Recovering Legal Expenses for Mistaken IRS Audit of Non-Resident

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The U.S. has significant and complex reporting and filing and notice requirements. This includes a myriad of state and local requirements and federal requirements, including income tax return filing requirements.

As odd as it sounds, it is part of what makes America great. We often don’t think about it, but these filing requirements are part of the rule of law that we have here in the U.S. Our whole system is based on the concept of notice which triggers various actions by the noticed party to respond. Then the law provides remedies, allowing parties due process of law before the government acts. While it creates burdens to take action, it can help curb arbitrary and unjust acts.

There are times when the system of reporting and filing doesn’t work in a way that might seem fair. For example, what happens when the IRS conducts an audit on a tax return for a year you didn’t file as you were not obligated to file as you had no U.S.-sourced income? What if you can prove that you have no tax liability in the U.S. and eventually the IRS agrees with you, can the IRS be held accountable for your legal expenses, including attorney’s fees?

The U.S. Tax Court addresses this in Yamada v. Commissioner, T.C. Memo. 2023-70.

Facts & Procedural History

This case involves a Japanese couple who resided in the U.S. until 2007. The husband was a dual U.S.-Japanese citizen. They filed their final income tax return with the U.S. in 2007.

In 2012 and 2013, the IRS started audits for the 2008, 2009, and 2011 tax years. Presumably, because the IRS could not reach or locate the taxpayers, it ended up issuing summonses to their banks for their bank statements. This led to audit notices being mailed to the taxpayers’ old pre-2008 address in the U.S.

The IRS sent the ensuing notice of deficiency to their address in Japan–which the taxpayers received and were able to respond to. By early 2015 the taxpayers provided records that showed that they had no U.S. income as it was excluded by the U.S. tax treaty. The records had to be translated from Japanese. This process took about a year, give or take.

The IRS reviewed the taxpayer’s audit reconsideration request at some point and agreed that no tax was due. Around two years later the IRS conceded the court case.

The taxpayers then filed an application for legal costs, including attorney’s fees and related costs.

Section 7430(a) provides that the prevailing party may be awarded reasonable administrative or litigation costs for any proceedings brought by or against the United States in connection with the determination, collection, or refund of any tax, interest, or penalty. This allows taxpayers to recover legal expenses incurred while defending their rights when the IRS takes an unreasonable position.

As with anything when it comes to the government, Section 7430 sets out several requirements taxpayers have to meet to successfully recover legal expenses.

The taxpayer has to first establish that they are the prevailing party. This means that the taxpayer must have substantially prevailed in relation to the amount of tax, penalties, and interest in controversy or the most significant issue or set of issues presented. The determination of the prevailing party status is crucial, as the IRS cannot be required to pay legal expenses if the taxpayer is not the prevailing party.

Second, the taxpayer must demonstrate that they did not unreasonably protract the proceedings. This discourages unnecessary delays or frivolous actions by taxpayers that may inflate the costs incurred by both parties. This is often not an issue for taxpayers as it is the IRS that normally delays the processing of cases. This may come up if the taxpayer did not respond to IRS audit requests, etc., however.

The taxpayer is also limited to amounts that are reasonable. This takes into account factors such as the nature and complexity of the case, the time and labor required, the prevailing rates in the relevant market compared to the allowable attorney fee rate, and any other relevant factors. Documentation for the expenses claimed is needed.

And taxpayers also have to demonstrate that they exhausted the administrative remedies. This means that they have pursued all appropriate avenues of administrative appeal or review before resorting to litigation. Typically this includes participating in the IRS Appeals Office process.

Legal Expenses Under Tax Court Rule 232

For litigation in the U.S. Tax Court, Tax Court Rule 232 explains how to submit a request under Section 7430. Here is a summary of the key points of this rule:

  1. The taxpayer and IRS attorney have to confer and exchange information on attorneys fees and if the attorneys cannot agree on the amount, the taxpayer attorney is to file an affidavit showing the amount charged, work performed, etc.
  2. The court has the discretion to dispose of a motion for litigation or administrative costs in various ways. It can enter an award or denial after the IRS’s response or it can order the taxpayer to respond to the IRS’s response.
  3. The court is then to enter an order deciding the case.

The court’s decision is similar to any other decision from the court, so it will address the facts (pulled from the filings) and state the reason and legal support for its decision.

The Prevailing Party Dispute

That brings us back to this case. This case focused on whether the taxpayers were the prevailing party.

The IRS argued that the taxpayers were not the prevailing party in this case. It argued that the IRS was substantially justified in its position.

According to the IRS, the IRS’s position was reasonable as the taxpayer-husband was a U.S.-citizen and had U.S. bank accounts. The IRS also argued that the taxpayers failed to provide records that they were entitled to tax benefits under the United States-Japan treaty and failed to update their address with the IRS.

The taxpayers argued that no evidence that they were engaged in a U.S. business or income-producing activity. Because there was no evidence of a U.S. business, the taxpayers argue that the IRS was not justified in conducting bank deposit analyses. The taxpayers further argue that once they received the deficiency notices, they provided all requested information. They contend that certified translations were not necessary to prove the income was tax-exempt in the United States. They claim that the filing itself was sufficient to show that they had no U.S.-source income.

The court concluded that the failure to update their mailing address with the IRS was enough to justify the IRS’s suspicion that there was unreported income and, once they did a bank deposit analysis, to pursue the case.

The court took an all-or-nothing approach to the request. The court did not even award legal costs from the date the taxpayers provided the IRS with proof that they had no U.S.-source income.

How to Update Your Address With the IRS

Taxpayers are better off updating their address with the IRS, and doing so frequently. This can result in IRS notices being mailed to the wrong address and invalidating the IRS’s actions.

To update your address with the IRS, you have a few options:

  1. Online: Visit the official IRS website and use the “Where’s My Refund?” tool or the “Get Transcript” tool. These tools allow you to update your address online while accessing other services provided by the IRS.
  2. Form 8822: Fill out Form 8822, “Change of Address,” available on the IRS website. Print the form, complete it with your updated information, and mail it to the address provided on the form.
  3. Written Notification: You can also notify the IRS of your address change in writing. Include your full name, old address, new address, Social Security number, and signature. Send the notification to the address where you would normally file your tax return.
  4. Notify the Post Office: Another useful step is to inform the U.S. Postal Service (USPS) of your address change. You can do this online or by visiting your local post office. The USPS will forward mail from the IRS to your new address for a certain period of time, ensuring that you receive important communications.
  5. Filing a Tax Return or Form 2848 Power of Attorney: The IRS will update your address to the last-filed tax return or Form 2848, power of attorney.

The Takeaway

Taxpayers should ensure that their address is kept up to date with the IRS. This was the critical factor that prevented the taxpayer from recovering legal expenses for a mistaken audit and what turned out to be an erroneous decision by the IRS. This is something that those who have ties with the IRS should be aware of. As this case shows, not only could this help avoid a negative IRS decision on audit but also help the taxpayer recover legal costs, such as attorneys fees.

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