                              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.
