An IRS audit or notice comes with a cost for the taxpayer who receives it. The cost can include additional tax, interest, and even penalties.
Even if the taxpayer did everything correctly, the IRS audit or notice still comes with a cost. The cost can include the time and effort the taxpayer has to expend to deal with the IRS audit or notice. If the taxpayer hires a tax attorney to assist with the audit or notice, they may also incur attorney’s fees.
Section 7430 allows taxpayers to recover some of these costs from the IRS. This includes costs incurred for the IRS administrative appeal. Taxpayers often fail to realize that this is even an option. Those who are successful in their appeals should consider whether they qualify to recover their costs from the IRS.
- 1 What Administrative Costs Count?
- 2 The Taxpayer Substantially Prevails
- 3 The IRS’s Position is Not Substantially Justified
- 4 The Taxpayer Exhausted All Administrative Remedies
- 5 Some Tax Collection Cases May Not Count
- 6 Some Well-to-Do Taxpayers Do Not Qualify
- 7 Submitting the Claim for Administrative Costs
What Administrative Costs Count?
Administrative costs include attorneys fees or fees for a non-attorney for handling the IRS administrative appeal, including:
- Attorneys fees (and fees incurred by CPAs or enrolled agents),
- Expenses of expert witnesses, and
- Cost of any study, analysis, engineering report, test, or project
Attorneys fees typically make up the bulk of most of these claims.
To count, these fees have to be incurred for services rendered after the IRS’s 30-day letter is received. The regulations provide an example that helps explain when the time for fees starts:
Taxpayer A receives a notice of proposed deficiency (30-day letter). A requests and is granted Appeals office consideration. The administrative file contains certain documents provided by A as substantiation for the tax matters at issue. Appeals determines that the information submitted is insufficient. Appeals then issues a notice of deficiency. After receiving the notice of deficiency but before the 90-day period for filing a petition with the Tax Court has expired, and before filing a petition with the Tax Court, A convinces Appeals that the information previously submitted and reviewed by Appeals is sufficient and, therefore, the notice of deficiency is incorrect and A owes no additional tax. Pursuant to section 6212(d), the notice of deficiency is rescinded. Appeals then closes the case showing a zero deficiency and mails A a notice to this effect. Assuming that Appeals did not rely on any new information provided by A in rescinding the notice of deficiency and that all of the other requirements of section 7430 are satisfied, A may recover reasonable administrative costs incurred after the date of the 30-day letter (the administrative proceeding date as defined in Treas. Reg. § 301.7430-3(c)).
In the example, had the taxpayer filed its petition with the tax court, it would have had to request administrative costs with the IRS attorney after having closed the case with Appeals. The timing would be the same. The recoverable costs start when the case is being prepared for Appeals. Presumably, this even includes the time to prepare the protest required to submit the case to Appeals.
The costs also have to be reasonable. The amount of the award can be reduced for amounts that are not reasonable. For example, in Tolin v. Commissioner, 929 F.3d 548 (8th Cir. 2019), the court upheld a reduction to the attorney’s time and cost for that time. It concluded that the time was not reasonable. The hourly rate is also capped under the rules. The hourly rate that is allowed is lower than the hourly rates most tax attorneys charge. Thus, even an award of administrative costs is not likely to make the taxpayer whole.
The Taxpayer Substantially Prevails
There are limits on the costs that are allowable. These limits are set out in Section 7430 and the corresponding regulations. One limit is that these costs are only allowable if the taxpayer substantially prevails in the appeal.
This limitation does not require that the taxpayer has to be 100% correct in its position. To substantially prevail, the taxpayer only has to prevail with respect to the most significant issue or set of issues appealed.
The regulations provide the following example:
In the purchase of an ongoing business, Taxpayer F obtains from the previous owner of the business a covenant not to compete for a period of five years. On audit of F’s individual income tax return for the year in which the business was acquired, the Internal Revenue Service challenges the basis assigned to the covenant not to compete and a deduction taken as a business expense for a seminar attended by F. Both parties agree that the covenant not to compete is amortizable over a period of five years; however, the Internal Revenue Service asserts that the proper basis of the covenant is $25,000, while F asserts the basis is $50,000 and claims a deduction of $10,000 in the year in which the business was acquired. F deducted $12,000 for the seminar. The Internal Revenue Service determines that the deduction for the seminar should be disallowed entirely. In the notice of deficiency, the Internal Revenue Service adjusts the amortization deduction to reflect the change to the basis of the covenant not to compete, and disallows the seminar expense. Thus, of the two adjustments determined for the year under audit, the adjustment attributable to the disallowance of the seminar is larger than that attributable to the covenant not to compete. Due to the impact on the next succeeding four years, however, the covenant not to compete adjustment is the most significant issue to both F and the Internal Revenue Service.
This helps explain that the most significant issue is the one that counts for this purpose.
The IRS’s Position is Not Substantially Justified
To be entitled to recover administrative costs, the IRS’s position cannot be substantially justified. This burden is on the IRS. The IRS has the burden to show that its position was substantially justified.
A review of the court cases shows that this is one of the primary reasons why the courts conclude that taxpayers cannot recover administrative costs.
This requires an analysis of published IRS guidance and court cases. Even non-binding IRS notices and publications can be considered. If the IRS does not follow its published guidance or has lost similar cases in court, the IRS’s position is presumed to not be substantially justified.
In Johnson v. Commissioner, 972 F.3d 655 (5th Cir. 2020), the court concluded that the IRS’s incorrect position was reasonable where it did not yet have the information to make a correct determination. This is consistent with the example provided in the regulations:
The Internal Revenue Service, in the conduct of a correspondence examination of taxpayer A’s individual income tax return, requests substantiation from A of claimed medical expenses. A does not respond to the request and the Internal Revenue Service issues a notice of deficiency. After receiving the notice of deficiency, A presents sufficient information and arguments to convince a tax compliance officer that the notice of deficiency is incorrect and that A owes no tax. The revenue agent then closes the case showing no deficiency. Although A incurred costs after the issuance of the notice of deficiency, A is unable to recover these costs because, as of the date these costs were incurred, A had not presented relevant information under A’s control and relevant legal arguments supporting A’s position to the appropriate Internal Revenue Service personnel. Accordingly, the position of the Internal Revenue Service was substantially justified at the time the costs were incurred.
In Dang v. Commissioner, T.C. Memo. 2020-150, the court held that the IRS can depart from its guidance if the guidance is not clear.
The Taxpayer Exhausted All Administrative Remedies
To recover administrative costs, the taxpayer also has to exhaust all administrative remedies. This generally means that the taxpayer has to pursue an administrative appeal with the IRS Office of Appeals. This is true even if Appeals is not likely to even offer an impartial review of the tax issue.
In Veal-Hill v. Commissioner, No. 19-2121 (7th Cir. 2020), the court addressed the administrative remedies requirement. In that case, the taxpayer had opted to contest his tax in U.S. Tax Court rather than having the IRS Office of Appeals consider the case first. He did so as he did not feel that Appeals would offer an impartial review of the tax issue. Appeals eventually considered the case after the case was docketed in the U.S. Tax Court and conceded the case. Because the taxpayer opted for tax court first, the court concluded that the taxpayer did not exhaust his administrative remedies. Thus, the taxpayer was not entitled to an award of administrative costs.
Some Tax Collection Cases May Not Count
The rules say that administrative costs are not to be awarded for some tax collection cases. It is not always clear what counts as a tax collection case.
The collection due process hearing is an example. The collection due process hearing does not count if it just challenges the collection of the tax. If the collection due process hearing challenges the liability (and the liability wasn’t previously considered by the IRS), the taxpayer may qualify for an award of costs from the IRS.
The court addressed this in Dennis v. Commissioner, T.C. Memo. 2020-98. In Dennis, the taxpayer challenged whether a payment was credited to his account. The challenge was raised during a collection due process hearing. The court concluded that the taxpayer was not challenging the amount of the liability and, therefore, the proceeding was a collection proceeding. The court did not allow an award of administrative costs due to this.
Some Well-to-Do Taxpayers Do Not Qualify
The rules also say that certain well-to-do taxpayers do not qualify for an award of administrative costs. This can limit the award for both individuals and for businesses.
For individuals and trusts and estates, this includes taxpayers who have a net worth in excess of $2 million at the time the request for administrative costs is submitted. If the tax return at issue is a joint income tax return, the net worth of both spouses is considered.
For businesses, the business cannot have assets in excess of $7 million or more than 500 employees.
Timing matters. The net worth amounts are determined at the time the claim is submitted. The taxpayer generally has to submit the claim within 90 days of the IRS determination. The taxpayer may be able to control the date of when the IRS makes its determination in some cases. This may include providing information to the IRS sooner rather than later, pressing the IRS for a decision on a case, and/or not providing information to the IRS timely (while not running afoul of the requirement that the taxpayer not protract the proceeding).
Submitting the Claim for Administrative Costs
The claim process itself presents additional challenges. It is not always clear where the claim is to be submitted.
The claim for administrative costs has to be submitted to the correct IRS employee. This is often the appeals officer who works for the IRS Office of Appeals. In other cases, it may include employees at the IRS national office or even the larger IRS service centers.
The claim itself has to meet several criteria, including having supporting affidavits. These requirements are detailed in the regulations and supplmented by the court cases.
We help clients submit claims for attorney’s fees. If you have prevailed in a matter with the IRS, we want to hear from you. Please contact our tax attorneys to see if we can help you recover your administrative costs.
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