IRS Issues Final Regulations on Awarding Litigation Costs

The IRS issued final regulations on awarding administrative and litigation costs under Sec. 7430 to a prevailing party in any administrative or court proceeding brought by or against the United States for determining, collecting, or refunding any tax, interest, or penalty (T.D. 9756). To qualify, a taxpayer must substantially prevail on the amount in controversy or the most significant issue or set of issues, exhaust any administrative remedies, meet net worth and size requirements, and pay or incur the costs. The IRS also simultaneously issued related guidance, as discussed below, in Rev. Proc. 2016-17.

The regulations finalize 2009 proposed regulations with a few changes. They also reflect statutory changes to Sec. 7430 in the Taxpayer Relief Act of 1997 (TRA), P.L. 105-34, and the IRS Restructuring and Reform Act of 1998, P.L. 105-206.

First, before the TRA, Sec. 7430 did not specify the time period in which a taxpayer must file a petition for administrative costs. Now, a taxpayer has 90 days after the date the IRS mails to the taxpayer a final decision determining tax, interest, or a penalty, to file an application to recover administrative costs. In addition, a taxpayer now has 90 days after the IRS mails the taxpayer a final adverse decision on an award of administrative costs, by certified or registered mail, to petition the Tax Court to review that decision. The final regulations provide rules to implement these “new” provisions.

Two other changes to Sec. 7430 include adding trusts to the lists of taxpayers that are required to meet net worth requirements before they qualify for costs and revising the rules for how taxpayers who filed joint returns determine their net worth.

The proposed regulations mentioned only that taxpayers who filed joint returns should have their net worth calculated separately but did not explain how. The final rules clarify that, when taxpayers who file jointly also jointly petition the court and incur joint costs, each taxpayer qualifies for a separate net worth limitation of $2 million, but the limitation will be evaluated together. So, taxpayers will meet the net worth limitation as long as their combined assets are equal to or less than $4 million, regardless of how the assets are distributed. If petitioners file jointly but petition the court separately, each will be subject to a separate net worth requirement of $2 million or less.

An important change from the proposed regulations is how to determine a taxpayer’s net worth. The proposed regulations required taxpayers’ assets to be valued at fair market value. The final rules provide for a value based on acquisition costs.

A second important change is that, in response to comments, the IRS is not finalizing regulations that limited the availability of awards of attorneys’ fees for legal services provided on a pro bono basis to taxpayers who satisfied certain income limitations (in which case, the attorneys’ fees would be awarded to the attorney, rather than the taxpayer). Rather than expand the list of taxpayers qualifying under the rules, the IRS decided not to issue the regulation at all because eligibility for attorneys’ fees for pro bono legal services should not be based on the income or financial resources of the recipient of the representation beyond what is required under the statute.

Other amendments provide that a taxpayer may be eligible to recover reasonable administrative costs from the date of the 30-day letter only if at least one issue (other than recovery of administrative costs) remains in dispute as of the date that the IRS takes a position in the administrative proceeding. If the IRS concedes an issue in the Office of Appeals before issuing a notice of deficiency or notice of the decision of the Office of Appeals, the Service has not taken a position and, therefore, an award of administrative costs is not available. Also, if the IRS concedes an issue in the notice of decision, the IRS’s position is substantially justified and no costs are awarded.

A final change from the proposed regulations is the elimination of the rule for determining the rate of compensation for pro bono attorneys who do not have a customary hourly rate. The rule is now contained in Rev. Proc. 2016-17, issued simultaneously.

The final regulations generally apply to costs incurred and services performed in cases in which the petition was filed on or after March 1, 2016, the date they were published in the Federal Register, but taxpayers may apply those rules retroactively. Separate effective dates apply to the rules under Regs. Sec. 301.7430-7, which govern the determination of “qualified offers.” No effective date was contained in the proposed rule, so the rules apply to qualified offers made in administrative court proceedings after Dec. 24, 2003, except that Regs. Sec. 301.7430-7(c)(8), which governs interest as a contested issue, is effective March 1, 2016.