The Ninth Circuit reversed the Tax Court and held that a taxpayer could “incur” attorneys’ fees initially paid by a third party for purposes of an award of litigation costs under Sec. 7430.
Background
Bradley Morrison and Nariman Teymourian formed an intellectual property management partnership, later reorganized as Caspian, a California corporation, of which Morrison owned 40% and Teymourian 60%. Morrison served as an officer and director at Caspian and was also employed in a technical capacity. In July 2002, Morrison sold his interest in Caspian to Teymourian and resigned from his officer and director positions and his employment with Caspian.
In November 2001, before Morrison resigned, the IRS began an audit of Caspian’s 1999 and 2000 tax returns; it later expanded its examination to include a separate audit of Morrison’s personal tax returns for the same time period. Eventually, the IRS issued notices of deficiency to both Caspian and Morrison. The notices raised several issues, the most significant of which was whether loans made by Caspian to its shareholders, including Morrison, in 1999 and 2000 were taxable as constructive dividends.
After trying but failing to resolve the dispute administratively, Morrison petitioned the Tax Court for a redetermination of the deficiencies. The Tax Court consolidated Morrison’s case for trial with Caspian’s related petition for redetermination, and both parties retained the same law firm—Taggart & Hawkins— as counsel for the litigation. The firm billed all its hours to an account titled “Caspian,” and Caspian paid all the associated fees. Both Caspian and Morrison prevailed on their petitions, and each filed a motion for an award of the litigation costs, including attorneys’ fees, under Sec. 7430.
The Tax Court found Caspian eligible to recover fees under Sec. 7430 and awarded Caspian fees equal to the portion of time Taggart & Hawkins spent on its case. The court denied Morrison’s motion, however, reasoning that “[b]ecause Caspian, a separate entity, paid all litigation costs in issue, petitioner did not . . . actually pay or incur any litigation costs.” Morrison appealed the Tax Court’s decision to the Ninth Circuit.
Sec. 7430
Under Sec. 7430, the prevailing party in a civil tax case brought by or against the government can be awarded reasonable litigation costs, including reasonable fees paid or incurred for the services of attorneys in connection with the court proceeding. The prevailing party is any party (other than the United States or any creditor of the taxpayer involved) that has substantially prevailed with respect to either the amount in controversy or the most significant issue or set of issues presented. Among other requirements to be awarded costs, the prevailing party must have exhausted all available administrative remedies within the IRS before bringing suit and must not have unreasonably protracted the proceedings.
The Ninth Circuit’s Decision
The Ninth Circuit reversed the Tax Court, holding that when a third party that has no direct interest in litigation pays a taxpayer’s attorneys’ fees in the litigation, the taxpayer incurs the fees for purposes of Sec. 7430 if the taxpayer assumes either an absolute obligation to repay the fees or a contingent obligation to repay the fees if the taxpayer is awarded fees under Sec. 7430. In Morrison’s case, it was unclear from the record whether Morrison had assumed such an obligation, so the court remanded the case to the Tax Court for further proceedings to determine if he was entitled to an award of attorneys’ fees.
The court first considered whether a taxpayer could incur attorneys’ fees without paying them. It found that the Tax Court had interpreted Sec. 7430 too narrowly by equating “paid” with “incurred” because it did not recognize that a taxpayer could incur a fee by assuming an obligation to repay a third party who paid the fee for the taxpayer. According to the court, if the taxpayer assumes a noncontingent obligation to repay the fee, under the normal definition of the term “incur” the taxpayer has incurred the fee.
In a case in which the taxpayer has a contingent obligation to repay attorneys’ fees if the taxpayer recovers the fees under Sec. 7430, the Ninth Circuit found that the answer was less clear but held that a taxpayer would also incur fees for purposes of Sec. 7430 by assuming such an obligation. The Ninth Circuit based its decision largely on the purpose of Sec. 7430, which according to the House report on the provision is to “deter abusive actions and overreaching by the Internal Revenue Service and . . . [to] enable individual taxpayers to vindicate their rights regardless of their economic circumstances” (H.R. Rep’t No. 97-404 at 11 (1981)).
The court found that disallowing an award of attorneys’ fees paid under this scenario would discourage third parties from helping taxpayers litigate otherwise meritorious claims and would provide an incentive for the government to unreasonably refuse to settle these claims. In the case of the taxpayer, the court noted that a third party would be less likely to pay attorneys’ fees for the taxpayer if it knew at the outset that it had no chance of recouping the fees out of an award of attorneys’ fees under Sec. 7430. In the case of the IRS, the court noted that the Service would be more likely to unreasonably litigate a claim if it was aware that it could not be held liable for attorneys’ fees.
The court also found that allowing for an award of attorneys’ fees in these circumstances would not encourage “stand-in litigants” because the litigation arises out of the government’s choice of a taxpayer for audit, and in Morrison’s case the specific facts showed that he was not a stand-in litigant for Caspian. Finally, the court found that the various requirements that a taxpayer must meet to be awarded attorneys’ fees ensured that the purpose of the statute (i.e., shifting the costs of litigation to the IRS when it erroneously or unjustifiably litigates an issue with a taxpayer) is not frustrated if the fee award is paid over to a third party.
Reflections
The Ninth Circuit considers an assumption of a contingent obligation to repay a fee (if it is recovered) as the equivalent of incurring the fee. In this situation, the taxpayer has no obligation to repay the fees paid by the third party until a court awards the fees to the taxpayer. Before the award of fees, the taxpayer has not incurred any fees, so the court cannot award any fees under the literal terms of Sec. 7430(a) (“reasonable litigation costs incurred”).
The Ninth Circuit looks
to the legislative history to avoid this logical problem and
reach what it believes is the correct policy conclusion. If it
is Congress’s intent that Sec. 7430 cover contingent fees, it
should amend the provision to make that clear.
Morrison, No. 06-75332 (9th Cir. 5/13/09)
