Powell v. C.I.R.

• Decision Date: 11 June 1986
• Docket Number: No. 85-4237,85-4237
• Citation: 791 F.2d 385
• Parties: -5215, 86-2 USTC P 9486 David J. POWELL and Estate of Jeane D. Powell, Deceased, David J. Powell, Executor, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 385

791 F.2d 385

58 A.F.T.R.2d 86-5215, 86-2 USTC P 9486

David J. POWELL and Estate of Jeane D. Powell, Deceased, David J. Powell, Executor, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 85-4237.

United States Court of Appeals, Fifth Circuit.

June 11, 1986.

William S. Lee, Claude R. Wilson, Jr., Dallas, Tex., for petitioners-appellants.

Bruce R. Ellisen, Atty., Glenn L. Archer, Asst. Atty. Gen., Tax Div., U.S. Dept. of Justice, Michael L. Paup, Chief, Appellate Section, Gilbert S. Rothenberg, Atty., Robert P. Ruwe, Director, Tax Litigation Div., Office of Chief Counsel by Dan Henry Lee, Chief, Washington, D.C., David A. Hampel, Counsel for I.R.S., Dallas, Tex., for respondent-appellee.

Appeal from the Decision of the United States Tax Court.

Before THORNBERRY, RUBIN, and JOLLY, Circuit Judges.

ALVIN B. RUBIN, Circuit Judge:

The issue is the standard to apply in determining the right to recover attorney's fees by a taxpayer who prevails against the Internal Revenue Service in tax litigation. The IRS contends that the test is whether the government's position taken after litigation has begun is reasonable and the Tax Court adopted this interpretation of the controlling statute. Because the Tax Court should also take into account the government's administrative position that necessitated the instigation of Tax Court litigation, we reverse the Tax Court's judgment denying the taxpayer attorney's fees and remand for application of this test.

I.

David J. Powell and Jeane D. Powell, who was then his wife and who is now deceased, invested $5,000 in WPGMA, a joint venture, which became a limited partner in INAS Associates, a coal mining limited partnership. The taxpayers claimed a deduction of $25,034 on their 1976 tax return as their share of the losses sustained by INAS. Most of INAS's 1976 loss was represented by a nonrecourse note it issued in payment for a coal royalty.

The IRS determined that the taxpayer's 1976 deduction was improper because, in addition to other reasons, the taxpayers had no "good faith expectation of profit" from their investment in INAS and because "the transaction for which [INAS] was organized lack[ed] economic reality." In 1980, the IRS issued a notice of deficiency to the taxpayers for their 1976 tax in the amount of $12,892.51. Powell and the IRS subsequently reached an agreement that settled part of their differences: Powell waived his right to file a Tax Court petition challenging the notice of deficiency. In return, the IRS agreed to freeze collection of the 1976 assessment until INAS, the limited partnership, had been audited and all partnership adjustments had been made. Powell reserved the right, if the deficiency assessment were not then withdrawn, to pay the deficiency and seek a refund in federal district court or the Court of Claims.

The IRS completed its audit of INAS in August 1982 and determined that the deductions claimed by the taxpayers as a result of INAS's losses should be disallowed. To settle the 1976 case, the IRS offered by letter to let the taxpayers deduct the $5,000 they had invested in INAS. Powell's letter in response stated: "Please make no further contacts with me other than to schedule a date for court, or similar 'within the service' forum with informed, senior people authorized to put an end to this agony." The IRS interpreted this response as a rejection of its settlement offer. In its brief, the IRS states that, since Powell made no counter-offer, a "conference would have accomplished nothing."

The IRS then, in January 1983, issued a notice of deficiency for the taxpayers' 1977 return in the amount of $12,240.53. The "Explanation of Items" accompanying the notice stated, in effect, the alternative position of the IRS, that, if some court decided that the INAS nonrecourse note (which had been the basis for the 1976 deficiency) had economic substance, then it was the IRS position that the same note was later forgiven or became unenforceable in 1977 and the taxpayers consequently realized 1977 income in the amount of $20,998.57, their share of the nonrecourse note. The IRS recognized that this 1977 income adjustment was inconsistent with its primary position, which disallowed the entire $25,034 INAS loss claimed by the taxpayers in 1976 (i.e., the 1976 disallowance denied tax effect to the note in the first instance). However, it asserts that the purpose of the 1977 adjustment was to protect the government's interest in the event the Powells successfully challenged the 1976 disallowance in a subsequent refund suit by establishing that the nonrecourse note did, in fact, have economic substance.

Powell filed a timely petition in the Tax Court seeking redetermination of the deficiency in the 1977 return. Soon afterward Powell and the IRS entered into settlement negotiations involving both the 1976 and 1977 notices of deficiency. In May 1984, they agreed that the taxpayers' $25,034 deduction for 1976 would be reduced to $5,000, the amount of their investment in INAS. In return, the IRS withdrew the notice of deficiency for 1977. After taking account of various undisputed adjustments, the parties agreed the taxpayers had overpaid their 1977 taxes by $238.34.

Powell then sought to recover the litigation costs he had incurred in presenting his 1977 case to the Tax Court. Powell offered three bases for his charge that the IRS position had been unreasonable: (1) the IRS notice of deficiency for the 1977 return disallowed deductions that Powell had not taken on the return; (2) the IRS repeatedly failed to respond to Powell's request for an explanation or a conference; and (3) the 1977 notice of deficiency required Powell to instigate the Tax Court litigation. ¹ The Tax Court found that the third stated basis was merely informative and did not constitute an allegation of unreasonableness, and the second concerned actions taken by the IRS before the petition was filed and, therefore, could not be considered as a basis for an unreasonableness finding. Finally, the Tax Court found the first stated basis without merit because the 1977 adjustment involved additional income in the amount of $20,998.57, not disallowed deductions. The Tax Court apparently construed the first allegation of unreasonableness as a complaint by Powell that this additional amount of income was not shown on their returns and dismissed it with the following statement, "It is obvious that this amount was not on the return because if it had been reported no adjustment to income would have been made."

Powell challenges the Tax Court's judgment on the basis that the court failed to consider, in its determination of reasonableness, the administrative position of the government that engendered the civil action. The three allegations of unreasonableness asserted by Powell in the Tax Court all refer, at least in part, to the position of the government before litigation. The Tax Court, however, held that, under the controlling statute, 26 U.S.C. Sec. 7430, "the taxpayer must establish that the Commissioner's position after the petition was filed was unreasonable."

II.

Section 7430 of the Internal Revenue Code permits a "prevailing party" ² to recover litigation costs incurred in a tax case against the United States. To be a prevailing party, a litigant must show, among other things, that "the position of the United States in the civil proceeding was unreasonable." ³ The crucial issue in this case is what is meant by the phrase "civil proceeding" in Sec. 7430(c)(2)(A)(i). The government asserts that the phrase permits the court to examine only the position taken by it "during the litigation," while Powell argues that the IRS position adopted at the highest administrative level must also be examined, because this is what engenders the court action.

Courts have interpreted the statute differently. The First Circuit and several district courts have held that both the IRS's prelitigation position and its litigation position should be examined for reasonableness. ⁴ By contrast, the District of Columbia Circuit, the Tenth Circuit, several district courts, and the Tax Court have read the statute to permit only the government's litigation position to be examined. ⁵

Analysis of the issue must begin with the language of Sec. 7430. The phrase "civil proceeding" is not defined in the statute. The government, however, points out that subsection (a) of Sec. 7430 provides that the statute applies to "any civil proceeding which is ... brought in a court of the United States." It is reasonable to assume that the phrase "civil proceeding" in Sec. 7430(c)(2)(A)(i), the crucial provision here, has the same meaning as it does in Sec. 7430(a), that is, court-related proceedings only, not administrative proceedings. ⁶ But as Judge Merhige observed in Finney v. Roddy, ⁷ "while reasonable, this is not a necessary conclusion." The IRS position, however, derives additional support from Sec. 7430(c)(1)(A)(ii) & (iv), which refers to the award of "reasonable litigation costs" incurred "in connection with the civil proceeding. ⁸ "Civil proceeding" as used in this clause clearly refers only to court-related litigation costs.

Section 7430 was added to the Internal Revenue Code by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). ⁹ The effective date provision of the statute states, "The amendments made by this section shall apply to civil actions or proceedings commenced after February 28, 1983." ¹⁰ Referring to this language, the Conference Committee Report notes that Sec. 7430 "applies to civil tax litigation, including U.S. Tax Court cases, begun on or after March 1, 1983." ¹¹ It is clear that in this context, Congress also did equate "civil actions or proceedings" with "civil tax litigation."

The debate, however, has another side. The reference in Sec. 7430(a) to "any civil proceeding" is similar to the words used in the attorney fees provision of the...