We welcome first-time guest blogger Professor Linda Galler to PT. Professor Galler is a co-author of the chapter, “Recovering Fees and Costs When a Taxpayer Prevails” in the forthcoming edition of Effectively Representing Your Client Before the IRS. Among Professor Galler’s many consulting, teaching, and scholarly pursuits, she directs the tax clinic at Hofstra University’s Maurice A. Deane School of Law.
In this post Professor Galler examines a recent decision denying a taxpayer fees and costs against the IRS. (Bryan Camp also covered the case here.) For those galvanized to learn more about qualified offers after reading this post, I recommend guest blogger Professor Ted Afield’s post on nominal offers, and Stephen Olsen’s grab bag of cautionary tales. Christine
Taxpayers rarely recover attorneys’ fees in tax cases despite the existence of a statute specifically providing for such recoveries. The Tax Court’s recent decision in Klopfenstein v. Commissioner, TC Memo 2019-156 (Dec. 9, 2019), is an example of why: the statutory requirements and the manner in which they are interpreted are overly exacting and counterintuitive. Klopfenstein involved a settlement of assessed penalties at Appeals for ten cents on the dollar – a 90 percent reduction in an assessed penalty – clearly raising the question of whether the government’s position in the case was substantially justified. Yet, in an opinion that relied heavily on established precedent, the court concluded that the IRS never took a “position” within the meaning of the statute and therefore that the taxpayer could not recover attorneys’ fees.
This essay does not argue the merits of recovery in Klopfenstein or in general. Clearly, there are policy arguments on both sides. Rather, the point is to both demonstrate the fruitlessness of seeking attorneys’ fees and to commend the taxpayer’s attorneys for having tried nonetheless.
Mr. Klopfenstein’s court filings describe him as an “investor, investment banker, and merchant banker” who “earned an MBA in finance and accounting from Emory University” and “is licensed as a CPA and as an investment banker.” In 2005, the IRS commenced a tax shelter investigation for 1998 through 2001 with respect to entities that Mr. Klopfenstein controlled. In November 2014, Exam issued a Notice of Proposed Adjustment (“NOPA”) asserting that Mr. Klopfenstein was a material advisor who failed to disclose reportable transactions as required by section 6111. The NOPA referenced more than 24 alleged transactions, which the IRS asserted should have been registered as tax shelters, and proposed penalties under section 6707 in excess of $1.6 million.
Mr. Klopfenstein timely requested that his case be considered by Appeals, which assigned the case to an Appeals Officer (“AO”) in October 2015. The penalties were assessed in March 2016 and the IRS immediately began collection efforts, culminating in the filing of notices of federal tax lien in two states. Meanwhile, the AO held a pre-conference meeting with Mr. Klopfenstein, his attorneys and Exam personnel in June 2016 and a settlement conference in August. A settlement was reached under which Mr. Klopfenstein agreed that he was liable for a section 6707 penalty of approximately $170,000 for 1998 and that he was not liable for penalties in an any other year. The settlement was memorialized in a closing agreement, which was returned to Mr. Klopfenstein, signed, on November 30, 2016. The following month, the IRS abated more than $1.4 million of the assessed penalties, roughly 90% of the original assessment.
On February 27, 2017, Mr. Klopfenstein submitted a request for reasonable administrative costs (attorneys’ fees) under section 7430(a)(1), contending that he was a “prevailing party” and therefore was entitled to an award for attorneys’ fees and costs incurred during the administrative proceeding. The IRS denied the request and Mr. Klopfenstein filed a petition with the Tax Court seeking review of the IRS’s action. Both parties filed motions for summary judgment limited to the question whether Mr. Klopfenstein was a prevailing party within the meaning of section 7430.
A taxpayer may recover costs under section 7430 by satisfying four requirements:
- The costs must be incurred in an administrative or court proceeding in connection with the determination, collection, or refund of tax, interest, or penalties;
- the taxpayer must exhaust all administrative remedies;
- the taxpayer must not unreasonably protract the proceedings; and
- the taxpayer must be the prevailing party.
(In addition, only taxpayers who satisfy certain net worth requirements qualify.) The term “prevailing party” is defined in section 7430(c)(4)(A) as the party who has substantially prevailed with respect to either the amount in controversy or the most significant issue or set of issues presented. Given the difference between the penalties asserted and those ultimately agreed upon in the settlement, the IRS agreed that Mr. Klopfenstein had substantially prevailed with respect to the amount in controversy.
Under section 7430(c)(4)(B), a party may not be considered the prevailing party if the government establishes that its position in the proceeding was substantially justified. Section 7430(c)(4)(B) defines the government’s position in an administrative proceeding as its position on the earlier of (i) the date on which the taxpayer received Appeals’ notice of decision or (ii) the date of the notice of deficiency. The court held in the government’s favor, explaining that a party can never be a prevailing party unless the IRS has taken a position that is “crystallized” into either one of those documents. As to the first, Mr. Klopfenstein’s case was settled at Appeals so no decision was issued. As to the second, taxpayers can never recover fees under this prong in proceedings involving assessed penalties, where a notice of deficiency is not issued. Consequently, Mr. Klopfenstein could not have been a prevailing party.
Mr. Klopfenstein’s losing argument was based on the structure of the statute. Section 7430(c)(4)(B) is an exception to the definition of prevailing party in section 7430(c)(4)(B). (Indeed, it is captioned as an exception.) Thus, if Mr. Klopfenstein substantially prevailed with respect to the amount in controversy (which the government conceded), he is the prevailing party unless the government establishes that its position was substantially justified. Logically, in Mr. Klopfenstein’s view, if the government never took a position (which the government also conceded), then Mr. Klopfenstein must be a prevailing party.
Mr. Klopfenstein’s argument is logical, reasonable and consistent with the statutory language. Indeed, a commonsense definition of “prevailing party” in the context of litigation likely would encompass a party whose adversary “lost” with respect to 90 percent of its claim. Thus, whether or not a denial of attorneys’ fees in cases such as this makes sense as a matter of policy, the viewpoint adopted by this court (based though it was on precedent) is awkward at best.
Had the government conceded that it took a position in the case, Mr. Klopfenstein might not have succeeded in recovering fees in any event. Under section 7430(c)(4)(B), attorneys’ fees are not awarded if the government establishes that its position was “substantially justified.” Substantial justification is a relatively low standard. It requires merely that the position have a reasonable basis in law and in fact. Treas. Reg. § 301.7430-5(d).
The best way to overcome the substantial justification hurdle is to make a qualified offer. Simply stated, if the IRS does not accept a taxpayer’s qualified offer to settle a case and the taxpayer receives a judgment that is equal to or less than the offer, the taxpayer is deemed to be the prevailing party; whether the government’s position was substantially justified or not is irrelevant. (The qualified offer rule is set forth in section 7430(c)(4)(E).) Unfortunately for Mr. Klopfenstein, however, the qualified offer rule applies only if a judgment is entered in a court proceeding. Because the case was settled before a court proceeding had commenced, the qualified offer rule did not apply.
Addendum: The Tax Court has jurisdiction to review IRS decisions whether to grant or deny (in whole or in part) requests for attorneys’ fees. Section 7430(f)(2); Tax Ct. R. 271. In docketed cases, the taxpayer must raise the claim during the case itself; res judicata precludes consideration of costs in a subsequent proceeding to the extent that the issue could have been pursued in the earlier case. Gustafson v. Commissioner, 97 T.C. 85 (1991); Foote v. Commissioner, T.C. Memo. 2013-276. Where the matter has been resolved administratively, the taxpayer must file a petition with the Tax Court within 90 days after the date on which the IRS mails a notice of decision. The taxpayer, not the attorney, is the proper party to file the claim. Greenberg v. Commissioner, 147 T.C. 382 (2016).