Recovering Attorney Fees for IRS Actions

James & Tiffany Manning, who prevailed in Tax Court, recently sued the IRS to recover the attorney fees necessary for their defense.  The mannings participated in an alleged abusive tax shelter, for which the IRS investigated and issued a deficiency notice (assessed tax) which included a significant accuracy related penalty.

Upon further review, the taxpayers did admit to mistakenly deducting $100,000 of commissions, but  prevailed with the most significant issues.  The prevailing party may be awarded reasonable costs if they establish:

1. They have exhausted the administrative remidies available
2. The party has substantially prevailed
3. The party satisfies net worth requirements
4. The party has not unreasonably protracted the proceedings
5. The amount is reasonable

(The details of these requiremens can be found in §7430(b))

The IRS did admit that the taxpayer did prevail in the proceedings, but that damages should not be awarded because the IRS had reasonable positions and that their actions were substantially justified.  The court disagreed.  Additionally, they did not satisfy the net worth requirements, as they had enough wealth to spend over $250,000 in their own defense. 

The taxpayers also attempted recovery under §6673(a)(2) which allows the court to award attorney's fees if the Government has unduly and unreasonbly delayed the case.  The court judged that the Government did not, and therefore decided against the taxpayer.

Aaron's Take:  Most people don't know about this provision, which allows for the reimbursement of court costs.  This provision is part of the tax code to prevent punitive, irrational, or unjustified actions by the Internal Revenue Service.  Legitimate arguments, especially those which deal with complicated tax shelter transactions, must be legitimately defended.  THE BURDEN OF PROOF ALWAYS RESTS ON THE TAXPAYER.  If it costs you 250k to defend your position, that's life!  You must factor the potential for litigation with the risk that the position you are taking may be challeneged.