A recent US Tax Court Memorandum Opinion held that a settlement agreement embodied in Internal Revenue Service (IRS) Form 870-AD does not preclude the IRS from reopening an audit and issuing a notice of deficiency.
In Howe v. Commissioner, T.C. Memo 2020-78, the Tax Court held that equitable estoppel did not bind the Commissioner to an agreement in Form 870-AD. Only settlements that comply with Internal Revenue Code (IRC) sections 7121 and 7122 are binding on both the taxpayer and government, and an IRS Form 870-AD does not comply with those provisions. Further, the Court held that equitable estoppel did not bar the IRS from asserting a larger deficiency against the taxpayer because, even if true, the alleged failures to follow internal IRS procedures would not rise to the level of affirmative misconduct.
An IRS revenue agent initially began an audit of the 2008 tax return for the taxpayer, who was CEO and majority shareholder of a healthcare company, in 2011. At the conclusion of the audit, the revenue agent issued a Notice of Proposed Adjustment (NOPA) and IRS Form 886-A. The taxpayer responded to the NOPA by filing a protest letter at the IRS Appeals Office. In settlement of the issue during the IRS Appeals Office review, the taxpayer and the IRS appeals officer (on behalf of the IRS) signed a Form 870-AD that reduced the asserted tax deficiency and eliminated the IRC section 6662 accuracy-related penalty. The IRS Appeals Officer filed an IRS Appeals Case Memorandum (ACM) summarizing the facts and legal arguments.
In response to the ACM, the revenue agent who conducted the audit, in consultation with her supervisor and local IRS counsel, internally filed a Dissent for Appeals Decision. The Dissent for Appeals Decision sought to reopen the case against the taxpayer on the grounds that the taxpayer made material factual misrepresentations during the IRS Appeals process. The IRS Appeals Director approved reopening the case, and the IRS issued a Notice of Deficiency.
The taxpayer sought review in the Tax Court on the grounds that the IRS improperly reopened the case and that the settlement represented in Form 870-AD equitably estopped the Commissioner from issuing the Notice of Deficiency. The Tax Court rejected the taxpayer’s argument. Following its holding in Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 327 (1974), the Tax Court will only look behind a Notice of Deficiency 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.” (Howe, at *12.) The Tax Court found there was no substantial evidence of unconstitutional conduct by the IRS.
Further, there is a heightened standard for applying equitable estoppel against the IRS. In addition to the traditional detrimental reliance elements, asserting equitable estoppel claims against the government requires a showing 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.” (Howe, at *15 (quoting Baccei v. United States, 632 F.3d 1140, 1147 (9th Cir. 2011)).) The Tax Court reasoned that even if the taxpayer made no material misrepresentations and the IRS did not comply with its internal procedures, the IRS did not engage in ongoing active misrepresentations, a pattern of false promises or affirmative misconduct. Thus, the heightened standard for asserting equitable estoppel against the government was not satisfied.
Moreover, the Tax Court raised doubts about whether the taxpayer would satisfy the traditional detrimental reliance test. In particular, the Tax Court suggested that the taxpayer should have known that the IRS was not bound by IRS Form 870-AD. Further, there was no detrimental reliance because agreeing to and making payments on a deficiency are not sufficient to constitute detrimental reliance under the prevailing case law.
Practice Point: Howe is a good reminder that when you settle an issue with the IRS, if you want to make sure it is binding, you must comply with the procedures in IRC sections 7121 or 7122. Any other documents that that IRS uses to “settle” a tax issue are not ultimately binding. The facts of Howe, however, are unique, and in our experience typically when you sign an IRS Form 870-AD with the IRS the settlement is effectively final.