Lesson From The Tax Court: The IRS's Substantial Justification Defense To §7430 Fee Awards

Getting an award under §7430 is hard, even if the taxpayer totally wins.  The major stumbling block is a statutory escape hatch called substantial justification.  If the IRS’ shows that its position was substantially justified at the relevant time, the taxpayer is not entitled to fees and costs even if the taxpayer wins on the merits.  But the relevant time may be different depending on whether the taxpayer is seeking recovery of administrative costs or litigation costs.  In Josefa Castillo v. Commissioner, 160 T.C. No. 15 (June 5, 2023) (Judge Kerrigan), we learn that the IRS must be able to show substantial justification at two different points in the process.  There, the Court found the IRS was substantially justified at the litigation stage.  But the IRS may not have been substantially justified at the administrative stage.  That may be why the IRS conceded a §7430 award as to administrative costs, even while successfully resisting an award of litigation costs.  The ultimate result reflects well on the taxpayer’s representative, Professor Elizabeth A. Maresca and her team at the Fordham Low Income Taxpayer Clinic.

This case involves the time period in §6330(d)(1) for taxpayers to seek Tax Court review of an adverse Collection Due Process (CDP) decision.  For decades the IRS and Tax Court believed that 30-day period was a jurisdictional requirement.  The Tax Court simply did not have the power to hear a late-filed petition.  The Supreme Court, however, held otherwise in Boechler v. Commissioner, 596 U.S. ___ (2022).  Today’s lesson concerns the consequences of the Boechler decision on the recovery of costs and attorneys fees under §7430.  It’s a surprisingly nuanced lesson.

Alert readers should note that this is a potentially important lesson for deficiency petitions.  That is because the IRS and Tax Court have a similar long-standing belief that the 90-day period in §6213 for NOD petitions is jurisdictional.  And that position, too, may be soon be rejected, at least by the Third Circuit.  The case to watch for is Culp v. Commissioner.  In this recent oral argument before the Third Circuit, the taxpayer was fortunate to have the terrific advocacy skills of Oliver Roberts and Professor Keith Fogg.  While one never knows until the opinion issues, one gets a sense that the Circuit Court panel was quite sympathetic to the argument that §6213 is not jurisdictional.  The panel even went to the extraordinary length of asking Professor Fogg to give additional oral argument!  For more on the Culp case, see Carl Smith’s post here over at Procedurally Taxing.  But for the lesson on how substantial justification works, the details are below the fold.

Law:  General Operation of  §7430
Section 7430(a) permits a court to award costs (including attorneys fees) to any person who is a prevailing party in “any proceeding which is brought by or against the United States in connection with the determination, collection, or refund of any tax, interest, or penalty under this title.”  Costs are broken into those incurred in two distinct stages: (1) the administrative, pre-litigation, stage of a controversy; and (2) the litigation stage.

Pursuing awards under §7430 takes some doing.  For details on all the hoops and hurdles and barriers to recovery, you cannot do better than read Maria Dooner and Linda Galler’s excellent treatment in Chapter 18 of that overflowing cornucopia of tax practice wisdom, Effectively Representing Your Client Before the IRS (8th ed., Christine Speidel and Patrick Thomas, eds.).

The first and perhaps most important hoop is that party seeking costs and fees must be a prevailing party.  That is a term of art.  To be a prevailing party, a taxpayer must first convince a court that they substantially prevailed with respect to either the amount in controversy or the most significant issues presented.  Even if they do that, however, they are not a prevailing party if the Government's position was substantially justified.  See §7430(c)(4).  Treas. Reg. 301.7430–5(a).

As to substantial justification, the government’s position will be substantially justified “if it has a reasonable basis in both fact and law and is justified to a degree that could satisfy a reasonable person.” Huffman v. Commissioner, 978 F.2d 1139, 1147 n.8 (9th Cir. 1992).

But the test comes at two points in time.  The statute itself distinguishes the pre-litigation administrative process from the litigation process.  Specifically, §7430(c)(4)(B)(1) says that “A party shall not be treated as the prevailing party...if the United States establishes that the position of the United States in the proceeding was substantially justified.”  And §7430(c)(7) defines the term “position of the Unites States” to mean: “(A) the position taken by the United States in a judicial proceeding..., and (B) the position taken in an administrative proceeding ... as of the earlier of— (i) the date of the receipt by the taxpayer of the notice of the decision of the Internal Revenue Service Independent Office of Appeals, or (ii) the date of the notice of deficiency.”

Note that the government bears the burden to prove substantial justification at both of the relevant times.  The Tax Court has explained:  “the United States can take two positions in a particular case, one position in the prelitigation administrative proceedings and another position in the judicial proceedings, and each position must be evaluated separately to determine whether it was substantially justified.” Estate of White v. Commissioner, T.C. Memo. 2007-54.  And in fact in the Huffman case, the Tax Court found found the government was substantially justified in litigation even when it was not at the administrative phase.

The reason for the bifurcation between administrative and judicial proceedings is likely because litigation brings with it a change in institutional representatives.  You also see this implied by §7430(d) which says that administrative costs get paid from one source but litigation costs get paid from a different source. During the administrative process, it is the decision of the IRS Office of Appeals that is generally the testing point for substantial justification.  But once the case gets into court, it will be either the IRS Office of Chief Counsel or the DOJ Tax Division that sets the position of the United States.  Thus, that position must be evaluated for reasonableness separately than the Office of Appeals.  Keith Fogg has a very nice discussion in this Procedurally Taxing post.  Section 7430 did not used to be bifurcated and there was considerable litigation over what point in time to test the government’s position.  The 9th Circuit explains this and gives the legislative history in Huffman, supra.

Finally, even if the taxpayer is a prevailing party, §7430 contains other requirements. While not relevant to today’s lesson, I would be remiss in not making you aware of them. Basically, the taxpayer must show that they: (1) exhausted all administrative remedies available to them; (2) did not unreasonably protract the proceedings; and (3) are not worth over $2 million (if they are individuals). §7430(b).  Then they must also show the reasonableness of the costs and attorneys fees they want.  §7430(c)(1). Whew!  It’s a slog.

Today’s lesson is to see how the government’s position is tested for substantial justification at two different points.  It is thus possible that the IRS might not be able to establish that its position was substantially justified at the administrative level even if its litigating position was so justified.  It all depends on the facts.

So let’s take a look at the facts.

Facts
The year at issue is 2014.  For that year, Ms. Castillo filed a return showing some $12,000 of income.  However, the IRS received information returns from payment cards and third party networks showing payments of over $127,000.

The next action given in the opinion was the issuance of a Notice of Deficiency whereby the IRS proposed to assess a deficiency of $44,000 plus penalties and interest.  The opinion is unclear on how the IRS got from the matching program to the NOD, but I would guess the IRS used the Automated Underreporter program (AUR), described in IRM 4.19.3.  One of the key features of AUR is supposed to be that a human tax examiner looks at any inventory selected by the AUR programming.

But once a taxpayer’s case is green-lighted, AUR operates the same as with all other IRS automated processes.  If the taxpayer does not respond in a way that gets human attention, the process churns on by making operational presumptions that the taxpayer’s return is incorrect and that the payments reported on third-party information returns should be counted as income.  We might question the robustness of that operational presumption—see Lesson From The Tax Court: The Inherent Unreliability Of Third-Party Reporting, TaxProf Blog (Mar. 3, 2023)—but I think that is the basic reason that the IRS sent Ms. Castillo an NOD: an operational presumption based on her failure to respond to whatever notices or letters AUR spit out.

That is just my supposition, but it is strengthened by the facts of the case as reported in the opinion.  The critical fact was that Ms. Castillo did not respond to the NOD either.  Judge Kerrigan tells us that “The deficiency notice was mailed to petitioner’s last known address. The United States Postal Service attempted delivery of the notice once, but the correspondence was unclaimed and returned to respondent.”  Op. at 3.

So the IRS assessed the tax and penalties and started down the collection road.  Eventually, that led to an NFTL CDP notice.  The opinion does not tell us whether it was sent to the same address as the NOD.  However, Ms. Castillo actually did receive it because, amazingly enough, she caught the CDP Butterfly and went to Appeals for a CDP hearing.

At the CDP hearing Ms. Castillo contested the tax liability, explaining that the third party information returns were just wrong.  They were apparently using her TIN to report payments to a business she had once owned but had sold several years before 2014.  The payments had not been made to her but to that business, Castillo Seafood.  The Settlement Officer (SO) refused to consider her argument, believing she had received the NOD since the Post Office had returned the NOD as unclaimed, not as undeliverable.

The SO issued a Notice of Determination to proceed with the levy on December 11, 2018.  It is not clear whether or when Ms. Castillo received the Notice of Determination.  She filed a Tax Court petition on October 8, 2019 and claimed the SO did not properly send her the Notice of Determination.  The IRS moved to dismiss, providing evidence of mailing and alleging the Tax Court lacked jurisdiction over a late-filed petition.  The Tax Court agreed with the IRS and entered an order dismissing the case on March 25, 2020.  Ms. Castillo appealed to the Second Circuit.  I doubt any of this would have happened had Ms. Castillo been proceeding pro se. 

The Second Circuit held off on deciding the jurisdictional issue until the Supreme Court decided Boechler.  After Boechler, the Second Circuit summarily reversed the Tax Court and remanded for further proceedings.  By that time, Professor Maresca and her team had managed to get someone at the IRS to actually consider Ms. Castillo’s basic argument on why the information returns were simply wrong.  I am guessing they probably used the audit reconsideration process.

However it happened, on remand the IRS totally conceded that Ms. Castillo owed no tax and owed no penalty!  Professor Maresca then asked for the government to pay both the administrative costs and fees, and also the litigation costs and fees.  Since Ms. Castillo obviously prevailed, both as to the amount and as to the most important issue, the debate was whether the government was substantially justified, either at the time Appeals issued its Notice of Determination or at the time the government moved to dismiss for lack of jurisdiction.

So we get to our lesson:

Lesson:  The Two Time Periods to Test For Substantial Justification
Ms. Castillo sought two awards under §7430: she asked for $5,601 for her administrative costs and $129,750 for her litigation costs.

The government conceded the award of administrative costs.  I think that’s a pretty big deal because it reflects the Chief Counsel attorney’s determination that the position of the SO in Appeals was not substantially justified. Or at least the Chief Counsel did not think that fight had much chance of success.

As to litigation costs, however, the government established that its litigation position was substantially justified.  Judge Kerrigan tells us that a litigation position “is generally established at the time the Government files its answer in the judicial proceeding.” Op. at 4 (citations omitted).  Here, when the IRS filed its Answer, it said it was going to file a Motion to Dismiss for lack of jurisdiction.  At that time the Boechler case had not been decided.  Tax Court precedent was solid that the 30-day period to seek review of an adverse CDP hearing was jurisdiction.  Hence, the litigating position was substantially justified.

That would seem to be the end of it.  However, it appears that Ms. Castillo wanted to argue that (1) the SO failed to follow some provision of the IRM (not given in the opinion) and, therefore, (2) that failure to follow the IRM during the administrative process tainted the judicial proceeding as well.  The argument likely relied on §7430(c)(4)(B)(ii) which says that “the position of the United States shall be presumed not to be substantially justified if the Internal Revenue Service did not follow its applicable published guidance in the administrative proceeding.”  That statutory language is ambiguous as to the effect of a failure to follow applicable published guidance.

Judge Kerrigan rejects the argument, however, for a different reason.  She holds that the IRM is not “applicable published guidance” for §7430 purposes, citing to the definition of applicable published guidance given in §7430(c)(4)(B)(iv).

Alert readers will thus see the lesson we do not learn in today’s case:  if the position of the IRS is deemed not substantially justified because of a failure to follow applicable published guidance at the administrative level, does that failure preclude the IRS from being substantially justified in subsequent litigation?  My instinct is that it would not, but I have not researched that question and would welcome comments from any reader who knows!

Bottom Line: If you are seeking to recover costs, do not neglect to bifurcate your administrative costs and your litigation costs.  If you actually win on either the dollars or the most important legal issue, then the IRS must show that it had a substantially justified position both at the administrative stage and then at the litigation stage.

Comment:  I have seen Ms. Castillo’s fact pattern happen all too often: a taxpayer gets slammed with a huge tax, based on wildly inaccurate information returns, and then struggles to find someone in the IRS to actually help them.  That is why it frustrates me no end to hear stupid comments like this one from this Congressman: “The IRS should never be weaponized against American taxpayers. Rather, it should be focused on providing quality service to taxpayers. Rescinding the funding for 87,000 new IRS agents is a great first step in that direction, and I was happy to vote ‘yes' on this legislation!"  Really?  As Bugs Bunny would say:  “what a maroon!”  Dude, it’s the computer systems that hurt taxpayer service, not IRS employees.  The IRS actually needs more employees—and more well-trained employees—to work the cases because no matter how good your computer systems are, even a small percentage error applied to hundreds of millions of taxpayers is still a lot of hurt taxpayers.  And they need human help.  More IRS employees is what the agency actually needs to provide quality service.

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Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.