Saturday, July 31, 2021
An issue that is problematic for many taxpayers that find themselves under audit with the IRS are the potential litigation and administrative costs if the matter were to end up in court. The IRS knows this and, as a result, sometimes asserts a tenuous position in situations where the amount in controversy is not enough to make it worth the taxpayer challenging the IRS position.
When can a taxpayer recover litigation costs against the IRS – it’s the topic of today’s post.
Tax Code Requirements
Under I.R.C. §7430, a taxpayer can receive an award of litigation costs in cases against the United States that involve the determination of any tax, interest or penalty. To be eligible to recover litigation costs, a taxpayer must satisfy four requirements: 1) be the “prevailing party”; 2) have exhausted available administrative remedies within the IRS; 3) not have unreasonably protracted the proceeding; and 4) make a claim for “reasonable” costs. The taxpayer must satisfy all four requirements. See, e.g., Minahan v. Comr., 88 T.C. 492 (1987). The decision to award fees is within the discretion of the Tax Court. That means any decision denying attorney fees to a prevailing taxpayer is reviewed under an abuse of discretion standard.
Note. Under the Tax Court’s rules, a party seeking to recover reasonable litigation costs must file a timely motion in the proper manner. U.S. Tax Court Rules, Title XXIII, Rule 231(a).
Exhaustion. Litigation costs will not be awarded unless the court determines that the prevailing party has exhausted available administrative remedies within the IRS. I.R.C. § 7430(b)(1). For example, when a conference with the IRS Office of Appeals is available to resolve disputes, a party is deemed to have exhausted administrative remedies only by participating in the conference before filing a Tax Court petition or requesting a conference (even if it isn’t granted) before the IRS issues a statutory notice of deficiency. See, e.g, Veal-Hill v. Comr., 812 Fed. Appx. 387 (7th Cir. 2020).
Unreasonable protraction. To be rewarded litigation costs, the taxpayer must not unreasonably protract the proceeding. I.R.C. §7430(b)(3). In Estate of Lippitz, et al. v. Comr., T.C. Memo. 2007-293, the petitioner sought innocent spouse relief and the IRS conceded the case. The petitioner sought to recover litigation costs and the IRS objected. The Tax Court largely rejected as meritless an IRS argument that the petitioner was otherwise disqualified from recovery due to her unreasonable protraction of proceedings. The dispute involved tax deficiencies from 1980-1985 stemming from the now-deceased spouse’s assignment of income to various trusts. The IRS based its argument on the taxpayer's failure to comply with an almost 20-year old summons that the taxpayer had no reason to know about concerning the couple’s joint liability until the IRS later “resurrected” it in 2003.
Prevailing party. Perhaps the requirement that is the most complex and generates the most litigation is that the taxpayer must be the “prevailing party.” A taxpayer can be a “prevailing party” only if the taxpayer satisfies certain net worth requirements or “substantially prevails” with respect to the amount in controversy on “the most significant issue or set of issues presented. I.R.C. §7430(c)(4)(A). An application to recover an award for fees and other expenses must be filed with the court within 30 days of the final judgment in the case. 28 U.S.C. §2412(d)(1)(B).
The net worth requirement is incorporated into the “prevailing party” requirement and specifies that a taxpayer’s net worth must not exceed $2 million. I.R.C. §7430(c)(4)(A)(ii). For this purpose, “net worth” is determined on the basis of the cost of acquisition of assets under generally accepted accounting principles (GAAP) rather than the fair market value of assets. See, e.g, Swanson v. Commissioner, 106 T.C. 76 (1996); see also H.R. Rept. No. 96-1418, 96th Cong., 2d Sess. 15 (1980). Depreciation is taken into account. Also, notes receivable are taken into account under GAAP. The acquisition cost of a note exchanged for cash is the amount of cash received in exchange for the note. If the interest on the note is unstated, it is recorded in the books as having value in an amount that reasonably approximates the fair value of the note.
A taxpayer cannot meet the prevailing party requirement, however, if the IRS takes a position with respect to the taxpayer’s return that is “substantially justified.” In other words, a taxpayer can’t “substantially prevail” if the IRS position is substantially justified.
For the IRS, a substantially justified position is one that has a reasonable basis in fact – one that is supported by sufficient relevant evidence that a reasonable mind might accept as adequate to support a conclusion. See Pierce v. Underwood, 487 U.S. 552 (1988). Reasonableness is based on the facts of the case and legal precedent. Maggie Management Co. v. Comr., 108 T.C. 430 (1997). The IRS position must also have a reasonable basis in law – the legal precedent must substantially support the IRS position based on the facts of the case. The courts have interpreted this standard as requiring sufficient relevant evidence that a reasonable mind might accept as adequate to support a conclusion. See, e.g., Pierce v. Underwood, 487 U.S. 552 (1988). Thus, the IRS could take a position that is substantially justified even if it is incorrect if a reasonable person could believe it to be correct. See, e.g., Maggie Management Co. v. Comr., 108 T.C. 430 (1997). Likewise, the IRS position could be substantially justified where only factual issues are in question. See, e.g., Bale Chevrolet Co. v. United States, 620 F.3d 868 (8th Cir. 2010). Also, the IRS concession of a case or an issue doesn’t mean that its position was unreasonable. It’s merely a factor for consideration.
What the IRS does at the administrative level have no bearing on whether its litigating position is substantially justified. The administrative process and the court process are two separate matters. I.R.C. §7430 distinguishes between administrative and judicial proceedings. See, e.g., Pacific Fisheries, Inc. v. United States, 484 F.3d 1103 (9th Cir. 2007). IRS conduct occurring after the petition is filed is all that matters. This means that the IRS can create a multitude of problems for a taxpayer, justified or not, at the administrative level and fees cannot be recovered because the conduct occurred pre-petition. That is the case even if the IRS conduct during the administrative process caused the litigation. See, e.g., Friends of the Benedictines in the Holy Land, Inc. v. Comr., 150 T.C. 107 (2018).
All of this means that the bar is set rather low for the IRS to establish a litigating position that is substantially justified. Conversely, the bar is set high for a taxpayer to be a “prevailing party” to be able to recover litigation costs.
Note. An exception exists for a “qualified offer.” A qualified offer is one that is made pre-trial. If the taxpayer makes such an offer and the IRS rejects it and the taxpayer goes on to win at the Tax Court, the taxpayer can be compensated for litigation fees that are incurred after the offer was made. I.R.C. §§7430(c)(4)(B)(i); 7430(c)(4)(E)(i).
The Tax Court recently issued an opinion in a case involving the issue of whether the petitioner was entitled to litigation fees. In Jacobs v. Comr., T.C. Memo. 2021-51, the petitioner had been a trial lawyer with the U.S. Department of Justice before becoming a full-time professor at a university in Washington, D.C. During this time, he was also an adjunct professor at another university in Washington, D.C., and a “Visiting Scholar” at yet another university for three months on the West Coast. He ultimately became a professor at a second West Coast university. On his tax returns for these years (2014 and 2015), he claimed $54,000 Schedule C deductions related to payments for meals and lodging for his Visiting Scholar position, the business use of his home, bar association dues and other professional fees, and travel expenses. The IRS audited the returns and denied the deductions.
After a tortured appeals process involving the Taxpayer Advocate Service, the U.S. Treasury Inspector General for Tax Administration, and four IRS Appeals offices, the IRS offered the petitioner a settlement proposal allowing most of the claimed deductions. The petitioner confirmed receipt of the settlement offer, but didn’t respond further. Five months later, the IRS Appeals Office turned the matter over to the IRS Chief Counsel’s Office to prepare the case for trial. At a Tax Court status conference a few days later, the IRS Chief Counsel conceded the case in its entirety and filed a stipulation of settled issues a couple of weeks later.
The petitioner then filed a motion for $32,000 of litigation costs. Those costs included fees for expert witnesses and lawyers. The IRS objected to the motion on the basis that its position in the Tax Court proceedings at the time the answer was filed (that the petitioner was not entitled to the deductions) was substantially justified.
The Tax Court noted that the petitioner bore the burden to establish that his expenses were deductible as ordinary and necessary business expenses under I.R.C. §162 and were not associated with the taxpayer’s activities as an employee. See, e.g., Weber v. Comr., 103 T.C. 378 (1994), aff’d., 60 F.3d 1104 (4th Cir. 1995). The Tax Court determined that a reasonable person could have concluded that a reasonable person could have concluded that the petitioner had not satisfied this burden by the time the IRS filed its answer. Accordingly, the Tax Court denied the petitioner’s motion for litigation costs.
The Jacobs case, although a negative result for the petitioner, is instructive on how difficult it is for a taxpayer to recover litigation costs from the IRS. It’s also an example of how the IRS can create an administrative “nightmare” for the taxpayer causing the taxpayer to ring up thousands of dollars of fees and costs with no hope of recovering those expenses. Litigation fees are only awarded for “litigation” – matters that happen after the IRS files its answer to the taxpayer’s Tax Court petition.
Many taxpayers would conclude that the system is “rigged.” Indeed, the present statutory construct allows the IRS to continue to assert positions with little basis in law when the amount in controversy is less than the anticipated attorney fees without much risk of being challenged in court.