Taxpayer Reimbursed Legal Fees Paid by Third Party

A taxpayer who successfully challenged a deficiency notice incurred legal fees eligible for reimbursement under IRC § 7430 even though the fees were paid by a co-litigant, the Ninth Circuit of Appeals said, overruling the Tax Court.

IRC § 7430 permits courts to reimburse reasonable administrative and litigation costs paid or incurred by certain taxpayers who prevail in administrative or civil judicial proceedings. The provision is intended to deter abusive actions by the IRS and to enable taxpayers to “vindicate their rights regardless of their economic circumstances” (Huffman v. Commissioner, 978 F.2d 1139 (9th Cir. 1992), quoting HR Rep. No. 97-404 (1981)).

Bradley Morrison was a part owner, director and former employee of Caspian Consulting Group, a California corporation that managed intellectual property. The IRS audited Caspian’s and Morrison’s 1999 and 2000 returns and issued notices of deficiency to both. Among the issues were loans by Caspian to Morrison and other shareholders that the IRS said were taxable constructive dividends. In 2003 Morrison petitioned the Tax Court to redetermine the deficiencies. His case was consolidated with that of Caspian, which paid all the litigation costs for itself and Morrison. Both taxpayers won and filed for reimbursement of their litigation costs. The Tax Court awarded Caspian the portion of fees attributed to its legal representation but denied reimbursement to Morrison. “Incurred” is not defined in the Code section. Black’s Law Dictionary defines it as becoming “liable or subject to, to bring down upon oneself.” The Tax Court concluded that by that definition and other legal uses of the term, Morrison did not incur legal costs because Caspian paid them, and evidence failed to support Morrison’s argument he was obligated to repay the company.

The Ninth Circuit reversed the Tax Court and held that where a third party with no direct interest in a case pays the legal fees of a taxpayer, the taxpayer has incurred the legal fees for purposes of section 7430 if he or she assumed: (1) an absolute obligation to repay the fees, regardless of whether fees are awarded; or (2) a contingent obligation to pay the fees in the event that the fees are recovered. The Ninth Circuit reasoned that to require the taxpayer to pay the expenses directly would conflate “paid” and “incurred” rather than treating them as separate transactions.

With respect to Morrison, although the Ninth Circuit acknowledged that the several agreements made at various times between Caspian and Morrison concerning the fees were “not models of clarity,” neither were they necessarily mutually contradictory, as the Tax Court and government asserted. Taken together, they provided generally that Caspian would advance the fees on Morrison’s behalf as consideration for its purchase of his stock in the company, but that if Morrison recovered his fees, he would repay Caspian, the court said. However, because it was possible that Morrison was not obligated to pay back the fees to Caspian, the court remanded the case to the Tax Court for further proceedings to determine the exact nature of the agreement between Morrison and Caspian.

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.