Well defined rules permit a taxpayer to recover certain litigation and administrative costs of federal tax controversies from the U.S. government when the government's position is not substantially justified. Recent legislation has clarified the circumstances in which recovery is available while imposing certain limitations on the amount of the award. The authors describe the rules, offer suggestions for taxpayers, and give examples of circumstances when recovery is and is not likely.

An important factor in any tax controversy is the cost of representation and counsel. Taxpayers in a dispute with the IRS may incur significant costs in defense of a position taken on a tax return. These costs may include accountant's and attorney's fees, court costs, expert witness fees and the cost of conducting expert studies. Their magnitude provides a significant impediment to many taxpayers when contemplating litigation. Litigation costs are typically borne by each party to the dispute. Therefore, a taxpayer could prevail in a tax issue being litigated, yet be economically worse off than had the proposed deficiency been paid without contest.

To make legal help more accessible to taxpayers, Congress has provided for reimbursement of certain legal and administrative expenses incurred by both businesses and individuals in disputes with the IRS.

STATUTORY BACKGROUND

In the U.S., each party to a legal dispute typically pays for its own litigation expenses. In addition, private parties generally may not sue the U.S. government unless Congress provides a specific statute waiving sovereign immunity. Without enabling legislation, many taxpayers would not be permitted, nor could they afford, to dispute a deficiency proposed by the IRS.

The Equal Access to Justice Act (EAJA), passed in 1980, was intended to enable taxpayers to seek judicial relief from arbitrary government actions and make governmental agencies accountable for their actions. EAJA was intended to shift the taxpayer's litigation costs to the U.S. government when the position of the government in a tax dispute was not substantially justified. However, EAJA did not have the effect intended for tax controversies. In the McQuiston case, the Tax Court ruled that EAJA was applicable only to Article III courts. As the Tax Court is not an Article III court and the preponderance of tax litigation takes place in that court, most litigants could not take advantage of relief offered by this statute.

In 1982, Congress rectified this problem by enacting Sec. 7430 as part of the Tax Equity and Fiscal Responsibility Act (TEFRA). Sec. 7430 specifically provided for the recovery of litigation expenses by a taxpayer when the position of the U.S. government was deemed to be unreasonable. This section has been amended by TRA 86 and the TAMRA 88. The purpose of the TRA 86 amendments was to more closely conform Sec. 7430 to the structure of EAJA. The amendments contained in TAMRA 88 further refined the definition of recoverable expenses and, more significantly, provided a definitive testing period for recovery of certain administrative costs incurred prior to commencing litigation.

REQUIREMENTS OF SEC. 7430

Currently, to obtain an award of administrative and litigation costs, a taxpayer must meet all of the following requirements:

* Taxpayer must be the prevailing party in the dispute. * Taxpayer must prove that the government's position was not substantially justified. * Taxpayer must show that he or she and his or her representatives exhausted all administrative remedies available within the IRS. * Taxpayer must not unreasonably protract the proceedings. * Taxpayer's net worth must be below specific levels set by reference to EAJA. * Nature and amount of the costs paid or incurred must be reasonable.

Taxpayer Must be the Prevailing Party

To qualify for an award of costs, a taxpayer must establish that he or she was the prevailing party in the tax proceeding. Sec. 7430(c)(4)(A)(ii) defines the "prevailing party" in a proceeding as the party who substantially prevailed with regard to either the amount in controversy or the most significant issue or set of issues arising during the proceeding. This determination is made either by mutual agreement or by the governing body that decides the case. When the controversy is resolved through litigation, the court makes the determination as to who was the prevailing party. If the issue is settled at the administrative level, then the IRS makes the determination. Taxpayers who have satisfactorily resolved their tax dispute at the administrative level, but were denied relief by the IRS for administrative costs, may appeal to the Tax Court.

IRS Position Not Substantially Justified

In addition to having been the prevailing party, the taxpayer must also establish that the position taken by the government was "not substantially justified" Sec. 7430 (c)(4)(A)(i). As originally enacted, the statute required that the taxpayer prove that the government's position was "unreasonable." Although the statutory language was amended by TRA 86, in Sher, the Tax Court stated that "there is no suggestion in the legislative history that the |substantially justified' standard was intended to be a departure from the |reasonableness' standard.' In essence, the Tax Court ruled that the substantially justified test is essentially one of reasonableness.

Proving that the government's position was not substantially justified can be a difficult task. The IRS is permitted to initiate tax litigation that might establish a conflict between the federal circuits on a particular tax issue. The IRS may even be allowed to explore an obscure legal theory with the hope of establishing precedent favorable to the government. The reasonableness of IRS conduct is determined on a case by case basis and is generally fact driven. Exhibit 1 lists some situations where the government's position was found to be "unreasonable." Exhibit 2 lists some of the situations in which the government's conduct was deemed "reasonable."

The time at which the government's position is determined is also crucial when measuring the reasonableness of the government's conduct. Substantial litigation has addressed the issue of whether the "position of the U.S." includes the conduct of the IRS at the administrative level (i.e., audit and appeals office positions) or is only determined after litigation has commenced.

Sec. 7430, as originally enacted, provided that the position of the U.S. was the position taken in a civil tax proceeding. This provision was ambiguous and resulted in non-uniform interpretation of the statute by the courts. TRA 86 amended Sec. 7430 by adding language which stated that "any administrative action or inaction by the District Counsel" must be considered in determining whether the substantially justified standard was satisfied. Despite efforts of Congress to clarify the statute, litigation continued with respect to the exact point in time at which the government's position should be judged.

The issue was ultimately settled by amendments in TAMRA, which provide a bright line test. For actions commencing after November 10, 1988, the position of the U.S. is determined at the earlier of the date that the taxpayer is notified of the decision of the Appeals Office or the date of the statutory notice of deficiency. In the event that neither of the preceding dates are applicable, the position the government takes during litigation will be used.

Exhaustion of Administrative Remedies

To qualify for a recovery of costs under Sec. 7430, a taxpayer must exhaust all administrative remedies available within the IRS. Reg. Sec. 301.7430-1 provides guidance as to when a taxpayer has done so. The regulation requires the taxpayer to participate, directly or through a representative, in an Appeals Office conference. Additionally, the government requires the taxpayer to agree to an extension of the statute of limitations for assessment of the tax liability. In Minahan, the Tax Court held that certain portions of this regulation paragraphs 301.7430- 1(b)(1)(i)(B) and (f)(2)(i) were invalid. The court stated that "in granting taxpayers the right to collect litigation costs, the Congress did not suggest that taxpayers should be required to consent to extend the period of limitations." The Tax Court concluded that a failure to extend the statute of limitations does not constitute a failure to exhaust the administrative remedies available.

From a practical standpoint, a taxpayer must request and participate in an IRS Appeals Office conference prior to filing an action in a U.S. court or in the Tax Court. However, a taxpayer only has to exhaust the administrative remedies available to it within the IRS. Therefore, administrative remedies will be deemed exhausted if the IRS denies the taxpayer's request for an appeals conference.

The extent of cooperation required by the taxpayer during the appeals conference is another intriguing issue. The applicable regulation indicates that a taxpayer has adequately participated in an Appeals Office conference if the "party or qualified representative discloses . . . all relevant information regarding . . . the tax matter to the extent such information and its relevance were known or should have been known . . . at the time of such conference" Reg. Sec. 301.7430-1(b)(2). Therefore, the extent of participation is apparently limited to a disclosure responsibility and facilitation of the overall proceeding.

Taxpayer Must Not Unduly Protract the Proceeding

Sec. 7430(b)(4) grants discretion to the court to deny costs awards "with respect to any portion of the administrative or court proceeding during which the prevailing party has unreasonably protracted such proceeding." For example, in Polyco, the Tax Court ruled that a taxpayer "waiting until the last minute to submit to counsel facts which demonstrate that the government's position is incorrect" had unreasonably protracted the proceeding. Therefore, the request for costs was denied. This provision applies to actions commenced on or after January 1, 1986.

Net Worth Requirements

A taxpayer must meet certain net worth requirements to qualify for an award of administrative or litigation costs Sec. 7430(c)(4)(A)(iii). These limits are set by reference to EAJA, which provides that an individual whose net worth exceeds $2 million at the beginning of the tax proceeding will not qualify for an award of costs. Additionally, business entities (sole proprietors, partnerships, corporations or other business associations) whose net worth exceeds $7 million or which have more than 500 employees at the beginning of the tax proceeding will not qualify for an award of costs.

REASONABLENESS OF RECOVERABLE COSTS

For actions commencing after November 10, 1988, taxpayers may recover both "reasonable administrative costs" and "reasonable litigation costs" paid or incurred relative to a tax dispute. However, only "reasonable litigation costs" are recoverable from actions originating before November 11, 1988. "Reasonable administrative costs" include:

* Any administrative fees or similar charges imposed by the IRS; * Reasonable fees paid or incurred for the services of a qualified representative; * Reasonable expert witness costs; and * Certain costs for engineering reports or other studies that are deemed necessary for the preparation of the taxpayer's case.

Reasonable litigation costs are comprised of the same expenses as reasonable administrative costs, with the exception of administrative fees, but also include court costs and filing fees. Amounts paid or incurred for the services of a qualified representative include those charged by any individual authorized to practice before either the IRS or the Tax Court.

LIMITATIONS ON RECOVERABLE COSTS

There are three primary limitations to restrict the amount that a taxpayer may recover. The first relates to the point in time at which the costs become recoverable. The second is a dollar limitation imposed by the statute. The final limitation is a statutory requirement that the professional fees being recovered must be paid or incurred.

Significant controversy has surrounded the award of costs incurred during the audit and appeals portion of the dispute. As previously discussed, TAMRA resolved this conflict by providing a bright line test for recovery of expenses incurred during the administrative stage Sec. 7430(c)(7)(B). For actions originating after November 10, 1988, recoverable costs include those incurred after the earlier of the following:

* Date of the receipt of the IRS Appeals Office decision; or * Date of the statutory notice of deficiency i.e., the 90-day letter.

Although the amended statute resolves the previously existing ambiguity, it also severely limits expenses that may qualify for an award. Any costs that are incurred during the initial audit or appeals conference will not qualify for recovery as both of these events precede the two test dates listed. In many cases, the majority of a taxpayer's costs may be incurred prior to the date at which they become eligible for recovery.

The second limitation is a cap on the hourly rate of a qualified representative. In general, the maximum recoverable fee for a qualified representative is limited to $75 per hour unless the court determines that a higher rate is justified. Special circumstances that may justify a higher fee are 1) lack of qualified professionals to deal with issues specific to the case, and 2) increases in the cost of living. Expert witness fees are permitted in an amount determined by reference to prevailing market rates, but are limited to the maximum amount that the IRS is permitted to pay its own expert witnesses Sec. 7430(c)(1)(B). For actions commencing before 1986, but after February 28, 1983, the hourly cap on fees does not apply. However, for these situations the maximum recoverable amount for the entire dispute may not exceed $25,000.

The final limitation is that the professional fees for which reimbursement is being claimed must have been paid to a third party acting on behalf of the taxpayer. The courts have rigidly enforced this requirement. The Tax Court has ruled in Frisch that attorneys or other individuals acting pro se may not receive awards calculated by reference to either their usual fees or their lost opportunity costs. The court has interpreted the statute as requiring that recoverable costs must actually be either paid or incurred.

In Minahan, a divided Tax Court has also denied a request for the reimbursement of fees paid to a law firm in which the taxpayer had an equity interest, even though other attorneys were acting on the taxpayer's behalf. As the taxpayer was effectively paying at least a portion of the fee to himself, the court reasoned that the fees were not recoverable. However, the court left open a possibility that fees may be recoverable when the taxpayer can demonstrate that all of the revenue from the award is to be allocated to the other equity holders of the firm.

PROCEDURAL ASPECTS

The procedures for recovering litigation and administrative costs are set forth by the Tax Court's Rules of Practice and Procedure Rules 230- 233. An application should be submitted to the court within 30 days of the final judgment or settlement of the tax dispute. The application must assert that the taxpayer was the prevailing party; the government's position was not substantially justified; all administrative remedies were exhausted; the net worth requirements were satisfied; and state the amount of reimbursement requested. To justify the reimbursement request, the filing should include detailed, itemized statements from the taxpayer's counsel as well as receipts or invoices for all recoverable costs. If the hourly rates for the professionals involved exceed the statutory maximum of $75 per hour, then the filing will also have to include an explanation as to why a higher rate should be allowed.

PLANNING STRATEGIES

To qualify for a reimbursement of expenses, a taxpayer must meet all the requirements enumerated in Sec. 7430. Demonstrating that all administrative remedies were exhausted prior to commencing litigation is of critical importance. Additionally, the following are several points to keep in mind to maximize costs that can be recovered.

Record Keeping

Detailed records should be kept on a contemporaneous basis. This will permit the documentation of costs associated with each issue at each stage of the dispute. The government may be substantially justified with respect to some actions, but fail to meet this criteria relative to other actions. For example, in Powell the Tax Court ruled that although the government's position in the original case was unreasonable, its appeal of an adverse decision was not. The taxpayer was granted an award for costs relative to the first trial, but not for the appeal. It was essential for the taxpayer to have been able to demonstrate exactly how much was expended with respect to each action.

Timing of Expenses

The time at which expenses become recoverable postdates the appeals conference. Thus, conference and pre-conference expenses should be kept (within the boundaries of practicality) to a minimum. However, circumstances may dictate that these expenses represent a significant portion, if not the majority, of the total cost.

Using Your Own Firm

Taxpayers planning to take advantage of Sec. 7430 should pay careful attention to the "paid" or "incurred" requirement. The Tax Court has taken a very restrictive position with respect to this provision. Individuals acting pro se should not expect to be reimbursed for the value of their time. At the post conference stage they may be better served utilizing their own time to generate revenue and paying a third party to act as their representative. If they are going to hire a firm in which they hold an equity interest, then an agreement should be executed that provides that the taxpayer will receive no benefit from any fee reimbursement received by the firm.

HALF A LOAF

Taxpayers who have suffered through an unreasonable position taken by the IRS in a tax dispute have an opportunity to recover at least a portion of their costs. Documentation of compliance with all of the requirements for recovery is essential to ensure an award. Although the provisions allowing reimbursement of legal and administrative costs will never leave the taxpayer whole, a partial reimbursement is generally preferable to none at all.

Brian R. Greenstein, PhD, is Director of Graduate Tax Programs and Assistant Professor of Accounting at Drexel University, Philadelphia, PA. Dr. Greenstein is a frequent contributor to both professional and academic journals. Mark B. Persellin, PhD, CPA, is Assistant Professor of Accounting at Southwest Texas State University, San Marcos, TX. Dr. Persellin is a member of the Texas Society of CPAs, the AICPA Tax Division, and the American Taxation Association. Lawrence J. Stein, MACC, CPA, is Tax Manager at Law, Redd, Crona in Tallahassee, FL. He is a member of the Florida Institute of CPAs and the AICPA. Mr. Stein teaches continuing professional education seminars and has previously published articles on accounting and tax matters.