In the case of Morreale v. Commissioner[1] the Tax Court found that the IRS position in his case was not substantially justified, awarding the taxpayer attorney’s fees for the costs incurred on this matter—but this matter alone, and only at the statutory rate.

The taxpayer is a hotelier and restaurateur who operated in Denver.  He failed to file income tax returns for 2011 and 2012 and in 2013 filed for bankruptcy.  The IRS bankruptcy specialists referred the case to the Examination Division to assist in the preparation of substitutes for returns for 2011 and 2012.[2]

The taxpayer agreed to prepare the delinquent income tax returns.  After the returns were submitted to the Revenue Agent, the RA proposed adjustments based on two primary issues:

• The taxpayer had not substantiated basis in Sketch, LLC which operated two restaurants[3] and

• The taxpayer had improperly reported income on the accrual basis of accounting, so that accrued but unpaid expenses were disallowed.[4]

Basis Issue

While the opinion does not tell us exactly what the impact of the failure to show basis in Sketch was on the returns, the most likely impacts would be to disallow any loss deductions claimed from the entity and/or taxation of any distributions received from the entity. The burden is on the taxpayer to prove sufficient basis exists to claim any losses, as well as to show that any distributions represented a nontaxable return of basis, so adjustments would likely be appropriate if a taxpayer was unable to document his/her basis.

But in this case the taxpayer did respond to the proposed adjustment by providing such information:

To attempt to substantiate his basis in Sketch, petitioner had his accountant email a “full basis calculation for Sketch LLC from the opening of the restaurant” to RA Taurchini on July 13, 2016. Petitioner's accountant attached a spreadsheet, which provided a detailed summary of petitioner's basis in Sketch for tax years 2006 through 2010. The record does not indicate that RA Taurchini responded to this email or considered the calculations set out in the attached spreadsheet.[5]

Cash Basis of Accounting

The RA’s assertion that the taxpayer should be on the cash basis of accounting likely surprises some readers—the IRS has a well known preference for taxpayers to file on the accrual basis, and under Reg. §1.446-1(c)(2)(i) businesses where inventory (which really means goods of some sort) are a material income producing factor must use the overall accrual basis of accounting for tax—the basis this taxpayer was using as food served in a restaurant is a material income producing factor.

The taxpayer pointed this out in their response:

In response to RA Taurchini's contention that petitioner's businesses should have reported on a cash basis, petitioner's counsel provided financial statements that purported to show petitioner's consistent use of the accrual method. Additionally, petitioner's counsel argued that petitioner's businesses must use the accrual method by operation of section 1.446-1(c)(2)(i), Income Tax Regs., which requires businesses that carry inventory to use the accrual method of accounting.[6]

However if the taxpayer had been previously reporting on the overall cash basis of accounting, under IRC §446(e) the taxpayer could not change to the overall accrual basis of accounting without getting the IRS’s permission.  While such permission would be automatically granted by the IRS, that only applies if the taxpayer follows the proper procedures outlined in Rev. Proc. 2015-13 (as clarified and modified by Rev. Proc. 2015-33, and as modified by Rev. Proc. 2017-59, and by Section 17.02 of Rev. Proc. 2016-1).  That requires filing a Form 3115 with a timely filed tax return.  As these returns were not timely filed, the automatic permission rules were off the table and, as the returns were under exam, the special rules for changes in accounting methods for returns in exam would have applied instead.

The RA’s position was that, in fact, the taxpayer had previously been reporting on the overall cash basis of accounting.

RA Taurchini rejected these arguments and, instead, determined that petitioner should have used the cash basis method of accounting. He based this determination on a single third-party contact discussion with petitioner’s former return preparer who stated that he recalled preparing petitioner’s returns on the cash basis.[7]

However, the Court notes that despite this position, the RA made adjustments to beginning and ending inventories, arguably something that should not have existed on a pure cash basis reporting entity:

Notably, however, in his lead sheets and eventually in his report, RA Taurchini adjusted petitioner’s beginning and ending inventories relating to Sketch for the tax years at issue “according to * * * [petitioner’s] balance sheets at 12/31/2011 and 12/31/2012.”

However, under Revenue Procedures in place at that time, certain taxpayers were allowed to use the cash basis of accounting so long as they treated amounts that would have been in inventory as supplies.  And, even if the business did not qualify for such treatments, it’s still possible the taxpayers recorded inventory but otherwise were on the overall cash basis.

Fundamentally, though, the RA’s position rested on his conclusion regarding the evidence related to the methods that the taxpayer had previously been using. He claimed this was the overall cash basis of accounting based on a single contact with a former return preparer.

Tax Court Filing and Trip to Appeals

A Notice of Deficiency was issued on September 7, 2017 based primarily on the original adjustments proposed by the RA.  The taxpayer chose to take the matter to Tax Court rather than having the matter disposed of in the bankruptcy proceeding.

After adopting the same position outlined in the Notice of Deficiency in its answer to the taxpayer’s petition to the Tax Court, the IRS referred the case to the Appeals Office.

The Appeals Office was not very impressed with the IRS’s case.  As the opinion notes:

The Appeals Office assigned petitioner’s case to Appeals Officer Rodney Largent (AO Largent). AO Largent noted in his case activity record that a critical issue in this examination was “the legal and professional adjustments disallowed for only the accrual issues”. After a 10-month review, AO Largent prepared a schedule of adjustments, which addressed seven substantive adjustments as well as the additions to tax for failure to file for tax years 2011 and 2012 and the accuracy-related penalty for tax year 2012 proposed by RA Taurchini. Of the seven substantive adjustments, four involved the method of accounting dispute. For these, AO Largent concluded that “[t]here isn’t sufficient evidence to establish the taxpayer ever used the cash method of accounting” and that “the accrual books appear to clearly reflect income and expenses.” With respect to petitioner’s basis in Sketch, AO Largent considered the July 13, 2016, email sent by petitioner’s accountant and concluded that “[t]he taxpayer provided a basis computation * * * [that] was sufficient to substantiate basis.” AO Largent also concluded that the additions to tax for both years and the accuracy-related penalty for tax year 2012 should be “conceded in full”.

On the basis of the Appeals Office’s conclusions, the parties filed a stipulation of settled issues on January 30, 2019. In the stipulation the parties agreed that petitioner owed deficiencies of only $1,367 and $30,639 for tax years 2011 and 2012 and that no addition to tax or penalty was owed for either year. The stipulation of settled issues ended the substantive dispute between the parties.[8]

Was the IRS Position Substantially Justified?

Under IRC §7430, in certain situations, a prevailing taxpayer may receive an award of reasonable costs related to a proceeding if the IRS position was not substantially justified.

The Tax Court notes that traditionally the Court normally used an item-by-item analysis, but as this case is subject to appeal to the Tenth Circuit Court of Appeals, the Court instead must use a test established by the Tenth Circuit in United States v. Johnson, 920 F.3d 639.  The opinion describes this test as follows:

In Johnson, the Court of Appeals addressed the proper scope of inquiry with regard to whether the “position of the United States” was substantially justified under section 7430. In its analysis, the Court of Appeals drew heavily on caselaw interpreting the Equal Access to Justice Act (EAJA), 28 U.S.C. sec. 2412. The EAJA, using wording similar, though not identical, to that found in section 7430, provides that a court “shall award [fees and other expenses] to a prevailing party” in any case “brought by or against the United States * * *, unless the court finds that the position of the United States was substantially justified”. 28 U.S.C. 2412(d)(1)(A).

Given this linguistic similarity, the Court of Appeals looked to caselaw interpreting the meaning of the “position of the United States” under the EAJA to guide its analysis under section 7430. To start, the Court of Appeals relied on the Supreme Court’s statements in Commissioner, INS v. Jean, 496 U.S. 154, 161-162 (1990), that the structure of “the EAJA — like other fee-shifting statutes — favors treating a case as an inclusive whole” when defining the word “position”. The Court of Appeals also relied heavily on the analysis in Roanoke River Basin Ass’n v. Hudson (Roanoke), 991 F.2d 132, 139 (4th Cir. 1993), where the U.S. Court of Appeals for the Fourth Circuit first held that the “position of the United States” should be understood as a singular, holistic position rather than multiple itemized contentions. The Court of Appeals in Johnson, 920 F.3d at 649, considered Roanoke’s “in-depth analysis of th[is] issue * * * [to be] persuasive” and adopted its approach.[9]

The panel found that the IRS position was not substantially justified for either the issue of lack of basis or the issue of the overall method of accounting—matters that were crucial to the case as a whole.

With regard to basis, the Court noted:

With regard to the basis dispute, after respondent filed his answer, which he concedes is “essentially the same” as the position taken by the Examination Division, the Appeals Office concluded that petitioner had “provided a basis computation along with prior year workpapers, schedules, and books * * * [that] was sufficient to substantiate basis.” The Appeals Office based its conclusion on the July 13, 2016, email from petitioner’s accountant to which the revenue agent did not respond. Because this email provided documentation sufficient to substantiate petitioner’s basis a month before the issuance of the 30-day letter but was not properly considered in forming the basis substantiation contention reflected in the notice and the answer in this case, we conclude that this contention lacked a reasonable basis in fact.[10]

As well, the Court found the IRS position wholly wanting with regard to the overall basis of accounting for tax purposes.

With regard to the method of accounting dispute, section 1.446-1©(2)(i), Income Tax Regs., provides, in relevant part, that “[i]n any case in which it is necessary to use an inventory, the accrual method of accounting must be used with regard to purchases and sales”. Petitioner’s restaurant businesses carried inventory during the years at issue, and the notice lists an adjustment to “Sch C1 — Beginning Inventory” that “allow[s] an additional deduction for purchases.” Finally, the Appeals Office concluded that “[t]here isn’t sufficient evidence to * * * [support] the examiner’s determination that in the prior years the taxpayer used the cash method of accounting.” Taking these circumstances into consideration, we can find no reasonable legal or factual basis for respondent’s determination relating to the proposed change in method of accounting determined in the notice and adopted in the answer. Moreover, we conclude that this contention “did not follow * * * applicable published guidance”, specifically section 1.446-1(c)(2)(i), Income Tax Regs. See sec. 7430(c)(4)(B)(ii), (iv)(I). Therefore we are compelled to presume that the overall position of the United States was not substantially justified.[11]

The Court notes that while a case can be entirely conceded and yet the position could still be substantially justified, that was clearly not so in this case:

Of course, it is true that conceding a case — even in full — does not, on its own, mean that the position of the United States was not substantially justified. Maggie Mgmt. Co. v. Commissioner, 108 T.C. at 443. But this case does not involve a mere concession in respondent’s answer; respondent’s concessions here came after filing his answer and were made because the Appeals Office concluded that the determination reflected in his answer lacked a basis in fact and law — a conclusion with which we agree. In the light of all the facts of this examination and litigation, we cannot say that the position of the United States was “justified * * * in the main”. Underwood, 487 U.S. at 565. Rather, these determinations were contrary to applicable guidance and were lacking in a factual basis, and they tainted the Government’s position in the entire case. See Roanoke, 991 F.2d at 139.[12]

[1] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/court-awards-business-owner-fraction-of-claimed-litigation-costs/76vyp (retrieved July 16, 2021)

[2] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[3] Note that the opinion does not tell us what tax entity type Sketch LLC had opted to be treated as, though it seems likely it was either an S corporation or a partnership.

[4] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[5] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[6] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[7] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[8] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[9] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[10] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[11] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021

[12] Morreale v. Commissioner, TC Memo 2021-90, July 15, 2021