention that the Tax
Court was bound to award the deduction requested by Smith merely
because the Commissioner’s valuation was unreasonable. We
continued:

       Where Smith’s argument fails is in suggesting that
       the refusal of the tax court to accept the
       Commissioner’s evidence requires this court to
       reverse the trial judge with instructions to expunge

                                 18
       the deficiencies. The teaching of Helvering v. Taylor
       . . . and Federal National Bank v. Commissioner of
       Internal Revenue . . . is that the appropriate remedy
       in the absence of evidence of proper valuation is a
       remand to allow for additional evidence to be
       presented. In this case, however, sufficient evidence
       was introduced to allow the tax court to reach a
       reasonable conclusion. The court is not limited to
       simply choosing one of the two values proffered. It
       is appropriate for it to evaluate all of the evidence
       and to make an independent determination that does
       not necessarily accept the valuation of either party.
Id. Indeed, in Taylor itself, the Supreme Court did not reject the
Commissioner’s arbitrary claimed deficiency; instead, it affirmed
the decision of the Court of Appeals remanding the case so that the
Board of Tax Appeals might “hear[] evidence to show whether a
fair apportionment might be made and, if so, the correct amount of
the tax.” 293 U.S. at 516. In sum, the taxpayer bears the burden of
proof on valuation, but where the Commissioner’s alternative
proposed valuation is unreasonable, the Tax Court must make a fair
apportionment, and is not confined to choosing between the two
proffered valuations.

     B. Proof of Separate Valuation; the Burden Framework

       Nonetheless, as Taylor recognized, it is not always possible
for the Tax Court to make a “fair apportionment” of a taxpayer’s
obligations and basis. 293 U.S. at 516. Capital argues that its
burden is only to prove that its aggregate deductions are correct,
even if it cannot apportion them precisely. See S. Pac. Trans. Co.
v. Comm’r, 75 T.C. 497 (1980); DiLeonardo v. Comm’r, 79 T.C.M.
(CCH) 1820 (T.C. 2000). The Commissioner disagrees, arguing
that Capital must prove the value of each contract, and may not take
an approximate deduction not based in the value of the contracts
actually lost.
       Newark Morning Ledger, which presents significant factual
analogies to this case, set a high bar for the taxpayer seeking to
prove deductions. The Court held that the taxpayer bears the burden
of proving “that a particular asset can be valued and that it has a
limited useful life,” and noted that “that burden will often prove too

                                 19
great to bear.” 507 U.S. at 566.
        Most mass asset cases before and after Newark Morning
Ledger make similar statements. These cases put the burden on the
taxpayer of “establish[ing] reasonably accurately a basis in the
particular account on which the loss is claimed.” Sunset Fuel, 519
F.2d at 783; see also 7 Mertens, Law of Federal Income Taxation
§ 28.15, at 49-50 (rev’d ed. 2001). Some of these cases go even
further, echoing Newark Morning Ledger’s warning that the burden
will often be too great for the taxpayer to bear. See, e.g., Globe Life
& Accident Ins. Co. v. United States, 54 Fed. Cl. 132, 136 (2002).
        There is some tension between the rule of Newark Morning
Ledger, which places on the taxpayer a “heavy burden” of proving
that its intangible assets may be valued separately, and the rule of
Taylor and R.M. Smith, which allows the Tax Court to determine a
fair value when neither the Commissioner’s nor the taxpayer’s
valuation is completely convincing. We think, however, that these
cases can be reconciled in a straightforward manner.
        Newark Morning Ledger stands for the proposition that the
taxpayer always bears the burden of proving that his lost intangible
assets are susceptible of separate valuation. A taxpayer who cannot
carry that burden possesses a mass asset, and may not depreciate it
or deduct losses of components of that asset. The Commissioner
may always put the taxpayer to his proofs in such a case, and the
Commissioner’s litigation position rejecting the entire claimed
deduction will not necessarily be unreasonable.
        But this heavy burden applies only to the taxpayer’s
obligation to prove that his intangible assets may be valued
separately and with reasonable precision. What we derive from the
foregoing is that, if the taxpayer can satisfy that burden, the process
of proof changes. Once a court is satisfied that the intangible assets
may be valued separately, its obligation is to find the correct value.
The taxpayer and the Commissioner may submit their own
proposed valuation, and dispute over the merits of each side’s
claims. Where the Commissioner refuses to submit any valuation,
or where his valuation is arbitrary, the court will essentially be
forced to start from the taxpayer’s valuation.
        The court may accept this valuation if it is reasonable, or it
may modify it to take into account objections raised by the
Commissioner or by the court sua sponte. But it will not, in our
view, be reasonable for a court to reject the taxpayer’s valuation out

                                  20
of hand simply because the Commissioner has identified minor
flaws in the valuation. Once it is established that the assets have a
reasonably ascertainable value, the court is obligated to seek the
correct value of the contracts not, upon catching the taxpayer in an
error, to deny any deduction automatically. See R.M. Smith, 591
F.2d at 251.
        Similarly, the dispute over whether Capital must prove only
its aggregate 1994 deduction, or the individual value of each
contract lost in that year, is a chimera. Under Newark Morning
Ledger, Capital must of course prove that each of the 376 lost
contracts has an individual value that exists separately from that of
the other contracts. But the court need not find each individual
valuation convincing in all respects in order to accept an aggregate
deduction. A court might find that ten individual contracts each
have a separate value, while being unable to put a precise dollar
value on each one. In such a case, if the court can easily calculate
the aggregate value of the ten contracts, while remaining uncertain
about the individual values, the taxpayer has satisfied its burden
under Newark Morning Ledger and may prove his aggregate
deduction under the logic of South Pacific Transportation and
DiLeonardo.

                     V. Capital’s Valuation

        The Tax Court’s “finding of fact with respect to valuation is
to be reviewed under the clearly erroneous standard.” R.M. Smith,
591 F.2d at 251. Here, the Tax Court concluded that Capital had
failed to meet its burden of proving the 1987 fair market value of
its lost contracts. Its basis for this conclusion was a litany of
perceived flaws in Capital’s valuation. Most importantly, the Tax
Court found that Capital’s “reinsurance model” for valuing the lost
contracts was flawed, 122 T.C. at 249-51; that the valuation did not
completely take into account individual characteristics of the group
contracts, id. at 251-55; and that the valuation was based on
defective assumptions regarding the expected life of the contracts,
id. at 255-57. We address each of these findings in turn. On appeal,
the Commissioner has added numerous instances of perceived error
in Capital’s valuation; we address those claims in the course of our
consideration of the Tax Court’s conclusions.

                                 21
                    A. The Reinsurance Model

       The Tax Court’s most significant criticism of Capital’s
valuation concerned the “reinsurance model” used by Daniel
McCarthy, Capital’s actuarial valuation expert, see supra n.2.

1. Highest and best use

        McCarthy valued the contracts at issue at their “highest and
best use.” He concluded that this use could be determined using a
“reinsurance model,” whereby he asked how much the 376
contracts cancelled in 1994 would have been worth if they had been
sold together in a reinsurance transaction in 1987. McCarthy argued
that this is the highest and best use of the contracts, and that they
would be worth more sold together in a reinsurance transaction than
they would be if they were sold separately. In fact, it seems unlikely
that any such contracts could be sold separately. See Trigon, 215 F.
Supp. 2d at 706 (“It is an undisputed fact that there are no known
sales of single group health insurance contracts between insurance
carriers either before January 1, 1987, or after.”). Blocks of
contracts can, however, be sold, and McCarthy represented that the
376 contracts lost in 1994 would have constituted a “credible”
block that could have been sold between insurers. See 122 T.C. at
250.
        The Trigon court reasoned that these contracts are properly
valued under a willing-buyer model that assumes a buyer with
facilities comparable to those of Capital:

       [Group] contracts must be valued on the theory that
       they would be sold to a hypothetical willing buyer
       having facilities comparable to those of the seller.
       Attempting to value the contracts on a stand-alone
       basis (which the government appears to advocate),
       rather than as part of a going concern, results in an
       improper determination of “liquidation value,” rather
       than fair market value.

215 F. Supp. 2d at 708-09 (citation omitted). We find this analysis
persuasive.
       We reject the government’s argument that a one-at-a-time

                                 22
sale model is required. The government cites cases holding that
minority shares of stock must be valued according to their own
value, without taking into account a control premium that might
inhere in a larger block of stock. See Ahmanson Found. v. United
States, 674 F.2d 761, 772 (9th Cir. 1981); Rev. Rul. 93-12, 1993-1
C.B. 202. But such cases are inapposite: the control premium for a
majority stock holding has a separate value over and above the
value of each individual share, while McCarthy’s use of the
reinsurance model is designed not to capture additional value but
to account for the transaction costs involved in selling a single
contract.4 Capital need not value its contracts only at their
liquidation value, rather it may use the reinsurance model to
determine its basis.

2. Separate values

       The Tax Court nonetheless took the reinsurance model as
evidence that Capital’s contracts could not be valued individually.
It found that, at most, McCarthy had proven the value of the 376-
contract block sold by Capital, but it had not proven the value of
each individual contract:

       [A]s it must, petitioner does not claim a single loss
       deduction in 1994 upon the termination of the 376
       group contracts. Rather, petitioner claims 376
       separate loss deductions relating to the termination of
       each of the 376 separate group contracts. What is
       required to support petitioner’s claimed loss
       deductions under section 165 are valuations of the
       group contracts that reflect a value for each contract
       as a separate and discrete contract. . . . [A]ll

       4
         A fairer analogy might be to odd-lot sales of stock. A
shareholder who sells stock in even lots—traditionally, of 100
shares—will usually get a better price and/or pay a lower commission
than one who sells “odd lots” of, say, one or six or twenty-three shares.
As far as we are aware, shareholders may always value their stock on the
assumption that it would be sold in normal market transactions, not in
inefficient odd-lot transactions. McCarthy’s method is no more
objectionable than this.

                                   23
       petitioner has done is establish that the group
       contracts are capable of being valued in blocks.
       Petitioner has not, however, established that the
       group contracts are capable of being valued
       separately and independently as individual assets.

122 T.C. at 250-51; see also Trigon, 215 F. Supp. 2d at 709 (“[T]he
issue is not whether the highest and best use of Trigon’s contracts
is as part of an ongoing health insurance company. . . . The issue,
instead, is whether specific contracts can be valued separately from
the block of contracts to which they belong.”).
        Capital argues that the contracts can be valued separately,
and that McCarthy did in fact value each contract separately.
McCarthy testified to this effect, noting that his valuation
methodology in this case was consistent with his practice in
appraising insurance contracts when advising insurers that are
demutualizing:

       It was consistent, in that it took into account the
       characteristics of each contract being valued. It was
       consistent, in that it took into account as the standard
       of that to be discounted of the emerging stream of
       expected statutory earnings, and it was consistent, in
       that they were discounted to present value.

He referred to this as a “seriatim or one-at-a-time valuation.” He
readily admitted, however, that he calculated the contracts’ value
based on an assumption that they would be sold in batches.
       We think that the Tax Court, and the Commissioner,
misunderstood the requirements of separate valuation. As noted
above, Newark Morning Ledger, 507 U.S. at 566, requires that a
taxpayer wishing to deduct his losses of intangible assets must
show that those assets are susceptible of separate valuation. In
many cases, this will be impossible, simply because the taxpayer
really possesses a single indivisible asset whose whole is
incommensurable with the sum of its parts, a single mass
“composed of constantly fluctuating components.” Id. at 567. Thus,
for instance, a company may not depreciate its “assembled work
force,” because new employees are constantly being trained to
replace old ones, and because there is no meaningful way to assign

                                 24
distinct values to each member of this workforce. Id. at 560. The
value inheres in the “assembly” of the workforce, not in any one
individual.
        Insurance contracts are different. They are valued all the
time; indeed, Daniel McCarthy, Capital’s expert, has spent much of
his career valuing health and life insurance contracts in order to
advise insurers and regulators on the fairness of demutualization
transactions. While the Tax Court and the Commissioner have
numerous quibbles with Capital’s valuation, they do not persuade
us that these contracts do not each have an individual value. As
Capital succinctly puts it, “the Tax Court erred because it confused
(1) the question of whether an intangible has a value and useful life
separate from goodwill . . . , with (2) the question of what the
asset’s value is.”
        The Commissioner cites several pre-Newark Morning News
cases for the proposition that taxpayers may not use average values
to compute the value of specific accounts. Sunset Fuel, 519 F.2d at
785-86; Skilken v. Comm’r, 420 F.2d 266, 270 (6th Cir. 1969). But
the averaging procedures in those cases were far cruder than
McCarthy’s sophisticated statistical methods here. McCarthy
represented that the 376 contracts lost in 1994 constituted a “fully
credible” block of contracts, such that a willing-buyer reinsurer
would expect high- and low-value contracts to cancel each other
out, and would therefore purchase the community-rated contracts
based on average rather than individual experience. Experience-
rated contracts were, at all points, valued individually.
        The evidence is clear that McCarthy’s voluminous,
thorough, and professional valuation was meant to determine a
value for each individual insurance contract. As part of that
individual valuation, McCarthy used various averaging procedures,
sometimes to check his work, but sometimes as part of his initial
calculations. The undisputed evidence appears to be that such
averaging procedures were consistent with industry standards for
valuing group insurance contracts for the purposes of reinsurance
or demutualization. McCarthy’s use of industry-standard statistical
methods does not render his appraisal invalid, or support the Tax
Court’s conclusion that Capital’s contracts could not be valued
individually. We thus hold that that conclusion was clearly
erroneous.

                                 25
3. The goodwill adjustment

        The Tax Court also rejected McCarthy’s reinsurance model
on the grounds that McCarthy made only “some type of vague
expense adjustment” to account for intangibles such as goodwill
that were associated with the 376 terminated contracts. 122 T.C. at
250-51. A larger adjustment for the intangibles, which the
Commissioner believes is justified, would lead to a smaller tax
deduction.
        McCarthy subtracted some $300 million from his total
valuation of all of Capital’s contracts, to account for the value
added by Capital’s name, reputation, and other goodwill factors, as
well as by its workforce and provider network. These factors made
up a part of the value of Capital’s contracts, but were not lost when
those contracts were lost; therefore, Capital did not—and could
not—claim them as part of its deduction. The dispute here is over
the method of calculating this goodwill adjustment. McCarthy used
a rental charge, whereby he valued these intangibles based on what
it would cost Capital to rent them in a market transaction. The
Commissioner argued, and the Tax Court agreed, that this was
improper. Instead, the Tax Court found that McCarthy should have
deducted a “capital charge” from the value of the contracts, based
on a valuation of the intangible factors that takes into account the
market rate of return on those factors. Although the Commissioner
has not attempted to calculate what such a charge would look like,
we assume that it would lead to a greater offset for these
intangibles, and so to a smaller tax deduction.
        Capital argues, however, that McCarthy’s method, which
used a rental charge rather than a capital charge, was proper and
indeed standard. The Tax Court found that McCarthy’s explanation
for not taking a capital charge for the related intangibles was “not
credible.” Id. at 251. Capital claims that this contradicted the
“undisputed testimony of all the experts,” which was that rental
charges are normally used in insurance valuation, and that
McCarthy’s use of them was proper. The Commissioner responds
that McCarthy’s charge for the related intangibles was based on
their cost to Capital rather than their market value, and that this
method of deducting the other intangibles overstated the value of
the lost contracts.
        Capital’s characterization of the record appears to be

                                 26
mistaken. The Commissioner’s witnesses did not concede that
McCarthy’s approach was correct, although neither did they claim
that it was professionally untenable. They did argue for an
alternative method, which presumably would have given a
different, and greater, value to Capital’s goodwill.
        Given the dispute in the record between well-qualified
experts, and the Tax Court’s greater familiarity with the issue, we
cannot conclude that the Tax Court’s finding here was clearly
erroneous. Indeed, this finding seem s conceptually
correct—Capital’s goodwill factors should be subtracted at their
value, not their cost—although Capital argues that McCarthy’s
rental charge was meant to estimate value and not cost. We thus
accept the Tax Court’s conclusion that McCarthy should have used
a capital charge, rather than a rental charge, to extract goodwill
from his valuation of the contracts.
        But, as explained above, see supra Part IV.B, Capital does
not lose its entire deduction merely because the Commissioner has
found some flaws in its method. On the remand that our other
holdings require, the Commissioner will have the opportunity to
explain what McCarthy should have done differently in this regard,
relying on specific calculations of cash flows rather than on generic
names like “capital charge” versus “rental charge.” The
Commissioner will also be able to propose an alternate valuation
for the $300 million goodwill adjustment. Capital, meanwhile, will
have another opportunity to demonstrate to what extent McCarthy’s
method captures the factors raised by the Commissioner.
        Ultimately, the Tax Court must determine what goodwill
adjustment is appropriate, using either McCarthy’s rental charge, a
capital charge proposed by the Commissioner on remand, or some
other adjustment taking into account the arguments of both sides.
In sum, the mere fact that McCarthy’s charge is flawed does not
mean that the Tax Court may reject Capital’s entire valuation.

               B. Specific Contract Characteristics

       The Tax Court next found that Capital’s “expert utilized
incomplete information and made erroneous assumptions relating
to the characteristics of the group contracts that alone would
support disallowance of the $4 million in loss deductions claimed.”
122 T.C. at 251. The Tax Court identified several instances of what

                                 27
it considered incomplete data or erroneous assumptions, and found
that these errors made McCarthy’s valuation so uncertain as to be
almost meaningless.
        Most importantly, the Tax Court found that McCarthy
“[i]gnored or did not consider historical premium payment and
claim patterns and renewal expectations relating to each contract.”
122 T.C. at 251-52. The Tax Court also noted that, for many of the
contracts that he valued, McCarthy used average premium or claims
data, because individual contract data was lacking. Id. at 252-53.
        Capital argues that the Tax Court was in error, because the
experience-rated contracts were appraised based on “premium rates
in effect on January 1, 1987, which reflect each of these factors on
a contract-specific basis.” Capital expert Constance Foster, an
insurance attorney and former Insurance Commissioner of
Pennsylvania, testified that “The demographics or any information
about the customer is embedded in the rate. All we would do in
renewing is look at their past claims experience and how many
people are represented to project new rates.” Put differently, the
experience rating process was intended to capture each group’s
claims and payment experience in calculating each year’s premium
rate. Thus, McCarthy was able to value the experience-rated
contracts using only rate information, because the rate information
captured the information that the Tax Court found missing. Capital
also explains that some 24 of the experience-rated contracts, which
together accounted for approximately $2.5 million of its $4 million
claimed deduction, were valued taking into account all of those
contract-specific factors, without any averaging or missing data
regarding premiums or claims.
        As an example of McCarthy’s failure to accurately appraise
the value of experience-rated contracts, the Tax Court cited the case
of Pennsylvania Farmer’s Union. This client group maintained three
experience-rated contracts that had a cumulative deficit of some
$700,000 in January 1988. By 1994, the deficit was $4 million, and
the contract was cancelled the following year, leaving Capital to
absorb the deficit. 122 T.C. at 255. The Tax Court noted that,
despite these deficits, McCarthy assigned the three Farmer’s Union
contracts “a total positive value of $479,000, or nearly 20 percent
of the total value attributed to all of petitioner’s experience-rated
group contracts that were terminated in 1994.” Id.
        The Tax Court’s reasoning is flawed because it assumes that

                                 28
the contract was not of positive value in 1987 merely because the
contract ultimately caused Capital a loss. As Capital persuasively
observes, it would not have renewed experience-rated contracts that
it expected to result in a loss, so it can reasonably be assumed that
in 1987 its contracts had a positive expected value. Indeed, one of
Capital’s experts testified that deficit accounts have “a bit of more
value” “as long as they stay with Capital Blue Cross,” because such
accounts “produce[] more margin” in that Capital will raise
premium rates going forward for contracts with high claims rates.
Testimony also indicated that such deficit contracts did stay with
Capital Blue Cross, or at least that their lapse rates were not
materially greater than those of other contracts.
        As it turned out, Capital continued to lose money on the
Farmer’s Union contract, and the group ultimately cancelled the
contract rather than paying a significantly increased premium,
leaving Capital with a large accumulated deficit. Capital’s Chief
Financial Officer, Robert Markel, testified that Farmer’s Union had
a deficit that was not “unusually large” as of 1987, which grew
larger in later years. He also testified that Farmer’s Union breached
its contract by transferring low-risk employees to another carrier,
and that Capital cancelled the contract in 1994 upon learning of the
breach. Capital submits that, if this breach had not occurred, it
would have been able to recoup its losses from the contract and
make it profitable. Capital’s position is that Farmer’s Union’s
ballooning deficit and contract breach were not foreseeable in 1987;
therefore, a reasonable buyer would have assigned the contract a
relatively large positive value.
        We believe that McCarthy’s valuation was reasonable. First,
some 60% of Capital’s claimed deductions come from experience-
rated contracts in which averaging was not used and the data is
complete. His assumptions about experience-rated contracts,
including those with a deficit in 1987, were economically sensible;
the fact that the Farmer’s Union contract turned out to be disastrous
does not prove that it had zero or negative value as of January 1,
1987.
        The Commissioner also seeks to defend the Tax Court’s
decision about the characteristics of group contracts by pointing to
the community-rated contracts, for which significant averaging was
used. He notes, as did the Tax Court, that a small change in the
expected claims ratio could have an enormous effect on the

                                 29
expected value of the contract: “use of a claims ratio just 1 percent
higher than the aggregate average claims ratio used by petitioner’s
expert for community-rated group contracts would reduce
petitioner’s projected profit relating to the contracts by more than
half.” 122 T.C. at 254. But the Commissioner has not demonstrated
that there is anything wrong with using averaging, and the evidence
indicates that an actual willing-buyer reinsurer would use an
averaging method essentially identical to McCarthy’s.
        The Tax Court is, of course, correct that averaging is
sensitive to initial assumptions: here, for instance, the valuation of
the community-rated contracts depends on the average claims ratio;
the appropriate discount rate will also have a significant effect. But
there is little in the record before us to suggest that McCarthy
should have used different assumptions. In view of this fact, we
must remand to the Tax Court to allow it to consider McCarthy’s
procedure in more detail.
        On remand, the Commissioner may explain his objections to
specific assumptions in McCarthy’s valuation, as regards both
individual experience-rated contracts and the collective
assumptions about community-rated contracts. If the Tax Court
finds that these assumptions were incorrect, it may find more
appropriate figures and use them to calculate a more appropriate
valuation of Capital’s contracts. But if McCarthy’s assumptions
were correct, or were those that a reasonable buyer would make,
then the fact that his calculations were sensitive to his assumptions
does not render his valuation incorrect.

               C. Lapse Rates and “Lifing Analysis”

        A central part of McCarthy’s valuation was his “lifing
analysis,” that is, the method by which he estimated the expected
life of each contract as of 1987. McCarthy used historical lapse
rates to determine the probability that each group’s contract would
lapse in any given year. These lapse rates were used to compute the
expected life of each contract, which was essential to calculating its
fair market value. 5 McCarthy used historical data from Capital’s

       5
        Essentially, the FMV of one of Capital’s contracts in 1987
equaled (a) the present value of all future premium payments on that
contract, minus (b) the present value of all future claims paid out under

                                   30
1982-1986 experience that “indicated that each group contract had
a 2.2-percent to 7.5-percent probability of lapsing from year to year,
depending on factors such as group size and duration of the
contract.” 122 T.C. at 255. The Tax Court had two objections to
McCarthy’s lifing analysis: first, that McCarthy did not take into
account the uncertainty in the insurance market in 1987, and
second, that he did not take into account certain “human elements”
that influence lapse rates.6

1. Prospective changes in the market

       First, the Tax Court found that the lapse rates did “not
account for foreseeable (as of January 1, 1987) and significant
changes in the health insurance marketplace.” 122 T.C. at 255-56.
More specifically, the Court found that McCarthy did not consider
the impact that increased competition from HMOs and other new
insurance products would have on Capital’s lapse rates. In 1987,
the argument goes, a willing buyer could have predicted that
increased competition would lead to greater lapse rates, and thus

that contract, over (c) the expected life of the contract. Cf. Sunset Fuel,
519 F.2d at 783 (“[The value] of a particular account is a function of the
flow of future income . . . discounted by the risk of discontinuance or
nonpayment of that particular account . . . .”). Since premiums would
normally exceed claims, this present value would be higher for contracts
with a long expected life than for those with a short life. Lapse rates
were used to determine the expected life of each contract, and thus its
expected value.
       6
         Earlier in its opinion, the Tax Court also suggested that
McCarthy “incorrectly assumed a 20-year useful life for all of
petitioner’s separate health insurance group contracts.” 122 T.C. at 249.
Capital points out that McCarthy simply used 20 years as the maximum
cutoff for projections, not as an assumed useful life for all of the
contracts. In its criticism of McCarthy’s lifing analysis, however, the
Tax Court seems to have correctly understood the 20-year cutoff. 122
T.C. at 255 (“[I]n his attempt to account for the reality that not all of
petitioner’s group contracts would remain in existence for 20 years,
petitioner’s expert utilized historical lapse rates . . . .”). We therefore
assume that its earlier error regarding the 20-year assumption did not
affect the Tax Court’s decision.

                                    31
would have valued Capital’s contracts at a rate lower than
McCarthy ascribed to them using historic lapse rates.
        Capital submits that this line of reasoning reflects a
misunderstanding of the evidence. Capital’s CEO testified that, in
the 1980s, Capital was aware of the competition from HMOs, but
expected that this competition would not significantly affect its
market share or lapse rates because central Pennsylvania, where
Capital operates, has a traditional market with relatively few
hospital choices and a strong organized-labor presence. McCarthy
testified that he took the competitive situation into account, but
determined that most of the “competitive factors” that led to lapses
had already taken effect in the 1982-1986 period that he used to
determine lapse rates.
        The Commissioner’s experts reasoned that “[i]n the presence
of such significant market changes, the assumption that future lapse
rates would be consistent with past lapse rates is, at best,
problematic,” and that the lapse rates were “speculative in the
extreme, given what was going on in the group health insurance
market at the time.” We are unconvinced. First of all, McCarthy,
unlike the Commissioner’s experts, seems to have spoken to Capital
management and considered circumstances unique to Capital’s
central Pennsylvania market, while the Commissioner’s experts
considered only the national health insurance market. Capital
presented evidence that its market was (for reasons suggested
above) uniquely resistant to the competitive pressures introduced by
HMOs and PPOs; therefore, McCarthy’s calculations based on
Capital’s own past data may well have been more accurate than the
Commissioner’s projections based on national trends.
        Furthermore, there does not seem to be any evidence that
McCarthy’s lapse rates were incorrect. Instead, Capital’s evidence
tends to show that subsequent experience proved Capital’s
projections correct: it has not lost significant market share to
HMOs, and its historic lapse rates from 1987 were very close to
those predicted by McCarthy. McCarthy’s table of historically
derived lapse rate assumptions—ranging from a 2.2% lapse rate for
groups of 10-24 members whose contracts had been in effect for
over ten years to a 7.5% rate for groups of 1-9 members whose
contracts had been in force for under one year — squares relatively
well with Capital’s actual 1987-1994 experience. McCarthy
testified that the experienced lapse rate by number of contracts was

                                32
5.6%, while the lapse weighted rate by total premiums lost was just
under 3%. As McCarthy explained, the former number corresponds
reasonably well to his predicted lapse rates for small groups, which
were the most numerous, while the latter corresponds quite well to
his predicted rates for large groups, which made up the bulk of
Capital’s premiums. Of course, it is theoretically possible that
McCarthy’s predicted lapse rates were speculative, but nonetheless
turned out to be correct. But the general accuracy of his predictions
is certainly strong evidence that they had a foundation in reasonable
analysis rather than speculation.
        The Commissioner denies that McCarthy’s lapse rate
predictions were accurate, although he has not pointed to any
statistical evidence to refute the numbers we have cited above.
Instead, the Commissioner cites a Capital marketing plan from
1993, which states that “[s]ignificant losses from existing accounts
are being incurred from HMO’s,” and that the Berkshire Health
Plan PPO had “targeted Blue Cross and Blue Shield customers and
[had] been successful in enrolling a significant number of accounts
through selective underwriting.”
        This document certainly supports the Commissioner’s thesis
that Capital faced competition from HMOs. But McCarthy’s
testimony was that this competition had already developed by the
1982-1986 period that he used to estimate post-1987 lapse rates,
and that his use of historical rates therefore accurately captured
Capital’s 1987 expectation of future rates. He testified that, based
on discussions with Capital executives, he concluded that “the
phenomena [of increased competition, including from HMOs and
PPOs] had really already developed in the period of time I used for
purposes of the lapse study . . . . And so I felt, after listening to
them, that based on the situation in 1986, it was not necessary to
modify those experience rates that i [sic] had derived for purposes
of projecting in the future.”
        Without any contradictory evidence, we have no choice but
to accept McCarthy’s representations that his predicted lapse rates
turned out to be accurate. Moreover, his procedure—relying on
recent historical rates that he concluded incorporated the
developing changes in the insurance industry, and discussing his
predictions with Capital management to get a sense of their
predictions as of 1987—does not strike us as “speculative in the
extreme.” The Tax Court appears to have ignored Capital’s

                                 33
evidence that McCarthy’s lapse rates were accurate, and to have
unduly credited the Commissioner’s experts’ conclusory assertions
that those rates were speculative. We thus reject as clearly
erroneous the Tax Court’s conclusion that “petitioner’s expert
largely ignored the industry changes of which petitioner’s
management, as of January 1, 1987, was aware.” 122 T.C. at 256-
57.

2. Human factors

       Tax Court also rejected McCarthy’s lifing analysis because
it found that McCarthy did not consider various “human elements”
that would influence lapse rates, viz., various subjective factors that
might make customers cancel their at-will contracts. It held that
“These human elements associated with petitioner’s group contracts
created a significant element of unpredictability with regard to the
useful life of petitioner’s group contracts.” 122 T.C. at 257.
       The Tax Court’s conclusion here reflects a fundamental
misunderstanding of McCarthy’s method, if not of the nature of the
insurance industry and actuarial methods. McCarthy took into
account the human factors in the way that all actuaries do:
actuarially. He divided the contracts into groups based on
distinctions that he found relevant, computed average lapse rates,
and used them to project future lapse rates. Capital quite wittily
cites Ehrhart v. Comm’r, 57 T.C. 872, 873 (1972) (“Actuaries are
highly skilled mathematicians who deal with various contingencies
affecting human life.”), for the proposition that an actuary of
McCarthy’s experience is well equipped to deal mathematically
with the human factors affecting the lapse rates of insurance
contracts.
       Furthermore, the Tax Court did not identify any “human
factors” that McCarthy’s valuation failed to take into account. The
Tax Court’s reliance on Ithaca II, supra, 17 F.3d at 689-90, and
Globe Life & Accident, supra, 54 Fed. Cl. 132, is misplaced. Those
cases concerned workforces, which are much harder to value than
insurance contracts; the valuations involved there were far less
careful and thorough than McCarthy’s valuation here; and those
cases concerned amortization (where precise lapse rates are
essential) rather than deductions for the direct loss of contracts.
       Because it ignored undisputed evidence and misunderstood

                                  34
the nature of McCarthy’s calculations, the Tax Court’s rejection of
Capital’s lifing analysis on the theory that McCarthy failed to take
into account any subjective “human factors” was clearly erroneous
and must be set aside.

3. The Commissioner’s lifing arguments

        In his appellate briefs, the Commissioner builds on the Tax
Court’s findings by arguing that McCarthy’s lapse rate assumptions
were flawed in other respects. Specifically, McCarthy only used
average rates for contracts of a given size and age, and did not
calculate different rates for different kinds of coverage or contract,
different premium payment histories, changing sizes, or financial
condition of the client group. Capital responds that McCarthy
complied with actuarial principles in coming to his conclusions, and
that the Commissioner has not shown that McCarthy’s valuations
would be different if he took into account the more specific factors
that the Commissioner urges.
        We agree with Capital. McCarthy’s efforts were thorough,
and it appears to be undisputed that he followed actuarial standards.
The Commissioner has identified some factors that he did not
consider, but this alone does not seem to be a reason to reject
McCarthy’s lapse rate calculations. As the Tax Court has
previously stated, “lapse rates may be determined from a statistical
analysis of actual past experience of policies in force at specified
intervals of time or from an informed judgment of a person who has
had experience in the field.” Union Bankers, 64 T.C. at 816.
        Simply put, it would be impossible for McCarthy to take into
account every factor that might distinguish one contract from
another. McCarthy did not classify contracts based on what
percentage of individuals in each group was left-handed, but the
Commissioner would not be heard to argue that this was a flaw in
his methodology. The Commissioner cannot invalidate McCarthy’s
methodology simply by pointing to factors that McCarthy
neglected; instead, he must also make a reasonable case that such
a factor would have changed his conclusions. The Commissioner
has not even attempted to do so here, and we see no reason to reject
McCarthy’s lifing analysis.

                D. The Commissioner’s Objections

                                 35
       In his appellate brief, the Commissioner has not confined
himself to defending the Tax Court’s opinion on its own terms. He
has also put forward several other purported grounds for
affirmance. The Commissioner now objects to the completeness
and accuracy of Capital’s records, arguing that coding errors and
missing data render many of Capital’s conclusions suspect. He also
argues that McCarthy drew improper inferences from the aggregate
value of Capital’s 23,526 contracts in 1987 to the value of the 376
contracts cancelled in 1994, without first demonstrating that those
376 contracts were a representative sample of the whole.
       Without the benefit of explicit factual findings by the Tax
Court on these issues, we will not undertake to decide them.
Instead, we will allow the Tax Court to consider these arguments
in the first instance. This consideration will involve both a
determination whether the Commissioner is correct about the
alleged flaws in Capital’s data and methodology and a decision
about the extent to which those flaws invalidate McCarthy’s
ultimate valuation.

                   E. Summary and Conclusions

        Two themes emerge from the above discussion. First and
foremost, we have rejected as clearly erroneous the Tax Court’s
ultimate conclusion that Capital “has not . . . established that the
group contracts are capable of being valued separately and
independently as individual assets.” T.C. 251. We find that
McCarthy’s model, including his use of some averaging
assumptions, established an individual value for each contract with
sufficient specificity to carry Capital’s burden under Newark
Morning Ledger. See supra Part IV.B.
        Second, we have rejected as clearly erroneous some, but not
all, of the Tax Court’s specific findings of flaws in Capital’s
valuation. Because of the centrality of these findings to the decision
we are constrained to reverse and remand. Because it is clear that
Capital had some basis in the contracts, we do not think that even
the Tax Court’s valid objections prevent Capital from taking a
deduction. On remand, the Commissioner will have the opportunity
to quantify his objections to Capital’s valuation, and the Tax Court
will be able to decide the proper valuation. Thus, for instance, the
Commissioner may dispute McCarthy’s goodwill adjustment by

                                 36
proposing his own capital charge, see supra Part V.A.3, and the
Tax Court may determine what the appropriate goodwill adjustment
should be. Similarly, the Commissioner may explain which of
McCarthy’s initial assumptions—about contract claims rates,
discount rates, etc.—were erroneous, see supra Part V.B, and the
Tax Court may adjust McCarthy’s valuation if it finds that his
assumptions need to be changed.
        That said, we expect that the Commissioner will not
continue to rely solely on experts who testify that the lost contracts
are impossible to value: without a competing valuation argument,
it would seem that the Tax Court will have little choice but to grant
Capital its claimed deduction. As we have stressed above, see supra
Part IV.B, once Capital has carried its burden of showing that the
contracts may be valued individually—as we believe it has—the
Tax Court’s role is to find the correct valuation. Because there is no
real dispute that the contracts had value in 1987, and because we
find that they may be valued individually, a valuation of zero is
unlikely to be the correct result.
        Because we find that Capital’s lost insurance contracts are
susceptible of individual valuation as of January 1, 1987, the Tax
Court’s conclusion that Capital is not entitled to a deduction for the
loss of those contracts must be set aside. We reverse and remand
for a determination of Capital’s basis in those contracts, informed
by the record and any further submissions from the parties that the
Tax Court may consider appropriate.