On May 5, 2021, the Tax Court issued a Memorandum Opinion in the case of Jacobs v. Commissioner (T.C. Memo. 2021-51). The primary issue presented in Jacobs v. Commissioner was whether the petitioner was entitled to reasonable litigation and administrative costs pursuant to IRC § 7430 and Tax Court Rule 231.
A Lawyer, Scholar, and Author in Jacobs v. Commissioner
The petitioner was a trial lawyer with the Department of Justice for 20 years before he became a full-time professor at American University. During 2014 and 2015, the petitioner lived in Washington, D.C., and also taught as an adjunct at George Washington University. For three months during the summer of 2014, the petitioner was a “Visiting Scholar” at UCLA (a non-compensated position). During this time, the petitioner researched and drafted a book on the 2010 BP oil spill, which was published in 2016.
Having gotten a taste for the West Coast, the petitioner left his teaching position at American and moved permanently to California. He took a position as a professor at Loyola Marymount University. Although the petitioner gained admission to the California Bar in 2013, he did not represent clients as an attorney in 2014 or 2015.
Petitioner’s Many Hats Catch Up with Him
On his 2014 and 2015 returns, the petitioner claimed $34,000 and $20,000, respectively, as deductions on Schedule C (Profit or Loss from Business). These deductions generally related to payments for meals and lodging for his Visiting Scholar position at UCLA, costs for the business use of the petitioner’s home, bar dues and other professional fees, and travel expenses incurred for various trips to California, Florida, Louisiana, New York, Washington, and Paris. The 2014 return described the petitioner’s business as “Attorney/Professor,” and the 2015 added “/Author” to complete the trio of businesses.
The Tortured Audit / Appeal / Audit / Appeal Ouroboros
We will spare the very detailed recounting provided by the Tax Court in the opinion. The 2014 and 2015 returns were audited, sent to the Taxpayer Advocate Service, appealed, referred to the U.S. Treasury Inspector General for Tax Administration (“TIGTA”) for an investigation, sent to Appeals again, sent to a different Appeals office, ended up in Tax Court for a redetermination of the deficiency that the second (or fourth, it was hard to keep track) Appeals office determined, and then sent back to Appeals.
The Offer of Settlement
After considering the petitioner’s explanations during the post-petition Appeals conference as well as the documentation on record, Appeals the petitioner a settlement proposal in January 2020. The proposal allowed most of the deductions that the petitioner had claimed for both years. In February 2020, the petitioner responded by fax to confirm his receipt of the proposal and to explain that he would determine next steps after he reviewed the proposal with a colleague and prepared a report on the remaining contested expenses.
The IRS’s Final Capitulation
In June 2020, having not heard from the petitioner, Appeals returned the case to Chief Counsel for trial preparation. Ten days later, at a status conference with the Tax Court, Chief Counsel conceded the case in full. The stipulation of settled issues was filed in July 2020.
The Motion for Litigation / Administration Costs
In August 2020, the petitioner filed a motion with the Tax Court requesting an award of $32,000 in litigation costs, including expert witnesses and legal fees. The IRS responded in October 2020, contending that the petitioner was not entitled to an award of litigation costs because the position of the IRS in the proceedings before the Tax Court was “substantially justified.” A hearing was held in February 2021.
Legal Framework
IRC § 7430 provides for an award of reasonable litigation costs to a taxpayer in a proceeding brought by or against the United States involving the determination of any tax, interest, or penalty. Such an award may be made where the taxpayer can demonstrate that he meets four specific requirements:[1]
- is the “prevailing party;”
- has exhausted available administrative remedies within the IRS;
- has not unreasonably protracted the proceeding; and
- has claimed “reasonable” costs.
These requirements are conjunctive, meaning that the failure to satisfy any one of them precludes an award of costs to the taxpayer. See Alterman Tr. v. Commissioner, 146 T.C. at 227; see also Minahan v. Commissioner, 88 T.C. 492, 497 (1987).
The decision to award fees is within the sound discretion of the Tax Court. See Morrison, 565 F.3d at 661 n.3. As such, a decision by the Tax Court denying an award of attorneys’ fees is reviewed for abuse of discretion. Id.; see also Huffman v. Commissioner, 978 F.2d 1139, 1143 (9th Cir. 1992), aff’g in part, rev’g in part T.C. Memo. 1991-144).
The IRS conceded that the petitioner exhausted all available administrative remedies and that he did not unreasonably protract the proceeding. Thus, of the four requirements in the IRC § 7430 test, only the first and last are at issue in Jacobs.
When a Taxpayer is a “Prevailing Party” (and When He is More Likely Not One)
To be the “prevailing party,” a taxpayer must satisfy certain net-worth requirements and must “substantially prevail” with respect to the amount in controversy or “the most significant issue or set of issues presented.” IRC § 7430(c)(4)(A). Under IRC § 7430(c)(4)(A)(ii), a “prevailing party” cannot have a net worth exceeding $2 million.
This doesn’t mean that rich people can’t be screwed by the IRS, incur substantial legal fees, and prevail on their claims. It just means that the government isn’t going to comp them for their time. This isn’t Vegas, and high rollers aren’t rewarded. Apparently.
There is no dispute in Jacobs that the petitioner substantially prevailed with respect to the amount in controversy. The real issue, then, is whether the position reflected in the IRS’s answer (that the petitioner’s deductions should be disallowed) was substantially justified when the answer was filed.
Substantially Justified Positions – A Rather Long Leash
The taxpayer generally will not be treated as the prevailing party, however, if the IRS establishes that the position it adopted in the proceeding was “substantially justified.” IRS § 7430(c)(4)(B)(i). IRC § 7430(c)(4)(E)(i) provides a limited exception to this rule in situations involving a “qualified offer,” which is basically a taxpayer’s way to call the IRS out on their shenanigans before trial, and if the IRS doesn’t relent, then the taxpayer can be compensated for the fees incurred after the offer. It’s not perfect, and in practical application it is a bit complex, but it’s worth a shot in some cases. Here’s a great article on the whole subject that was written, ironically, by my boss. Don’t tell him that I gave him a shout-out in this post. It will just go to his head.
The IRS bears the burden of making the showing that the position was “substantially justified.” Id.; Pac. Fisheries Inc. v. United States, 484 F.3d 1103, 1107 (9th Cir. 2007). The “position” that must be substantially justified (in a Tax Court proceeding) is the position that is set forth in the IRS’s answer to the taxpayer’s petitioner. See IRC § 7430(c)(7)(A); Huffman, 978 F.2d at 1148; Maggie Mgmt. Co. v. Commissioner, 108 T.C. 430, 442 (1997).
A position is “substantially justified” if it is justified “to a degree that could satisfy a reasonable person” or has a “reasonable basis both in law and fact.” Swanson v. Commissioner, 106 T.C. 76, 86 (1996) (quoting Pierce v. Underwood, 487 U.S. 552, 565 (1988)); see also Huffman, 978 F.2d at 1147. The determination of reasonableness is based on all the facts of the case and the available legal precedents. Maggie Mgmt. Co., 108 T.C. at 443.
A position has a reasonable basis in fact if there is enough relevant evidence that a reasonable mind might accept as adequate to support a conclusion. Pierce, 487 U.S. at 565. A position has a reasonable basis in law if legal precedent substantially supports the IRS’s position given the facts available to it. Maggie Mgmt. Co., 108 T.C. at 443. Nonetheless, for a position to be substantially justified, “substantial evidence” must exist to support it. Pierce, 487 U.S. at 564. Lest we be confused that this means that there must be a large or considerable amount of evidence, but rather “such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.” Id. at 564-565; Maggie Mgmt. Co., 108 T.C. at 443.
Thus, substantially justified means “more than merely undeserving of sanctions for frivolousness.” United States v. Yochum, 89 F.3d 661, 671 (9th Cir. 1996). Admittedly, this is a low freaking bar. The IRS’s position may be substantially justified even if incorrect “if a reasonable person could think it correct.” Maggie Mgmt. Co., 108 T.C. at 443.
Courts have found that the Commissioner’s position was substantially justified in cases that involve primarily factual questions. See, e.g., Bale Chevrolet Co. v. United States, 620 F.3d 868 (8th Cir. 2010). Finally, the fact that the IRS loses a case or ultimately makes a concession “does not by itself establish that the position taken is unreasonable,” but is “a factor that may be considered.” Maggie Mgmt. Co., 108 T.C. at 443.
The Burden
For both the 2014 and 2015 tax years, the burden was on the petitioner to establish that his expenses met all the requirements for deductibility under IRC § 162. See Tax Court Rule 142(a); Frost v. Commissioner, 154 T.C. 23, 29 (2020); see also INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
To deduct an expense under IRC § 162, a taxpayer must establish that the amount was an ordinary and necessary expense paid or incurred in carrying on a trade or business. IRC § 162(a); see also INDOPCO, Inc., 503 U.S. at 84. To deduct the expense on Schedule C, the taxpayer must also show that the expense was not associated with the taxpayer’s activities as an employee. See, e.g., Weber v. Commissioner, 103 T.C. 378, 386 (1994), aff’d, 60 F.3d 1104 (4th Cir. 1995). The Tax Court concluded that, based on the record before it, a reasonable person could have concluded that the petitioner had failed to satisfy this burden by the time the IRS filed his answer.
Actions at the Administrative Level
The Tax Court has repeatedly held that the IRS’s actions at the administrative level do not determine whether its position in litigation was substantially justified. Rather, the Tax Court evaluates the reasonableness of the Commissioner’s position separately for administrative and judicial proceedings. See Maggie Mgmt. Co., 108 T.C. at 442; see also, e.g., Kenney v. United States, 458 F.3d 1025, 1032-33 (9th Cir. 2006); Huffman, 978 F.2d at 1146.
Courts have held that the plain language of IRC § 7430 “distinguishes administrative from judicial proceedings.” Pac. Fisheries Inc., 484 F.3d at 1108. Thus, the Tax Court considers the IRS’s actions only after the petition is filed, even if the IRS was pure Busch League at the administrative level, and even if that activity gave rise to the litigation. See id. at 1110-1111 (holding that the IRS’s litigating position was “reasonable” despite arguably unreasonable prelitigation conduct that “forced the taxpayers into litigation”); see also Friends of Benedictines in Holy Land, Inc. v. Commissioner, 150 T.C. 107, 117-118 (2018).
Thus, even when the IRS is a complete and utter administrative blowhole, litigation fees will only be awarded in…wait for it…litigation, which the Tax Court defines as anything that happens after the answer to the petition.
(T.C. Memo. 2021-51) Jacobs v. Commissioner
Footnote
[1] IRC § 7430(a); IRC § 7430(b)(1), (3); IRC § 7430(c)(1), (2); Morrison v. Commissioner, 565 F.3d 658, 661 (9th Cir. 2009), rev’g on other grounds T.C. Memo. 2006-103; Alterman Tr. v. Commissioner, 146 T.C. 226, 227 (2016).
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