Attorney Fees in Tax Litigation: Jury Says Yes, Judge Says No – Houston Tax Attorneys

In most litigation, each party pays their own attorney fees regardless of who wins the case. This “American Rule” applies even when one party is clearly right and the other clearly wrong.

But litigation against the government, such as tax litigation, presents a unique inequity. When taxpayers are forced to defend against an incorrect IRS position, they effectively pay twice–once through their taxes that fund the IRS’s litigation costs (including the courts, government attorneys, and administrative proceedings), and again for their own defense. As taxpayers in this situation often ask: “Why should I have to pay for both sides of the litigation when I was right all along?”

The recent decision in Ankner v. United States, No. 2:2021cv00330 (M.D. Fla. Nov. 19, 2024) provides an opportunity to consider the rules for recovering attorneys’ fees from the IRS.

Facts & Procedural History

This case involved penalties assessed under Section 6700 against a group of companies that operated a captive insurance program.

The IRS has long challenged captive insurance programs. The IRS claimed this program didn’t qualify as “insurance” for tax purposes, making the tax deductions for their clients’ premium deductions improper. After a lengthy IRS audit and administrative process, the taxpayer filed suit in federal district court and the case proceeded to a jury trial.

The jury completely rejected the IRS’s position, finding that the taxpayer was not liable for any penalties and ordering refunds of all penalties previously paid. The taxpayer then filed a motion to recover their attorney fees under Section 7430. The taxpayer sought to recover $5,601 in administrative costs and $129,750 in litigation costs, which was the subject of this court opinion.

Attorney Fee Awards in Tax Litigation

Section 7430 allows courts to award reasonable administrative and litigation costs, including attorney fees, to prevailing parties in tax cases. However, there are some requirements.

First, there are limits on who can recover. Individual taxpayers must have a net worth under $2 million and business taxpayers have to have a net worth under $7 million and fewer than 500 employees.

Second, not all costs are recoverable. The hourly rate for attorney fees is capped at $125 (adjusted for inflation), though higher rates may be allowed in limited circumstances. But these rates are much lower than the prevailing rates for tax attorneys. Thus, even with an award of attorneys fees, the taxpayer is not going to be made whole.

Recoverable costs can include expert witness expenses, reasonable costs for studies and analysis, and court costs. These costs are also limited by timing. Administrative costs can be recovered from the earliest of: (1) the IRS Appeals Office decision, (2) the notice of deficiency, or (3) the first letter proposing a deficiency that allows for Appeals review. Litigation costs cover the period after court proceedings begin. This excludes time for the IRS audit or tax return submission or processing.

The “Substantially Justified” Defense

The biggest hurdle is often the “substantially justified” defense. Even if a taxpayer wins their case, they cannot recover fees if the IRS shows its position was “substantially justified.” This term means that the IRS had a reasonable basis in both law and fact.

Substantial justification means justified in substance or in the main — that is, justified to a degree that could satisfy a reasonable person. In other words, it means a reasonable basis both in law and fact. The courts have said that a party’s position can be substantially justified but incorrect, as long as a reasonable person could think that the position was correct.

This must be evaluated at two distinct points:

The administrative stage – when the IRS takes its position through Appeals

The litigation stage – when the IRS or Department of Justice attorneys handle the case

In Ankner, while the IRS conceded administrative costs (suggesting its position wasn’t justified at that stage), it successfully argued its litigation position was substantially justified because it was following established precedent at the time. The jury’s rejection of that position didn’t automatically make it unjustified.

This result is due to the procedure. The request for attorneys fees is submitted by a motion that is filed with the court. This was not a question submitted to the jury. This differs from state tax litigation practice in Texas, for example, where the jury decides both the merits and whether attorneys fees should be awarded. The Texas approach recognizes that the jury, having heard all the evidence, is best positioned to determine whether the government’s position was reasonable. This leads to more frequent fee awards, as juries who find the government’s position meritless are likely to also find it unreasonable. In Ankner, had the question been presented to the jury that had just rejected every aspect of the IRS’s case, the jury would have no doubt awarded attorneys fees to the taxpayer.

Strategic Use of Qualified Offers

One way around the “substantially justified” defense is making a “qualified offer” under Section 7430(g).

As shown in the recent Mann Construction v. United States case, even a $1 qualified offer can work. If the taxpayer makes a qualified offer that the IRS rejects, and then obtains a judgment for less than the offered amount, they can recover fees regardless of whether the IRS’s position was justified.

To be valid, a qualified offer must:

Be in writing

Specify the offered amount

Be designated as a “qualified offer”

Remain open until the earlier of: 90 days, trial date, or rejection

Be made after the 30-day letter but before 30 days pre-trial

Taxpayers should consider submitting qualified offers if they meet the net worth requirements noted above. This can put some pressure on the IRS to actually resolve the case expeditiously and, hopefully, in the taxpayer’s favor.

The Takeaway

This case shows that winning at trial doesn’t guarantee attorney fee recovery under Section 7430. The fact that this question is left to the judge, rather than the jury that heard all the evidence, makes it harder for taxpayers to recover their fees. Taxpayers need to carefully document their case from the administrative stage forward and consider making qualified offers to preserve their ability to recover fees. While jury verdicts remain important, the “substantially justified” standard means taxpayers must think strategically about fee recovery from the outset of their case. Making qualified offers early in the process, even nominal ones, may help secure fee recovery if successful.