It’s always nice to beat the IRS in court. It is even sweeter when you can also make the IRS pay your attorneys fees. But that is not so easy, even when you win. In last week’s Tax Court opinion in Jason Bontrager v. Commissioner, T.C. Memo. 2019-45 (May 1, 2019) (Bontrager II) Judge Lauber teaches a short lesson about the attorneys fees award provisions in §7430. Section 7430 balances policies of paying taxpayers when the government loses with protecting the federal fisc when the government’s litigating position was reasonable.
Bontrager II was a proceeding where the taxpayer sought to recover reasonable litigation costs under §7430 after having won the most significant issue in the case. Mr. Bontrager followed all the proper administrative steps to get attorneys fees. Yet he failed to get fees because Judge Lauber found that the IRS’s losing position was substantially justified. That idea of substantial justification often prevents attorneys fees. But if you click the "continue reading" button you can learn the one weird trick taxpayers use to overcome it! (Except it’s not really a trick. And it’s not really weird. It’s right in the statute. I am just trying to get you to read on.)
Facts of The Case
Mr. B’s Dad went to prison in 1994, for conspiracy to commit wire fraud. Apparently the conspiracy worked, because the court ordered Dad to pay restitution of $687,000. Then the IRS piled on by assessing Dad $185,000 in tax for the unreported income for the 1994 tax year.
When Dad got out of prison sometime in the late 1990’s he wormed his way into Mr. B’s real estate business. Judge Lauber writes that Dad exercised “substantial control over financing arrangements and negotiating terms for complex real estate deals.”
The money flowed. But none of it flowed to pay off the 1994 tax liability. Turns out that dear old Dad “had evaded payment of his outstanding Federal tax and restitution liabilities by using petitioner’s real estate business as a front to conceal...income and assets.”
Mr. Bontrager helped his Dad. He was a good son. Too good, perhaps. He apparently used business funds to pay for Dad’s personal expenses, titled various assets in his own name when Dad was the one using them, and created offshore accounts to hide Dad’s income and assets.
In 2012 Mr. B. pleaded guilty to charges that he violated §7201 although the actual charge was “Aiding and Abetting the Evasion of Payment of Income Tax.” The District court sentenced him to prison and imposed restitution to help the government recover the 1994 tax liability, which had grown from $185,000 to $727,000. We all know how that can happen. But the court recognized that 90% of the culpability for the evasion was Dad. It did not order Mr. B. to all $727,000 in restitution. It thought Mr. B. should be responsible for about 10% of it. The court ordered restitution of $72,710 (don't ask me where the $10 came from).
The IRS assessed the $72,710 against Mr. B. in 2012, under the authority of §6201(a)(4). It also hit him with about $185,000 in interest on that amount, as calculated from Dad’s 1994 return due date.
Not surprisingly, Mr. B. neglected to pay. When the IRS filed an NFTL, Mr. B. timely requested a CDP hearing. But he did not offer any collection alternatives. Instead he argued the assessment was wrong, alleging that: (1) the IRS did not have the authority to assess him the $73,000 under §6201(a)(4) because his Dad was the taxpayer and not he; (2) even if the IRS could assess the restitution, it could not assess the $185,000 underpayment interest; (3) the restitution obligation had been discharged in a Chapter 7 bankruptcy he had filed.
As you might expect, Mr. B. lost all these arguments in the CDP hearing. He timely petition the Tax Court for review. The IRS filed its Answer to the petition in April 2016. In the Answer, the IRS Office of Chief Counsel took the position that all three arguments were wrong: it asserted its ability to make the assessment of both the restitution order and the interest and said both survived the bankruptcy.
In October 2017, the Tax Court decided Klein v. Commissioner, 149 T.C. 341. Mr. Klein had raised one of the exact same issues Mr. B. had raised: that the IRS could not assess interest on the amounts of restitution assessed under §6201(a)(4). The Klein Court agreed with the taxpayer: the IRS could not assess interest on amounts assessed under §6201(a)(4).
That was great news for Mr. B! It wiped $185k off the table. Following Klein, he and the IRS submitted a joint stipulation where the IRS conceded that he was not liable for interest on the restitution-based assessment. That just left the $72,710 assessment on the table.
The case moved forward on the other two issues: (1) whether §6201(a)(4) authorized assessment when the restitution order against Mr. B. was for his father’s tax liability, not his; and (2) whether Mr. B.’s bankruptcy wiped out the obligation. Mr. B. lost both issues in the fully reviewed opinion Bontrager v. Commissioner, 151 T.C. No. 12 (December 12, 2018) (Bontrager I).
In Bontrager I, the Court held that the plain language of §6201(a)(4) permits the IRS to assess “the amount of restitution [ordered] for failure to pay any tax imposed under this title...” (emphasis supplied). The key to the Court’s reasoning was that the bolded text did not specify against whom the tax was imposed. In contrast, Mr. B. wanted the court to change the wording to “any tax imposed [upon the taxpayer] under this title.” Nor was the Tax Court impressed that Mr. B.’s conviction was for aiding and abetting someone else’s evasion and not for his own evasion. The Court pointed out that case law held that aiders and abettors were treated the same as principals in criminal evasion cases and that the text in the criminal statute, §7201, matches that in §6201(a)(4): it criminalizes attempts to evade payment of “any tax imposed by this title.”
As to the second remaining issue, the Bontrager I Court held that Mr. B.’s Chapter 7 bankruptcy discharge did not relieve him of the obligation. The straightforward rule in bankruptcy is that debtors do not get discharged from criminal restitution orders. 11 U.S.C. §523(a)(13). Mr. B.’s representative, however, confused priority issue with discharge, a common error. The IRS had filed the restitution order as an general unsecured claim and not as a priority claim. And, generally speaking, priority tax claims are not dischargeable. 11 U.S.C. §523(a)(1)(A). But while priority tax claims are excepted from discharge, that does not mean that all general unsecured tax claims are subject to discharge. This situation is one example. A claim for a tax for which the taxpayer had failed to file a return, or had submitted a fraudulent return, is another example. Id. So Mr. B.’s representative (apparently a CPA from Washington State) was just confused.
Still, Mr. B. had won on the big issue. So his representative followed the proper procedure to try and get an award of attorneys fees. In Bontrager II, Judge Lauber denied attorneys fees. The reason why, and what Mr. B.'s representative might have done differently, forms the lesson.
Lesson: No Attorneys Fees When The Government Was Substantially Justified
Under proper circumstances, §7430(a) permits a court to award “reasonable administrative costs” and “reasonable litigation costs” (the largest being attorneys fees) to a taxpayer who is a “prevailing party” in a dispute with the IRS. I say “under the proper circumstances” because there are a bunch of other requirements, such as a net worth requirement, a very strict administrative exhaustion requirement (see, e.g. Covert v. Commissioner, T.C. Memo 2008-90, but you'll have to go on LEXIS or Westlaw for it), and more. While fascinating, those are not relevant to today’s lesson, which focuses on the “prevailing party” requirement.
To be a prevailing party a taxpayer must have “substantially prevailed” as to either the total amount in controversy or the most significant issue. Usually, those match as they did in this case. Mr. B. substantially prevailed on the most significant issue, the issue of whether the IRS could assess interest on the restitution order. True, he did not actually get the win---the Tax Court ruled on that issue in a different case. But after that win, the IRS conceded the issue in his case. That made him a winner. And since that issue took $185k off the table he was a winner on the most significant issue.
But even when the taxpayer has substantially prevailed, a court will not award litigation costs if the IRS can show that its litigation position was “substantially justified” as of the relevant testing dates established by the statute and by case law. See §7430(c)(4)(B)(i), (c)(7) (setting two dates for testing the IRS position during administrative proceedings) and Maggie Mgmt. Co. v. Commissioner, 108 T.C. 430 (1997) (date of IRS Answer to taxpayer’s petition is relevant testing date for IRS position during court proceeding).
“Substantially justified” is an intuitive concept. It means only that the IRS position needs to be such that a reasonable person would agree it had a reasonable basis in law and fact, given the lay of the legal landscape as of the relevant testing date. Id. Just because the IRS takes a position that turns out to be wrong does not means that position was unreasonable at the earlier testing date.
In Bontrager II, the government said that its position on the lost issue had been substantially justified, within the meaning of the statute. Each of the relevant testing dates occurred before the Tax Court issued its opinion in Klein. The IRS had consistently taken the position it asserted in Court in its own internal guidance. The IRS had even won on its position in a bankruptcy court and two federal district courts. In short, this was an easy call for Judge Lauber to find that the IRS had been substantially justified.
Note that the fact the IRS conceded the issue has nothing to do with the substantial justification analysis. Rather, the IRS concession just establishes that Mr. B. prevailed. If the IRS had decided to fight the Klein decision by appealing, it may not have conceded the issue in Bontrager. In that event, and assuming the Tax Court held to the same interpretation, I think the IRS would still likely have been substantially justified for the same reasons (existing case law, consistent internal guidance). But I could be wrong. The point at which an IRS position loses the protection of the substantial justification concept is not always clear. But that is not the subject of our lesson today. Just be aware that the substantially justified requirement is there to give the IRS room to take litigating positions in more than one case, and not to simply reward taxpayers just because the IRS takes a position which it ultimately loses.
The One Weird Trick: Qualified Offers
It's right in the statute. And while it is not a trick, it is tricky to pull off sometimes. Section 7430(c)(4)(E) provides that if a taxpayer makes a Qualified Offer within the meaning of §7430(g), then if the taxpayer wins a judgment that is equal to or less than the offer the taxpayer will be deemed to be the prevailing party the IRS is disabled from asserting that its position was substantially justified.
Chief Counsel Notice 2010-007 gives a nice outline of the five basic requirements for a Qualified Offer: First, it must be a written offer that says it’s a qualified offer. Second, it must be made to the right office. Third, it must be made during the right time period, called the qualified offer period. Fourth, it must remain open, and cannot be withdrawn, during the time period defined in §7430(g)(1)(D). Finally, it must specify the offered amount of the taxpayer's liability, as determined (pay attention here!) “without regard to interest.”
The other annoying rules in §7430 still apply, however. You still have to meet net worth requirements. Critically, you still must have exhausted administrative remedies. So if your client had the opportunity to go to Appeals but refused, then fuggedaboutit. But what a Qualified Offer does for you is take away the IRS’s chief defense: that its position was substantially justified. As Notice 2010-007 notes, the purpose of the Qualified Offer process is to encourage settlement of specific cases.
Note well that fifth requirement: there must be some tax liability at issue for there to be a Qualified Offer. That means you won’t see qualified Offers in CDP hearings unless the underlying liability is properly at issue.
In Mr. B’s case, he was in a CDP proceeding but his allegations when to the underlying liability: the IRS’s ability to assess the restitution order (of $73,000) and interest (of $185,000). Since he was permitted to dispute the merits of the underlying assessment, he was in a position to make a Qualified Offer.
If Mr. B. had made a Qualified Offer of $72,711---the restitution amount plus $1---then once the IRS abandons the interest issue, the result would have been a judgment for the IRS of less than the Qualified Offer, even if the IRS won the restitution issue. That means Mf. B. would have received reasonable litigation costs.
So why did not his CPA make a Qualified Offer? Well, because it’s a hard call to make! Besides, as far as we know, Mr. B.’s representative might actually have made a Qualified Offer, of $10 total. That way, if the taxpayer ran the table on all the issues, the Qualified Offer would have eliminated the IRS’s ability to say any of its positions were substantially justified. So maybe that happened. I know some practitioners who will make low dollar Qualified Offers as kind of an insurance play. Otherwise, it’s like a poker game: what are you willing to bet on the outcome of the case? Here, it may have taken a pretty astute and persuasive representative to get Mr. B. to make the exactly correct Qualified Offer of $72,711, the total restitution amount plus $1 of interest.
Sharp-eyed readers will say “but that was interest!” The rest will need to look again at that fifth requirement: a Qualified Offer is defined as an amount proposed to resolve the taxpayer’s tax liability “without regard to interest.” That language is right in §7430(g)(1)(B). It seems to mean that Mr. B. could not have made a qualified offer.
What enabled Mr. B. to make a Qualified Offer here is Treas. Reg. 301.7430-7(b)(2), which says than an Offer is typically “calculated without regard to interest, unless the taxpayer's liability for, or entitlement to, interest is a contested issue in the administrative or court proceeding.” In other words, if interest is itself a contested matter, as it was here, resolution of that contest can be part of a Qualified Offer. The "without interest" language is just a way of simplifying the task of seeing whether the ultimate judgment is higher or lower than the Qualified Offer made.
For those interested in learning more about Qualified Offers, a great place to start (and often finish) is the excellent chapter on §7430, written by Jan Pierce and Frank Agostino in that lovely treatise: Effectively Representing Your Client Before the IRS.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law