f a taxpayer successfully challenges the IRS, can that taxpayer recover reasonable litigation costs? Recently, the Tax Court applied the substantial justification standard when it reviewed Images and Allemeier , two cases involving litigation costs.
In Images , Denise Lopez owned and operated a dance studio. The IRS challenged her classification of dance instructors as independent contractors. After interviewing Lopez and the instructors and reviewing the employee manual, the IRS examining agent concluded an employer-employee relationship existed between Lopez and her staff. On administrative appeal, however, the appeals officer decided Lopez would likely win at trial. Lopez then sought to recover reasonable costs of litigating the matter.
In Allemeier the taxpayer claimed as business expenses the cost of an MBA and other expenses related to his work. The IRS argued the MBA was a minimum educational requirement that qualified the taxpayer for a new trade or business. The Tax Court held for Allemeier , who then sought to recover the reasonable litigation costs.
Result . In Images , for Lopez; in Allemeier , for the IRS. Under IRC section 7430(c)(4), a taxpayer who is the prevailing party can recover reasonable litigation costs. To be considered as such, the taxpayer must substantially prevail with respect to the amount at issue or the most significant issue presented and meet net worth requirements. In addition the IRS’s position must not be reasonably justified. Lopez was considered the prevailing party while Allemeier was not, even though he won his case.
In Images the court held the IRS did not substantially justify its position. The employee manuals were guidelines rather than requirements. Further, the dance instructors bought their own music and costumes and determined their fee structures. Therefore, it was not substantially justified for the IRS to reclassify these independent contractors as employees. In Allemeier , even though the taxpayer prevailed, the court held the IRS had justified its arguments.
Images in Motion of El Paso, Inc. v. Commissioner, TC Memo 2006-19; Allemeier v. Commissioner, TC Memo 2006-28.
Prepared by Michael H. Brown, CPA, PhD, assistant professor of accounting, Tabor School of Business, Millikin University, Decatur, Ill.