[ X ]     Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2004

or

[    ]     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 0-49663

Delaware                                                                85-0410612
        (State of Incorporation)                             (I.R.S. Employer Identification No.)

18831 Von Karman, Suite 400
Irvine, CA 92612
(949) 255-7100
(Address and telephone number of Registrant)

     As of November 1, 2004, there were 15,327,928 shares of the Registrant's $.01 par value Common Stock outstanding.

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2

See accompanying notes.

3

See accompanying notes.

4

See accompanying notes.

5

See accompanying notes.

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See accompanying notes.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

     References throughout this document to the Company include Sun Healthcare Group, Inc. and our direct and indirect consolidated subsidiaries. Beginning as of July 1, 2004, Sun Healthcare Group, Inc.'s financial statements also include the accounts of three partnerships, five limited liability companies and one sole proprietorship (collectively known as "Clipper"), each of which we own five percent or less of their voting interests, as a result of our application of FASB's Revised Interpretation No. 46 "Consolidation of Variable Interest Entities" ("FIN No. 46R"). See "Note 7 - Variable Interest Entities" for additional information concerning this accounting pronouncement. In accordance with the Securities and Exchange Commission's "Plain English" guidelines, this Quarterly Report on Form 10-Q has been written in the first person. In this document, the words "we," "our," "ours" and "us" refer to Sun Healthcare Group, Inc. and its direct and indirect c onsolidated subsidiaries and not any other person.

     We are a provider of long-term, subacute and related specialty healthcare services in the United States. We operate through five principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, (iii) medical staffing services, (iv) home health services and (v) laboratory and radiology services. Inpatient services represent the most significant portion of our business. As of September 30, 2004, we operated 106 long-term care facilities in 13 states.

     The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States. In our opinion, the accompanying interim consolidated financial statements present fairly our financial position at September 30, 2004 and December 31, 2003, the consolidated results of our operations and the consolidated cash flows for the three and nine month periods ended September 30, 2004 and 2003, respectively. We believe that all adjustments are of a normal and recurring nature with the exception of the adjustments related to our application of FIN No. 46R. These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations. Readers of these statements should refer to our audited consolidat ed financial statements and notes thereto for the year ended December 31, 2003, which are included in our Annual Report on Form 10-K for the year ended December 31, 2003. The results of operations presented in the accompanying consolidated financial statements are not necessarily representative of operations for an entire year.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of third-party payor settlements, allowances for doubtful accounts, self-insurance obligations and loss accruals. Actual results could differ from those estimates.

     Certain reclassifications of assets, liabilities, income and expense have been made to the prior period financial statements to conform to the 2004 financial statement presentation.

     For the nine months ended and as of September 30, 2004, our net loss was $14.2 million and our working capital deficit was $20.0 million. As of September 30, 2004, we had cash and cash equivalents of approximately $28.9 million, no balance outstanding under our revolving loan agreement and approximately $30.5 million of funds available for borrowing under our revolving loan agreement which expires September 5, 2005. We believe that our existing cash reserves and availability for borrowing under our loan agreement will provide sufficient funds for our operations, capital expenditures and regularly scheduled debt service payments through the next twelve months. We expect to extend our revolving loan agreement upon its expiration.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     For the three months ended September 30, 2004, the net cash increase was approximately $5.8 million. The increase was primarily due to:

     For the nine months ended September 30, 2004, the net cash increase was approximately $3.4 million. The increase was comprised primarily of the $52.3 million of equity proceeds realized from the private equity placement and the collection of $15.6 million of accounts receivable of divested facilities, offset by:

     We have a Loan and Security Agreement with CapitalSource Finance LLC, as collateral agent, and certain other lenders (the "Revolving Loan Agreement") that expires on September 5, 2005. The Revolving Loan Agreement is a $75.0 million revolving line of credit that is secured by our accounts receivable, inventory, equipment and other assets, and the stock of our subsidiaries. Pursuant to the Revolving Loan Agreement, we are paying interest (i) for Base Rate Loans at the greater of (a) prime plus 1.0% or (b) 5.25%, and (ii) for LIBOR Loans at the greater of (a) the London Interbank Offered Rate plus 3.75% or (b) 5.25%. The effective interest rate as of September 30, 2004 on borrowings under the Revolving Loan Agreement was approximately 5.58%, however, no borrowings were outstanding on September 30, 2004. The weighted average borrowing interest rate for the period from January 1, 2004 through September 30, 2004 was 5.25%. Our

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

borrowing availability under the Revolving Loan Agreement is generally limited to up to eighty-five percent (85%) of the value of Eligible Receivables plus eighty-five percent (85%) of the value of Eligible Divested Company Receivables, but not to exceed $75.0 million. The defined borrowing base as of September 30, 2004 was $45.8 million, net of specified reserves of $14.0 million. The availability of amounts under our Revolving Loan Agreement is also subject to our compliance with certain financial ratios. As of September 30, 2004, we were in compliance with these ratios. We are also prohibited under our Revolving Loan Agreement from borrowing money from third parties without the prior consent of CapitalSource Finance. As of September 30, 2004, we had issued approximately $15.3 million in letters of credit, leaving approximately $30.5 million available to us for additional borrowing. In connection with entering into the Revolving Loan Agreement, we incurred deferred financing cost s of $2.6 million, which are amortized using the effective interest method over the life of the loan agreement. For the three and nine months ended September 30, 2004, we amortized $0.4 million and $1.4 million, respectively, of these deferred financing costs. In September 2004, $0.9 million of the deferred financing costs were refunded to us.

(4)  Long-Term Debt

     Long-term debt consisted of the following as of the dates indicated (in thousands):

     The scheduled or expected maturities of long-term debt as of September 30, 2004, were as follows (in thousands):

     In accordance with the provisions of SFAS No. 144, the results of operations of the disposed assets and the gains (losses) related to these divestitures have been classified as discontinued operations, net of $0 income taxes, for all periods presented in the accompanying consolidated statements of operations.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     Inpatient Services: During the nine months ended September 30, 2004, we divested four skilled nursing facilities in accordance with our restructuring plan. During the nine months ended September 30, 2003, we divested 114 skilled nursing facilities.

     Other Operations: In July 2004, we decided to divest BioPath, our California clinical laboratory and radiology operations. These operations were considered assets held for sale for the third quarter of 2004 and their net operating income (losses) were classified into discontinued operations for the three and nine months ended September 30, 2004 and 2003. See "Note 6 - Assets Held for Sale." On November 7, 2003, Shared Healthcare Systems, Inc. ("SHS"), a majority owned subsidiary, sold substantially all of its software development assets to Accu-Med Services of Washington LLC, a wholly-owned subsidiary of Omnicare, Inc., for approximately $5.0 million in proceeds at closing and up to $0.5 million to be paid in cash in December 2004. In addition, we sold our mobile radiology operations in Washington and Oregon for $0.2 million in October 2003.

     The following tables set forth a summary of the discontinued operations for the periods presented (in thousands):

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     As of September 30, 2004, assets held for sale consisted of (i) assets of BioPath Clinical Laboratories, Inc. ("BioPath"), a wholly-owned subsidiary with a fair value of $3.3 million, (ii) three undeveloped parcels of land and various office buildings valued at $4.1 million and (iii) artwork valued at $0.7 million. (See "Note 15 - Subsequent Events.")

     We recognized a $1.4 million charge to loss on sale of assets associated with the write-down of a land and building held for sale in third quarter of 2004.

     BioPath reported revenues of $5.0 million and $11.6 million for the three and nine month periods ended September 30, 2004, respectively, in discontinued operations. The net operating losses of $3.0 million and $11.5 million, respectively, for the same periods, were included in discontinued operations. Also included in discontinued operations were the net revenues of $6.5 million and $17.5 million and net operating income of $0.3 million and $0.6 million, for the three and nine month periods ended September 30, 2003, respectively.

     In December 2003, the FASB issued a revision to Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN No. 46R"), which was originally issued in January 2003. FIN No. 46R provides guidance on the consolidation of certain entities when control exists through means other than ownership of voting (or similar) interests and was effective for public entities that have interests in variable interest entities commonly referred to as special purpose entities for the first reporting period that ends after March 15, 2004. FIN No. 46R requires consolidation by the majority holder of expected residual gains and losses of the activities of a variable interest entity ("VIE").

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     We currently own a five percent interest in each of eight limited liability companies and partnerships, each of which own one facility that we operate in New Hampshire. In April 2004, we entered into an agreement with the owners of the remaining interests in those eight entities, and with the sole proprietorship owner of a ninth entity which also owns a facility in New Hampshire that we operate (collectively known as "Clipper"). That agreement granted us options, exercisable sequentially over a period of seven years, pursuant to which we can acquire up to 100 percent of the ownership of those nine entities for an aggregate amount of up to approximately $10.7 million, subject to reduction in certain circumstances. The agreement also provides the owners the right to require us to purchase those ownership interests at the above described option prices. These put rights can be exercised for any options that have come due but which were not exercised by us up t o that point in time, but no later than December 31, 2010.

     We have concluded that Clipper, as identified above, meets the definition of a VIE because we have agreements with the majority owners granting us the option to acquire, and the right of the owners to put to us 100% ownership of Clipper. Clipper's objective is to achieve rental income from the leasing of skilled nursing and assisted living facilities owned by Clipper. The debt of Clipper is collateralized by the fixed assets of the respective partnerships, limited liability companies and sole proprietorship. None of our assets serve as collateral on the Clipper debt and creditors do not have any general recourse against us.

     As the primary beneficiary of the VIE, we consolidated Clipper beginning in the third quarter of 2004. This change will have no affect on previously reported net earnings. Our consolidated assets and liabilities increased approximately $45.9 million and $41.2 million, respectively, based upon the fair value of the assets and liabilities of Clipper, as of July 1, 2004. Upon consolidation, we eliminated our investment in Clipper. The following provides a summary of the balance sheet impact of Clipper upon consolidation as of September 30, 2004 (in thousands):

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     Upon consolidation, a $12.5 million unfavorable lease intangible related to the nine entities and recorded on our books prior to consolidation, was allocated against the $60.9 million basis of property, plant and equipment, and provided a consolidation value of $48.4 million. The allocation of the fair value is subject to refinement.

     For the three and nine month periods ended September 30, 2004, the consolidation of Clipper included a charge to net income of $0.5 million comprised primarily of a $0.8 million credit to rent expense and a charge of $1.0 million and $0.3 million in interest and depreciation, respectively.

(a)  Insurance

     We self-insure for certain insurable risks, including general and professional liability, workers' compensation liability and employee health insurance liability, through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that the amounts funded to our programs of self-insurance may not be sufficient to respond to all claims asserted under those programs. In addition, in certain states in which we operate, state law prohibits insurance coverage for punitive damages arising from general and professional liability litigation, and we could be held liable for punitive damages in those states. Although we believe the companies we have purchased insurance from are solvent, in light of the dramatic changes occurring in the insurance industry in recent years, we cannot be assured that they will remain solvent and able to fulfill their obligations . Provisions for estimated reserves, including incurred but not reported losses, are provided in the period of the related coverage. These provisions are based on actuarial analyses, internal evaluations of the merits of individual claims, and industry loss development factors or lag analyses. The methods of making such estimates and establishing the resulting reserves are reviewed periodically, and any resulting adjustments are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

     Prior to January 1, 2000, the maximum loss exposure with respect to the third-party insurance policies was $100,000 per claim for general and professional liability. Since January 2000, we have relied upon self-funded insurance programs for general and professional liability claims up to a base amount per claim and an aggregate per location, and we obtained excess insurance policies for claims above those amounts. The programs had the following self-insured retentions: (i) for events occurring from January 1, 2000 to December 31, 2002, $1.0 million per claim, and $3.0 million aggregate per location, (ii) for claims made in 2003, $10.0 million per claim with excess coverage above this level, and (iii) for claims made in 2004, $5.0 million per claim with excess coverage of $5.0 million above this level. An independent actuarial

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

analysis is prepared twice a year to determine the expected losses and reserves for estimated settlements for general and professional liability under the per claim retention level, including incurred but not reported losses. For the years 2000 through 2004, these reserves are provided on an undiscounted basis. We estimate our range of exposure at September 30, 2004 was approximately $105.8 million to $129.3 million. We anticipate that the range will decline over time as risks associated with facilities we no longer operate age past the applicable statute of limitations. The paid claims for the three months ended September 30, 2004 and 2003 were $5.6 million and $2.4 million, respectively, and $16.0 million and $13.3 million for the nine months ended September 30, 2004 and 2003, respectively.

     The majority of our workers' compensation risks are insured through insurance policies with third parties. Our reserves are estimated by independent actuaries beginning with the 2000 policy year and by company analysis using industry development factors for prior years. Effective with the policy period beginning January 1, 2002, we discount our workers' compensation reserves based on a 4% discount rate. At September 30, 2004, the discounting of these policy periods resulted in a reduction to our reserves of approximately $7.3 million. We estimate our range of exposure at September 30, 2004 was approximately $55.6 million to $68.0 million. The paid claims for each of the three months ended September 30, 2004 and 2003 were $4.6 million and $3.5 million, respectively, and $15.2 million and $19.2 million, respectively, for the nine months ended September 30, 2004 and 2003.

     The provision for loss for insurance risks for the periods presented (in thousands):

     A summary of the assets and liabilities related to insurance risks at September 30, 2004 and December 31, 2003 were as indicated (in thousands):

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     Restricted cash, included in current assets, as of September 30, 2004 and December 31, 2003, was $26.0 million and $33.7 million, respectively, related to our funding of self insurance obligations and various escrow and bond commitments. Of the $26.0 million restricted as of September 30, 2004, $17.1 million was held for workers' compensation claim payments, $3.1 million was held for the payment of patient care liability claims and settlements, $3.9 million was held for bank collateral, various mortgages and bond payments and $1.9 million was held as a reserve for capital expenditures on HUD buildings. Of the $33.7 million restricted as of December 31, 2003, $22.4 million was held for workers' compensation claim payments, $5.0 million was held for the payment of patient care liability claims and settlements and $6.3 million was held for bank collateral, various mortgages and bond payments.

     Non-current restricted cash as of September 30, 2004 and December 31, 2003 was $34.9 million and $33.9 million, respectively. Of the $34.9 million restricted as of September 30, 2004, $31.8 million was related to our funding of future workers' compensation self-insurance obligations and $3.1 million was maintained to repay a mortgage. Of the $33.9 million restricted as of December 31, 2003, $31.0 million was related to our funding of self-insurance obligations and $2.9 million was maintained to repay a mortgage.

     As of September 30, 2004, we had 15,320,766 shares of our common stock outstanding. These shares were issued as follows: 9,895,534 shares in connection with our emergence from proceedings under chapter 11 of title 11 of the United States Code, 240,000 shares pursuant to the 2004 Equity Incentive Plan, 4,425,232 shares in a private placement in February 2004, and 760,000 shares to Omega Healthcare Investors, Inc. ("Omega") upon Omega's exercise of its right to convert approximately $7.8 million of deferred base rent into our common stock. As of September 30, 2004, we expected to issue up to an additional 104,466 shares of our common stock to general unsecured creditors with claims of more than $50,000 in accordance with our Plan of Reorganization. The fair value of the additional common stock to be issued is approximately $2.8 million valued at $27.00 per share by our Plan of Reorganization and is recorded in other long-term liabilities in the September 30, 200 4 consolidated balance sheet. On November 1, 2004, the closing price of our common stock on Nasdaq was $7.85 per share.

     In April 2002, we issued warrants to purchase approximately 500,000 shares of our common stock to the holders of our senior subordinated notes prior to emergence from bankruptcy. The warrants have a strike price of $76.00 per share and expire on February 27, 2005. The fair value of the warrants was estimated to be $1.8 million and was recorded in additional paid-in capital in the September 30, 2004 consolidated balance sheet.

     In February 2004, in conjunction with our private equity offering, we issued warrants to purchase 2,017,897 shares of our common stock, of which 1,707,924 shares have a strike price of $12.65, 62,160 shares have a strike price of $12.82, and 247,813 shares have a strike price of $15.87. The warrants have an exercise period of five years.

     In February 2002, we adopted the 2002 Management Equity Incentive Plan (the "2002 Plan"), which allowed for the issuance of up to 900,000 shares of our common stock. In March and May 2004, our Board of Directors and stockholders, respectively, amended and restated the 2002 Plan and renamed it as the 2004 Equity Incentive Plan (the "2004 Plan"). Under

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

the 2004 Plan, an additional 1.2 million shares are authorized for issuance as awards. As of September 30, 2004, our employees and directors held options to purchase 442,430 shares under this plan and we had issued 240,000 shares of restricted common stock and awarded 134,300 shares of stock units.

     In March 2002, we adopted the 2002 Non-employee Director Equity Incentive Plan (the "Director Plan"), which, as amended in August 2002, allowed for the issuance of up to 160,000 options to purchase shares of our common stock. Upon the adoption of the 2004 Plan, the grant of further awards under the Director Plan was suspended so that no additional awards could be made under the Director Plan. As of September 30, 2004, our directors held options to purchase 60,000 shares under the Director Plan.

     As of September 30, 2004, we had outstanding options covering an aggregate of 502,430 shares of our common stock to our employees and directors, of which 442,430 options were granted with a strike price of $6.85 per share and expire in 2011, 30,000 options were granted with a strike price of $11.25 per share and expire in 2011, and 30,000 options were granted with a strike price of $27.00 per share and expire in 2009. The strike prices were equal to or greater than the estimated market value at date of issuance. The options vest 25% per year on the first four anniversary dates.

     On June 2, 2004, we canceled stock options to purchase an aggregate of 660,000 shares of common stock at an exercise price of $27.00 per share. The holders of the canceled options, who are all our employees, received the contingent right to receive a replacement stock option to be granted on or about December 3, 2004, with the replacement stock option covering the same number of shares as the canceled option and a per share exercise price equal to the market price of a share of our stock on the date of grant of the new stock option.

     We account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25"), and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of our stock at the date of grant over the amount an employee must pay to acquire the stock. We currently do not recognize compensation expense for our stock option grants, which are issued at fair market value on the date of grant and accounted for under the intrinsic value method, prescribed in APB No. 25.

     Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure ("SFAS No. 148"), issued on December 31, 2002, provides companies alternative methods to transitioning to Statement of Financial Accounting Standards No. 123, Stock-Based Compensation ("SFAS No. 123"), fair value method of accounting for stock-based employee compensation and amends certain disclosure requirements. SFAS No. 148 does not mandate fair value accounting for stock-based employee compensation but does require all companies to meet the disclosure provisions.

     For purposes of pro forma disclosures, the estimated fair market value of the stock options is amortized to expense over their respective vesting periods. The fair market value has been estimated at the date of grant using a Black-Scholes option pricing model. The following table summarizes our pro forma net income and diluted net income per share assuming we accounted for our stock option grants in accordance with SFAS No. 123, for the periods indicated (in thousands, except per share amounts):

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Since our stock options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

     On October 13, 2004, the FASB concluded that Statement of Financial Accounting Standards No. 123R, "Share-Based Payment" ("SFAS No. 123R") which would require all companies to measure compensation cost for all share-based payments (including employee stock options) at fair value, would be effective for public companies for interim or annual periods beginning after June 15, 2005. Retroactive application of the requirements of SFAS No. 123R to the beginning of the fiscal year that includes the effective date would be permitted, but not required. Early adoption of SFAS No. 123R is encouraged. We are currently assessing the potential impact on our financial condition and results of operations from the adoption of SFAS No. 123R.

     Basic net income (loss) per share is based upon the weighted average number of common shares outstanding during the period. The weighted average number of common shares for the three and nine months ended September 30, 2004 include the common shares issued in connection with emergence from bankruptcy, 104,466 common shares outstanding to be issued once the prepetition claims are finalized, the common shares issued in connection with our private placement in February 2004, the common shares issued to Omega, and the common shares issued as common stock awards. See "Note 9 - Capital Stock."

     The diluted calculation of income (loss) per common share includes the dilutive effect of warrants, stock options and non-vested restricted stock. However, in periods of losses, diluted net loss per share is based upon the weighted average number of common shares outstanding during the period.

     The provision for income taxes is based upon our estimate of taxable income or loss for each respective accounting period. We recognized an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled. We also recognized as deferred tax assets the future tax benefits from net operating loss ("NOL"), capital loss, and tax credit carryforwards. A valuation allowance was provided for deferred tax assets as it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

     There is no provision for income taxes for the three months ended September 30, 2004. The current provision for income taxes of $0.2 million for the three months ended September 30, 2003 was based on estimated state income tax liability for that period. The current benefit for income taxes of $1.1 million for the nine months ended September 30, 2004 consisted of $1.4 million of IRS refunds received due to NOL carrybacks less $0.3 million of estimated state income tax liability for this period. The current provision for income taxes of $0.7 million for the nine months ended September 30, 2003 was based on estimated state income tax liability for that period. These estimated state income tax liabilities resulted from the operations of profitable subsidiaries in states that do not allow combined, consolidated or unitary tax return filings. No overall tax benefits other than for refunds received were recorded for these periods for federal income tax purpos es since the realization of NOL carryforwards is uncertain.

     In connection with our emergence from bankruptcy on February 28, 2002, we realized a gain on the extinguishment of debt of approximately $1.5 billion. This gain was not taxable since the gain resulted from our reorganization under the Bankruptcy Code. However, pursuant to Section 108 of the Internal Revenue Code, we were required as of the beginning of

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

our 2003 taxable year to reduce certain tax attributes, including (a) NOL and capital loss carryforwards, (b) certain tax credits, and (c) tax bases in assets, in an amount equal to such gain on extinguishment.

     After considering the reduction in tax attributes discussed above, we have federal NOL carryforwards of $1.1 billion with expiration dates from 2004 through 2024. Various subsidiaries have state NOL carryforwards totaling $1.2 billion with expiration dates through the year 2024. In addition, we have capital loss carryforwards of $272.6 million, of which $10.1 million, $260.4 million and $2.1 million will expire in 2004, 2006, and 2007, respectively. Our alternative minimum tax credit carryforward of $4.3 million has no expiration date. Our $7.2 million of other tax credit carryforwards will expire in years 2004 through 2022.

     Internal Revenue Code Section 382 imposes a limitation on the use of a company's NOL carryforwards and other losses when the company has an ownership change. In general, an ownership change occurs when shareholders owning 5% or more of a "loss corporation" (a corporation entitled to use NOL or other loss carryovers) have increased their ownership of stock in such corporation by more than 50 percentage points during any 3-year testing period beginning on the first day following the change date for an earlier ownership change. The annual base Section 382 limitation is calculated by multiplying the loss corporation's value at the time of the ownership change times the greater of the long-term tax-exempt rate determined by the IRS in the month of the ownership change or the two preceding months.

     Our reorganization under the Bankruptcy Code effective February 28, 2002, constituted an ownership change under Section 382 of the Internal Revenue Code. Therefore, the use of any of our losses and tax credits generated prior to that date which remain after attribute reduction are subject to the limitations described in Section 382. Our application of the rules under Section 382 and Section 108 is subject to challenge upon IRS review. A successful challenge could significantly impact our ability to utilize deductions, losses and tax credits generated prior to 2003.

     We have had significant changes in the ownership of our stock since our emergence from bankruptcy as a result of changes in the holdings of our 5% or more stockholders and our private placement of common stock and accompanying warrants. A second ownership change has not yet occurred. However, future acquisitions and/or capital needs may necessitate the issuance of additional shares which could trigger such a change. In addition, subsequent changes in the holdings of current or future 5% or more shareholders could result in a second ownership change. The resulting base Section 382 limitation that would be imposed on us upon a second ownership change to limit the use of our tax attributes for federal income tax purposes would depend on our value at that time as calculated under the applicable Treasury Regulations.

(a)  Litigation

     In February 2003, the Bureau of Medi-Cal Fraud and Elder Abuse (the "BMFEA"), which is a division of the Office of the Attorney General of the State of California, alleged that we violated the terms of the Permanent Injunction and Final Judgment (the "PIFJ") entered in during October 2001. Those allegations were reiterated in correspondence we received from the BMFEA in October 2004. Pursuant to the PIFJ, we are enjoined from engaging in violations of federal or state statutes or regulations governing the operation of health care facilities in the State of California. Among other things, the BMFEA alleged that our California facilities have had inadequate staffing, training and supervision. To remedy these alleged violations, the BMFEA requested that we pay their costs of the investigation and to audit our operations in California, and, initially, requested an unspecified cash penalty. We believe that we are in compliance with the PIFJ; however, it no w appears probable that the BMFEA will ultimately initiate proceedings against us to assert a violation. We are unable to determine any action that the BMFEA might take if a court were to find that we have violated the PIFJ nor can we estimate any amount that the BMFEA may ultimately seek or the remedies that court may ultimately award against us, or the cost to us resulting from an adverse outcome in this matter. An adverse outcome in these matters could have a material adverse effect on our financial position, results of operations and cash flows. We intend to defend this matter vigorously.

     In January 2004, 12 care givers, now former employees of SunBridge Care and Rehab for Escondido-East, were arraigned on charges brought by the California Attorney General with respect to allegations that care given to an elderly woman resident was deficient. The court dismissed all charges against the twelve defendants in June 2004. In September

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2004, the California Attorney General refiled misdemeanor charges against the same defendants. SunBridge Care and Rehab for Escondido-East is a skilled nursing facility in Escondido, California that is operated by Care Enterprises West, an indirect subsidiary of Sun Healthcare Group, Inc. Neither Sun Healthcare Group, Inc. nor Care Enterprises West has been charged with any wrongdoing.

     On June 1, 2004, we commenced a declaratory relief action in the Orange County, California Superior Court in which Steadfast Insurance Company, American International Group ("AIG") and certain of AIG's subsidiaries are parties. The action seeks, among other things, a judicial determination that the carrier providing coverage under our excess/umbrella insurance policy for the 2000 through 2002 policy years is obligated to provide first dollar insurance coverage for those three policy years pursuant to the terms of the excess/umbrella policy. That policy provides that the excess/umbrella policy continues in force as underlying insurance upon exhaustion of the underlying primary insurance policy.  If we prevail in this action, such a judicial determination would eliminate a portion of our self-insured liabilities for general and professional liability claims.  We can give no assurances that we will in fact prevail and, accordingly, our financial state ments reflect no positive adjustment for the drop down of the excess/umbrella coverage asserted in this litigation.

     We are a party to various other legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our facilities, claims relating to employment and commercial matters. We have experienced an increasing trend in the number and severity of litigation claims asserted against us. We believe that this trend is endemic to the long-term care industry and is a result of the increasing number of large judgments, including large punitive damage awards, against long-term care providers in recent years resulting in an increased aggressiveness due to the heightened awareness by plaintiff's lawyers of potentially large recoveries. In certain states in which we have significant operations, including California, insurance coverage for the risk of punitive damages arising from general and professional liability litigation is ge nerally not available due to state law public policy prohibitions. There can be no assurance that we will not be liable for punitive damages awarded in litigation arising in states for which punitive damage insurance coverage is not available.

     We operate in industries that are extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are or have been and/or may in the future be non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, these industries are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is ever found by a court of competent jurisdiction to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief, and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there has been, and will co ntinue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

(b)  Reimbursement Matters

     In the ordinary course of business, fiscal intermediaries and Medicaid agencies examine cost reports filed by our skilled nursing facilities. If, as a result of any such examination, it is concluded that overpayments were made, we would be held financially responsible for such overpayments. At this time we are unable to predict the outcome of any existing or future examinations.

     During a routine compliance audit of a division of SunAlliance, our laboratory and radiology services subsidiary that has estimated annual revenues of approximately $45.0 million, we discovered billing problems related to a 2003 billing system conversion. A revenue adjustment of approximately $3.3 million for the prior year was recorded in March 2004 of which $2.4 million related to a revenue overpayment. See "Note 6 - Assets Held for Sale" and "Note 15 - Subsequent Events."

     We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     The following summarizes the services provided by our reportable and other segments:

Inpatient Services: This segment provides, through SunBridge Healthcare Corporation and other of our direct and indirect subsidiaries (collectively "SunBridge"), inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. We provide 24-hour nursing care in these facilities by registered nurses, licensed practical nurses and certified nursing aids. At September 30, 2004, we operated 106 long-term care facilities (consisting of 89 skilled nursing facilities, six mental health facilities, eight assisted living facilities and three specialty acute care hospitals) with 10,826 licensed beds as compared with 124 facilities with 12,544 licensed beds at September 30, 2003.

Rehabilitation Therapy Services: This segment provides, through SunDance Rehabilitation Corporation ("SunDance"), physical, occupational and speech therapy services to affiliated and nonaffiliated skilled nursing facilities. At September 30, 2004, this segment provided services to 401 facilities, of which 311 were nonaffiliated and 90 were affiliated, as compared to 477 facilities at September 30, 2003, of which 364 were nonaffiliated and 113 were affiliated.

Medical Staffing Services: This segment provides temporary medical staffing, primarily through CareerStaff Unlimited, Inc. ("CareerStaff"). For the nine months ended September 30, 2004, CareerStaff derived approximately 17% of its revenues from schools and governmental agencies, 53% from hospitals and other providers and 30% from skilled nursing facilities. CareerStaff provides (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians and (iv) related medical personnel. As of September 30, 2004, CareerStaff had 33 division offices, which provided temporary therapy and nursing staffing services in major metropolitan areas and 3 division offices, which specialized in the placement of temporary traveling therapists and nurses in smaller cities and rural areas.

Home Health Services: This segment provides skilled nursing care, rehabilitation therapy and home infusion services to adult and pediatric patients in California and Ohio through SunPlus Home Health Services, Inc. ("SunPlus"). SunPlus also operates three licensed pharmacies in California.

Laboratory and Radiology Services: This segment provides mobile radiology and medical laboratory services in Arizona, Colorado and Massachusetts to skilled nursing facilities, primarily through SunAlliance Healthcare Services, Inc. ("SunAlliance"). See "Note 15 - Subsequent Events."

     Corporate assets primarily consist of cash and cash equivalents, receivables from subsidiary segments, notes receivable and property and equipment.

     Our reportable segments are strategic business units that provide different products and services. They are managed separately, among other reasons, because each business has different marketing strategies due to differences in types of customers, different distribution channels and different capital resource needs.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

    The following tables summarize, for the periods indicated, operating results and other financial information, by business segment:

Segment Information (in thousands):