T.C. Memo. 2020-78
UNITED STATES TAX COURT
FREDERICK HOWE AND BONITA A. MACVAUGH-HOWE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 29743-14. Filed June 8, 2020.
Gregory S. Markow, for petitioner Frederick Howe.
Mitchell B. Dubick, for petitioner Bonita A. MacVaugh-Howe.
Chad E. Martinelli and Darrick D. Sun, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
KERRIGAN, Judge: Respondent determined a deficiency, as amended by
amended answer to petitioners’ amended petition, in petitioners’ 2008 Federal
income tax of $8,431,433 and an accuracy-related penalty pursuant to section
6662(a) of $1,972,815. Pursuant to the Court’s order dated March 1, 2019, this -2-
[*2] case was bifurcated for the purpose of addressing the application of equitable
estoppel.1 The Court held a partial trial commencing on May 28, 2019. The issues
for our consideration are: (1) whether the notice of deficiency is valid and (2)
whether respondent is estopped from denying the executed settlement agreement
in Form 870-AD, Offer to Waive Restrictions on Assessment and Collection of
Tax Deficiency and to Accept Overassessment.
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect at all relevant times, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulated
facts and attached exhibits are incorporated in our findings by this reference.
Petitioners resided in California when they timely filed their petition. On
July 31, 2018, the parties filed a joint stipulation of settled issues in which they
stipulated that petitioner wife no longer contests respondent’s determination for
2008 set forth in respondent’s amended answer to amended petition and that she is
1 If petitioners prevail, no further proceedings are necessary. If respondent prevails, further trial is necessary to redetermine the deficiency and the penalty pursuant to sec. 6662(a) determined in the notice of deficiency and the amended answer to the amended petition. -3-
[*3] entitled to relief from joint and several liability for the deficiency pursuant to
section 6015(f).
I. Background
Throughout 2008 Frederick Howe (petitioner) was the chief executive
officer and majority common stock shareholder of MedImpact Healthcare
Systems, Inc. (MedImpact). MedImpact was a C corporation incorporated in
Delaware on November 6, 2002. On October 31, 2008, MedImpact’s board of
directors approved a resolution declaring a $45 million dividend to be paid pro
rata to the shareholders.
Summit Ventures Holdings Fund 1, LP (Summit Ventures), was formed as a
limited partnership in Delaware on August 23, 2007. Summit Ventures was a
private equity firm that received funds from investors to invest in healthcare
entities. During 2008 Summit Ventures owned interests in the following entities:
Herae, LLC, Ventegra, LLC, Chronohealth, LLC, Intellitap, LLC, and Medical
Pipeline, LLC (collectively, Schedule E entities). MedImpact transferred funds to
the Schedule E entities in 2008.
Petitioner was the trustee of the Howe Family Trust pursuant to a grantor
trust agreement dated May 30, 2003, and, as trustee, he was the sole limited
partner in Summit Ventures. Effective October 31, 2008, petitioner, as trustee of -4-
[*4] the Howe Family Trust, assigned a 20% limited partner interest in Summit
Ventures to MedImpact. For 2008 Chronohealth, LLC, issued a Schedule K-1,
Partner’s Share of Income, Deductions, Credits, etc., to Summit Ventures. The
other four Schedule E entities issued Schedules K-1 to the Howe Family Trust.
II. Corporate Audit
Internal Revenue Service (IRS) Revenue Agent Lord (RA Lord) began an
audit of MedImpact’s 2008 return in February 2011. David Wheeler,
MedImpact’s chief financial officer, represented the corporation during its audit.
As part of the audit RA Lord performed a risk analysis which identified potential
issues for audit, and she identified loans to the Schedule E entities. She looked at
the transfers MedImpact made to the Schedule E entities to determine whether
they were bona fide loans to those entities or whether they were dividends to
petitioner.
On its books and records MedImpact recorded the transfers it made to the
Schedule E entities as loans to petitioner. The Schedule E entities recorded the
transfers they received as capital contributions by petitioner. RA Lord requested
documents in support of the shareholder loans. She received a promissory note, an
Excel spreadsheet listing loans that totaled the amount of the promissory note, and -5-
[*5] an auditor’s letter referencing the promissory note. The promissory note
records petitioner as the borrower and MedImpact as the lender.
Mr. Wheeler provided a loan roll-forward schedule which listed the prior
notes from MedImpact to petitioner. Using the loan roll-forward schedule, RA
Lord traced the direct transfers from MedImpact to the Schedule E entities. From
the loan roll-forward schedule RA Lord concluded that petitioner took draws from
MedImpact which it recorded as receivables due from petitioner. MedImpact’s
corporate board meeting minutes show that petitioner’s pro rata share of the $45
million dividend was credited to his note receivable balance. RA Lord determined
that the loans from MedImpact to petitioner were bona fide loans with a stated
interest rate, maturity date, and repayment date.
III. Petitioners’ Individual Audit and Appeals Office Process
Petitioners timely filed a joint Form 1040, U.S. Individual Income Tax
Return, for 2008. Petitioner concluded that he had sufficient at-risk bases in the
Schedule E entities and claimed deductions for losses they generated on Schedule
E, Supplemental Income and Loss, for 2008. In February 2011 RA Lord began an
audit of petitioners’ individual 2008 Form 1040. Mr. Wheeler represented
petitioner during the individual audit. Mitchell Dubick represented petitioner
wife. -6-
[*6] On May 10, 2012, after completing the individual audit, RA Lord sent
petitioners a Notice of Proposed Adjustment (NOPA) and a Form 886-A,
Explanation of Items. As part of her examination she considered whether
petitioner had sufficient at-risk bases in the Schedule E entities and whether he
was entitled to claim the loss deductions they generated. She looked at whether
the transactions between MedImpact and the Schedule E entities were loans to
petitioner or whether the corporation had made dividend distributions. On Form
886-A, RA Lord stated the facts as:
[Petitioner] borrows amounts from MedImpact to personally invest in entities tied to the healthcare industry (“Schedule E entities”).
[Petitioner] takes draws from MedImpact throughout the year, which are converted to loans at year end with a stated interest rate.
[Petitioner] provided the outstanding loan balance schedule as of December 31, 2008.
She further stated that petitioner deducted the loss generated by each of the
Schedule E entities “rather than as a single flow through loss from the Summit
Fund.”
In the NOPA RA Lord denied the at-risk loss deductions petitioner claimed
from the Schedule E entities. In reliance on Van Wyk v. Commissioner, 113 T.C.
440 (1999), and section 465 she concluded that because MedImpact had obtained -7-
[*7] a capital interest in Summit Ventures during 2008, petitioner’s claimed loss
deductions from Schedule E were suspended for the year.
Petitioner retained Phillip Jelsma, a tax attorney and C.P.A., to draft a
protest letter in response to the NOPA and to represent him before the IRS
Appeals Office.2 Mr. Jelsma reviewed the NOPA, including RA Lord’s
adjustment to the calculation of petitioner’s at-risk bases and disallowance of the
associated loss deductions. On June 12, 2012, Mr. Jelsma sent a protest letter on
behalf of petitioner. He contended that the at-risk calculation was done
incorrectly, including the calculation of the at-risk bases. He argued that RA
Lord’s reliance on Van Wyk was misplaced because petitioner did not borrow
from another shareholder to invest in the Schedule E entities. He explained that
the loans from MedImpact to petitioner were shown on MedImpact’s financial
statements and treated the same as any loan to a third party.
After RA Lord reviewed petitioner’s protest letter, she closed the individual
audit in July 2012 and transferred the individual administrative file to the Appeals
Office. The individual audit file included a copy of the loan roll-forward schedule
provided by MedImpact during the corporate audit. She did not send the Appeals
Office the full corporate audit file of MedImpact.
2 Mr. Dubick represented petitioner wife’s interest at the IRS Appeals Office. -8-
[*8] In February 2013 Appeals Officer James Parker (RO Parker) was assigned
to consider petitioners’ appeal of adjustments made by RA Lord, including the at-
risk adjustment. RO Parker reviewed the NOPA, the individual audit file, and RA
Lord’s at-risk adjustments and disallowance of at-risk loss deductions. He held
meetings with Mr. Dubick and Mr. Jelsma, and during one of those meetings they
discussed the at-risk adjustments.
On February 12, 2014, Mr. Wheeler, on behalf of petitioner, and Mr.
Dubick, on behalf of petitioner wife, each signed a Form 870-AD. A person with
the appropriate authority signed and accepted the Form 870-AD on behalf of the
Commissioner. Form 870-AD reduced petitioners’ deficiency to $1,511,192 and
the accuracy-related penalty to zero. Form 870-AD stated that the case would not
be reopened by the Commissioner unless there were specific occurrences
including “fraud, malfeasance, concealment, or misrepresentation of a material
fact”.
In March 2014 RO Parker finalized his Appeals Case Memorandum (ACM),
which explained the resolution of the proposed adjustments to petitioners’ Federal
income tax for 2008. The ACM included a fact section which explained that
petitioner reported losses on Schedule E for the Schedule E entities, MedImpact
recorded loans to the Schedule E entities, and the Schedule E entities recorded -9-
[*9] capital contributions in 2008. The ACM summarized RA Lord’s position that
amounts lent by MedImpact were not considered in computing the extent to which
petitioner was at risk and that the loss deductions exceeding the at-risk amount
were includible in gross income.
The ACM described petitioner’s position as stated in his protest letter,
which was that the at-risk amount was incorrectly computed as a basis calculation
rather than at-risk. The ACM explained that during the meetings Mr. Jelsma
raised a different argument, which was the following:
The loans were not bona fide loans: • No notes were ever executed. • No repayments were ever made. • While interest accrued on MedImpact’s books, no interest was ever recorded on the entity books or paid. • In lieu of interest, a “non-cash dividend” was reported by * * * [petitioner] in 2008. • On the books and tax returns of the entities, the amounts were reported as capital contributions, not loans.
So the advances do not meet the IRS criteria for bona fide loans. And despite how they were recorded by MedImpact, the amounts were not treated as loans by * * * [petitioner]. The amounts were incorrectly reported as loans by MedImpact’s accountant, and correctly recorded as capital contributions by each entity.
Therefore the amounts should be included in the at-risk computations. When included, * * * [petitioner] was adequately at- risk to deduct the losses in full. - 10 -
[*10] RO Parker described petitioner’s argument as “a different argument” from
the one he made during the audit. Before petitioners were sent the Form 870-AD,
the parties each made concessions in an effort to reach the agreement. Because of
litigating hazards for the Government, RO Parker conceded the at-risk adjustments
made by RA Lord in the NOPA.
On April 22, 2014, respondent assessed the deficiency in Form 870-AD.
Approximately a week before the deficiency was assessed petitioners paid $887 on
April 15, 2014. For tax year 2008 petitioners paid $17,149 of interest to
respondent before the execution of the Form 870-AD.
RA Lord received a copy of the ACM from RO Parker. On May 28, 2014,
RA Lord, her immediate supervisor, and local IRS counsel met with RO Parker to
go over information discussed during the Appeals process. RA Lord and her
immediate supervisor filed a Dissent for Appeals Decision (Dissent) to RO
Parker’s ACM. RA Lord filed the Dissent because a disposition of an issue in the
case involved misrepresentation of material facts by petitioner. The Dissent
explains that because of a misrepresentation of material facts, the Appeals Office
concluded that the amounts petitioner borrowed were not bona fide loans. In the
Dissent RA Lord claims that the during the Appeal’s Office process, petitioner - 11 -
[*11] claimed for the first time that amounts that he had withdrawn from
MedImpact were not bona fide loans.
The Dissent requested that petitioner’s case be reopened pursuant to Policy
Statement 8-3 in the IRS Internal Revenue Manual (IRM) pt. 1.2.17.1.3(2) (Jan. 5,
2007), because the disposition of an issue in the case involved misrepresentations
of material facts by petitioner. The Appeals Director for Field Operations West
approved reopening petitioners’ case for tax year 2008.
IV. Notice of Deficiency
On September 17, 2014, respondent issued a notice of deficiency. In a
statement attached to the notice of deficiency, respondent explained that petitioner
had not established entitlement to the loss deductions he claimed from Schedule E.
Before respondent issued the notice of deficiency RO Parker notified petitioners
that the audit for their 2008 tax year would be reopened because of respondent’s
conclusion that petitioner had made misrepresentations of material facts.
OPINION
Challenge to the Validity of the Notice of Deficiency
The Court’s jurisdiction to redetermine a deficiency depends upon the
issuance of a valid notice of deficiency and a timely filed petition. Secs. 6212,
6213, 7442; Rules 13, 20; see, e.g., Midland Mortg. Co. v. Commissioner, 73 T.C. - 12 -
[*12] 902, 907 (1980). Section 7522(a) provides that the notice must “describe
the basis for, and identify the amounts (if any) of, the tax due, interest, additional
amounts, additions to tax, and assessable penalties included in such notice.” The
parties do not dispute that a notice of deficiency was issued and that a petition was
timely filed. Rather, petitioner contends that the notice of deficiency is invalid
because respondent deviated from internal policies in reopening the audit for his
2008 tax year.
A proceeding before this Court to redetermine a deficiency is a proceeding
de novo, and we generally will not look behind a notice of deficiency to determine
its validity. Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 327 (1974).
Our decision is based on the merits of the record before us and not on the record
developed at the administrative level. Id. at 328. We have recognized an
exception to this rule when there is substantial evidence of unconstitutional
conduct on the Commissioner’s part and the integrity of our judicial process would
be impugned if we were to let the Commissioner benefit from such conduct. Id.
On the facts before us we hold that there is no substantial evidence of
unconstitutional conduct by respondent. Accordingly, the notice of deficiency
sent to petitioners is a valid notice. - 13 -
[*13] Equitable Estoppel
Generally, the Commissioner’s determinations in a notice of deficiency are
presumed correct, and the taxpayer bears the burden of proving that those
determinations are erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111,
115 (1933). Petitioner argues that the Form 870-AD executed by the parties is
presumptively valid and that respondent is bound by contract law to honor the
agreement. He contends that respondent bears the burden of proving the
affirmative defense of fraud to reopen the audit for his 2008 tax year. We
disagree.
Sections 7121 and 7122 and their accompanying regulations establish
procedures for closing agreements and compromises of tax liabilities, respectively.
These procedures are exclusive and must be satisfied for there to be a compromise
or settlement that is binding on both the taxpayer and the Government. Dormer v.
Commissioner, T.C. Memo. 2004-167, slip op. at 11-12; Rohn v. Commissioner,
T.C. Memo. 1994-244, 1994 WL 232360, at *4. Form 870-AD is not a binding
settlement agreement under section 7121. Whitney v. United States, 826 F.2d 896,
898 (9th Cir. 1987); see also Botany Worsted Mills v. United States, 278 U.S. 282,
288-289 (1929). - 14 -
[*14] Petitioner contends that the settlement agreement embodied in Form 870-
AD equitably estops respondent from setting aside the agreement and issuing a
notice of deficiency which increases the parties’ agreed-to deficiency. Respondent
contends that petitioner concealed or misrepresented material facts, or both, and
that this justifies respondent’s reopening of the audit for petitioner’s 2008 tax
year. Respondent contends that during the Appeals Office process petitioner
concealed that there were loans from MedImpact to petitioner.
Equitable estoppel is a judicial doctrine that precludes a party from denying
his own acts or representations which induced another to act to his detriment.
Hofstetter v. Commissioner, 98 T.C. 695, 700 (1992). The Supreme Court has
held that “equitable estoppel will not lie against the Government as it lies against
private litigants.” Office of Pers. Mgmt. v. Richmond, 496 U.S. 414, 419 (1990).
The doctrine of equitable estoppel is applied against the Commissioner
“with utmost caution and restraint”. Schuster v. Commissioner, 312 F.2d 311, 317
(9th Cir. 1962), aff’g in part, rev’g in part 32 T.C. 998 (1959). Any successful
attempt to invoke equitable estoppel against the Commissioner must outweigh the
policy consideration in favor of “an efficient collection of the public revenue”. Id.
According to the Court of Appeals for the Ninth Circuit the traditional
elements of equitable estoppel include: “(1) the party to be estopped must know - 15 -
[*15] the facts; (2) he must intend that his conduct shall be acted on or must so act
that the party asserting the estoppel has a right to believe it is so intended; (3) the
latter must be ignorant of the true facts; and (4) he must rely on the former’s
conduct to his injury.” Baccei v. United States, 632 F.3d 1140, 1147 (9th Cir.
2011) (quoting Morgan v. Gonzales, 495 F.3d 1084, 1092 (9th Cir. 2007)). If one
of these elements is not present, equitable estoppel is not appropriate. Nolte v.
Commissioner, T.C. Memo. 1995-57, 1995 WL 37631, at *5, aff’d, 99 F.3d 1146
(9th Cir. 1996).
In addition to the traditional elements, the party seeking equitable estoppel
against the Government must show that: “(1) the government engaged in
affirmative misconduct going beyond mere negligence; (2) the government’s
wrongful acts will cause a serious injustice; and (3) the public’s interest will not
suffer undue damage by imposition of estoppel.” Baccei, 632 F.3d at 1147. These
three requirements need to be met before any determination of whether the
traditional elements of equitable estoppel are present. Purcell v. United States, 1
F.3d 932, 939 (9th Cir. 1993).
“Affirmative misconduct on the part of the government requires an
affirmative misrepresentation or affirmative concealment of a material fact such as
a deliberate lie or a pattern of false promises.” Baccei, 632 F.3d at 1147 (citation - 16 -
[*16] omitted); see also Purcell, 1 F.3d at 940 (“Affirmative misconduct involves
‘“ongoing active misrepresentations” or a “pervasive pattern of false promises”’ as
opposed to ‘an isolated act of providing misinformation.’” (quoting Watkins v.
U.S. Army, 875 F.2d 699, 708 (9th Cir. 1989))). There is no bright-line rule for
detecting affirmative misconduct; “each case must be decided on its particular
facts and circumstances.” Watkins, 875 F.2d at 707.
Petitioner argues that respondent engaged in affirmative misconduct by
intentionally and deliberately failing to follow IRS internal policies and
procedures in setting aside the parties’ agreement in Form 870-AD. He contends
that affirmative misconduct is evidenced by respondent’s intentionally ignoring
the express terms of Form 870-AD in reopening the audit for his 2008 tax year and
by accepting partial performance under the agreement.
The Form 870-AD executed by the parties specifically stated that, upon
acceptance, petitioners’ case would not be reopened unless there was “fraud,
malfeasance, concealment or misrepresentation of material fact”. Policy Statement
8-3 similarly states that “[a] case closed by Appeals on the basis of concessions
made by both Appeals and the taxpayer will not be reopened by actions initiated
by the Service unless the disposition involved fraud, malfeasance, concealment or
misrepresentation of material fact”. IRM pt. 1.2.17.1.3(2). - 17 -
[*17] For petitioner to estop respondent from reopening petitioners’ audit for the
2008 tax year, resulting in making the notice of deficiency null and void,
petitioner must show that respondent’s action constituted affirmative misconduct
such as a pattern of false promises or lies that respondent relied on when executing
Form 870-AD. Procedural rules and IRM policies “are merely directory, not
mandatory, and ‘compliance with them is not essential to the validity of a notice of
deficiency.’” Collins v. Commissioner, 61 T.C. 693, 701 (1974) (quoting Luhring
v. Glotzbach, 304 F.2d 560, 563 (4th Cir. 1962)); Estate of Brocato v.
Commissioner, T.C. Memo. 1999-424, slip op. at 10.
Respondent contends that petitioner’s concealment or misrepresentation of
material facts at the Appeals Office conference justified reopening the audit for the
2008 tax year. Petitioner argues that there was no concealment or
misrepresentation of material facts and that respondent has been unable to point to
what constituted either concealment or misrepresentation of material facts. RA
Lord testified that petitioner withheld that there was a promissory note between
himself and MedImpact. Mr. Jelsma testified that during the Appeals Office
conference the loan between petitioner and MedImpact was never discussed and
the discussions assumed that MedImpact made payments to the Schedule E entities - 18 -
[*18] on petitioner’s behalf. He testified that the discussions focused on how to
characterize the payments made by MedImpact to the Schedule E entities.
We do not need to decide whether petitioner concealed or misrepresented
material facts because even if we concluded that he did not and that respondent
did not comply with IRS internal procedures, respondent’s action would not be
affirmative misconduct. There is no evidence of ongoing active
misrepresentations, a pervasive pattern of false promises, or any affirmative
misconduct by respondent. Therefore, petitioner has not satisfied the threshold
elements of equitable estoppel.
However, assuming arguendo that petitioner did satisfy the threshold
elements of equitable estoppel, he fails to satisfy all the elements of traditional
equitable estoppel. He does not meet the requirements of the third and fourth
elements.
Under the third element of traditional estoppel, the party seeking estoppel
must be ignorant of the true facts. Baccei, 632 F.3d at 1147. Petitioner argues that
he relied on respondent’s statement that the settlement agreement in Form 870-AD
could not be reopened unless there was a concealment or misrepresentation of
material facts. Petitioner had the responsibility of understanding the law
pertaining to whether respondent was bound by Form 870-AD. See Lavin v. - 19 -
[*19] Marsh, 644 F.2d 1378, 1383 (9th Cir. 1981) (“Persons dealing with the
government are charged with knowing government statutes and regulations, and
they assume the risk that government agents may exceed their authority and
provide misinformation.”). Since 1987 the Court of Appeals for the Ninth Circuit
has taken the position that Form 870-AD is not a binding settlement agreement
pursuant to sections 7121 and 7122. See Whitney, 826 F.2d at 898.
Under the fourth element of traditional estoppel the party asserting estoppel
must detrimentally rely on the other party’s conduct. Baccei, 632 F.3d at 1147.
Detrimental reliance is a primary element of an estoppel claim. See Heckler v.
Cmty. Health Servs. of Crawford Cty., Inc., 467 U.S. 51, 61-62 (1984). Reliance
should be reasonable. See Estate of Brocato v. Commissioner, slip op. at 10.
Petitioner argues that he relied on the agreement in Form 870-AD to his
detriment when he agreed to the decreased deficiency and paid $17,149 of interest
against that deficiency. Agreeing to and making payments on a deficiency are not
detrimental reliance for the purposes of equitable estoppel. See Hudock v.
Commissioner, 65 T.C. 351, 363-364 (1975) (finding that executing an agreement
and making a payment pursuant to that agreement was insufficient “to establish
the requisite ‘substantial change of position to (their) detriment in reliance upon
the government’s conduct’” (quoting United States v. Saladoff, 233 F. Supp. 255, - 20 -
[*20] 258 (E.D. Pa. 1964))). Paying “taxes which are legally assessed does not
constitute the type of detrimental reliance necessary to invoke estoppel.” Bunce v.
United States, 28 Fed. Cl. 500, 506 (1993) (citing Boulez v. Commissioner, 76
T.C. 209, 215 (1981), aff’d, 810 F.2d 209 (D.C. Cir. 1987)), aff’d, 26 F.3d 138
(Fed. Cir. 1994).
We conclude that petitioner has not met the requirements of equitable
estoppel. We have considered all arguments made, and to the extent not
mentioned above, we conclude that they are moot, irrelevant, or without merit.
To reflect the foregoing,
An appropriate order will be issued.