Recovering litigation and administrative costs.

Taxpayers' disorganized records cost them the opportunity to recover administrative and litigation costs. If taxpayers expect to be reimbursed for these costs, they must keep adequate records and cooperate with the IRS from the beginning. Proper recordkeeping with adequate upfront substantiation would eliminate the need to incur administrative and litigation costs at all.

How to Avoid Costs

The rules for recovering reasonable administrative and litigation costs are not new or complex. To be eligible for reimbursement, taxpayers must prevail substantially, under Sec. 7430(c)(4)(A), either on the amount involved or on the most significant issues, and their net worth must fall below a stated threshold. According to Sec. 7430(c)(4)(B), the taxpayer fails to qualify as the prevailing party if the IRS establishes that its position was substantially justified under Sec. 7430(c)(4)(B). A finding of substantial justification might take into account the taxpayer's behavior and condition of his or her records. Said another way, a finding of lack of substantial justification may require that the taxpayer provided adequate records and demonstrated cooperation in the examination process.

If taxpayers meet the criteria, Sec. 7430(a) provides that they can obtain reimbursement of reasonable administrative costs incurred during an administrative proceeding for any procedure or other action before the IRS, and recover reasonable litigation costs incurred in a court proceeding. For the latter, taxpayers must also exhaust all administrative remedies available within the IRS, under Sec. 7430(b)(1). Administrative and litigation costs might be denied if, under Sec. 7430(b)(3), the taxpayer has unreasonably protracted the administrative or court proceeding.

Authority

In Pierce v. Underwood, 487 US 552 (1998), the Supreme Court held that the government's position would be substantially justified if, based on all the facts and circumstances and legal precedents, the government:

1. Acted reasonably;

2. Has a reasonable basis in both law and fact; and

3. Is justified to a degree that could satisfy a reasonable person.

Taxpayers are required to maintain books and records in accordance with the prescribed rules and regulations and to bear the burden of proving and substantiating claims. On the other hand, the IRS may reasonably oppose a taxpayer's claims until the taxpayer provides adequate information that the Service can verify. The Service's position may be incorrect, but substantially justified, "if a reasonable person could think it correct" (Pierce at 566, n. 2). The question is whether the IRS knew or should have known that its position was invalid at the onset or when it took the position, given the facts and circumstances known at that time. The fact that the Service eventually loses or even concedes is relevant, but it does not establish that the position was unreasonable; see McIntosh, TC Memo 2001-144, and the authorities cited therein.

In McIntosh, the taxpayers did not keep a set of books, nor did they provide an accounting of the expenses incurred in their business. They gave to the IRS folders containing receipts and canceled checks. The examining agent attempted to verify the amounts shown on the returns in question and to reconstruct costs incurred. The agent contacted third parties and submitted numerous Information Document Requests (IDRs). The taxpayers gave IDR information that was disorganized to the agent; they did not submit the final supporting documentation until after the Service issued a deficiency notice. The Service had several conferences with the taxpayers and their representative, who were adequately informed about the IRS's objections to the deductions claimed.

The taxpayers argued that the Service's positions on the adjustments were not reasonable in fact, based on the evidence they ultimately presented. Although the IRS agreed that the taxpayers had substantially prevailed on the amount in controversy, it contended that they failed to fully substantiate, or account for, certain items. The Service argued (and the court agreed) that taxpayers are responsible for substantiating the amounts and the purposes of deductions claimed. It is reasonable not to concede adjustments until adequate substantiation is received and the items in question are verified. Thus, the court concluded that the IRS's position was reasonable when taken and appropriately conceded within a reasonable time after suitable substantiation was provided.

Because the Service's positions on the disputed issues were reasonable and sufficiently supported by the facts and circumstances known at the time, the court held that they were substantially justified. Thus, even though the IRS conceded the substantive issues, the court found the taxpayers not to be the "prevailing" parties, because the Service's position was substantially justified. As a result, it denied the administrative and litigation costs.

FROM RONALD J. BLAIR, CPA, MBA, SCHOOL OF MANAGEMENT, UNIVERSITY OF TEXAS AT DALLAS, DALLAS, TX

Mark H. Ely, J.D., CPA

Partner

Washington National Tax

KPMG LLP 

Washington, DC