Why More Taxpayers Should Pursue Attorney’s Fees through Qualified Offers

Today we welcome back guest bloggers Maria Dooner and Linda Galler, who in this post urge representatives use the qualified offer provisions more often. Statistics that Maria and Linda received though FOIA show that surprisingly few cases result in attorneys fees given the volume of Tax Court litigation. Regular readers will be familiar with some of the reasons why this may be the case – we have discussed the hurdles to winning fees in many posts (e.g. here, here, and here). Taxpayers in the Ninth Circuit may have a slightly easier time thanks to the Knudsen precedent, but the road is not easy. However, as Maria and Linda explain, there are benefits to submitting a qualified offer even if it does not result in the government paying fees. Christine

Over the past decade, advancements in data collection and analytics at the Internal Revenue Service (IRS) have led to better insights into the world of federal tax administration. The agency has significantly relied on data to enhance both criminal investigation and civil enforcement.  The ability to access and analyze IRS data also can be valuable to practitioners who desire a better understanding of the use and impact of certain procedural provisions that benefit taxpayers.

As the authors of Chapter 18 in the upcoming 8th edition of Effectively Representing Your Client Before the IRS, we requested and obtained data from the IRS regarding the pursuit and recovery of attorney’s fees through IRC 7430.  This blog post summarizes that data and offers our observations and thoughts on using qualified offers (“QOs”) for strategic, rather than monetary, purposes.

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What the data show (and do not show)

There is very little data on the pursuit and recovery of attorney’s fees in tax disputes because the IRS only partially tracks it. For example, the IRS does not track the total number of cases in which recovery of administrative or litigation costs is sought under the general provisions of IRC § 7430. Nor does the IRS track or maintain any information on QOs (e.g., number of QOs submitted, number of QOs that resulted in settlement of the underlying case, number of QOs that resulted in an award, or whether an award was for administrative or litigation costs). Such information would be useful both to the government and to practitioners, and we were surprised to learn how little the IRS knows.

The IRS does track the number of cases in which the Office of Chief Counsel (Procedure and Administration) processed a payment of an award from the General Judgment Fund, which includes all cases in which attorney’s fees are awarded in cases before the U.S. Tax Court:

YearNumber of Cases
20158
201613
20177
201810
Attorneys’ Fee Awards in Tax Court Litigation

To place this data in context,  Chief Counsel reported approximately 25,000 cases for fiscal year 2018, 27,000 cases for fiscal year 2017, 30,000 cases for fiscal year 2016, and 32,000 cases for fiscal year 2015 in the U.S. Tax Court.  Consequently, the extremely low number of cases that resulted in an award of fees suggests that practitioners may be overlooking the ability to pursue an award of attorney’s fees and, we suspect, are greatly underutilizing QOs.

What is a qualified offer?

A QO is essentially a written offer made by the taxpayer to the government in a case involving the validity of a tax liability or refund. The taxpayer offers a specific amount (tax liability or refund) to resolve the taxpayer’s case. If the government rejects the offer and there is a court judgment that is equal to or more favorable (to the taxpayer) than the offer, the taxpayer can be awarded attorney’s fees. Thus, for those serious about recovering attorney’s fees, the amount detailed in a QO (which can be a dollar amount or a percentage of the adjustments at issue) should be a realistic estimate of what the taxpayer truly believes to be the correct liability or refund. Though it may be tempting, submitting an offer that is too favorable to the taxpayer (in terms of merit) will likely result in a quick rejection by the IRS and can be a waste of time for all parties.

In terms of timing, a taxpayer can submit a QO any time after they receive a notice of proposed deficiency (i.e., “30-day letter”), which provides rights to administrative review in Appeals.  While a taxpayer can submit a QO up until the day before trial begins, a taxpayer should submit a QO as soon as practical. (Under Reg. § 301.7430-7(a), a taxpayer is entitled to recover only fees incurred subsequent to the offer.) A QO is open for acceptance or rejection by the IRS for 90 days or until the date the trial begins, whichever is earlier. For QOs to be successful, taxpayers must exhaust all administrative remedies with the IRS and not unreasonably protract the proceedings, as well as satisfy a net worth requirement. 

What are the benefits of submitting a qualified offer?

As compared to pursuing costs and fees under the general provisions of IRC § 7430, QOs do not require proof that the government’s position was not substantially justified.  Proving a lack of substantial justification is often the main challenge in recovering attorney’s fees.  Therefore, a taxpayer who submits a QO (and receives a court judgment that is equal to or better than the offer), can expect a more straightforward path toward receiving an award.

The benefits of submitting QOs go beyond monetary compensation; a major benefit is quick case resolution. (The Internal Revenue Manual explicitly instructs Appeals Officers to expedite QOs.)  Efficient case resolution is equally important to LITC/pro bono and compensated attorneys.  For example, given the challenges facing the IRS at the moment, even cases with a predictable outcome can take a long time to make their way through the administrative process.  For clients of LITCs or pro bono counsel, refunds can be held up for lengthy periods, causing financial difficulties to taxpayers who ultimately will prevail.  Moreover, these cases take up unnecessary time and resources for tax professionals on both sides.  Indeed, LITCs and nonprofit organizations themselves are harmed by lengthy administrative processes; pro bono attorneys have less time and bandwidth to represent other clients while struggling to resolve what they reasonably thought were predictable cases. 

In Chapter 18 of the forthcoming edition of Effectively Representing Your Client Before the IRS,  we discuss in more detail the rules on how to submit a QO and when one is warranted.  Ultimately, we explain why QOs are the “easy way” to recover costs and fees and how they serve to encourage the settlement of tax disputes.  While a QO is not and should not be a panacea for every case, QOs should be considered in strong cases that encounter time-consuming challenges or delays in resolution through no fault of the taxpayer. 

Logic Loses in Taxpayer’s Effort to Recover Attorneys’ Fees

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.

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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:

  1. The costs must be incurred in an administrative or court proceeding in connection with the determination, collection, or refund of tax, interest, or penalties;
  2. the taxpayer must exhaust all administrative remedies;
  3. the taxpayer must not unreasonably protract the proceedings; and
  4. 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).