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Taxpayer Awarded Costs After Court Finds IRS's Positions on Basis and Method of Accounting Issues Were Not Substantially Justified

(Parker Tax Publishing July 2021)

The Tax Court awarded litigation and administrative costs to a taxpayer after finding that the IRS's positions that the taxpayer's business used an incorrect method of accounting and that the taxpayer failed to substantiate his basis in the business were not substantially justified. However, the court found that the taxpayer's claimed costs were not reasonable because he included costs that were incurred before the commencement of the Tax Court proceeding. Morreale v. Comm'r, T.C. Memo. 2021-90.


Jesse Morreale is a hotelier and restauranteur who operated various related businesses in Denver, Colorado, in tax years 2011 and 2012. Specifically, Morreale owned Morreale Hotels, LLC (Hotel LLC); Hotel Restaurant, LLC d.b.a. Rockbar; and Sketch Restaurants, LLC (Sketch). Sketch operated two restaurants in Denver, both of which leased space from Hotel LLC.

Morreale failed to file tax returns for 2011 and 2012. In 2013, Morreale filed for bankruptcy, and his case was referred to the IRS Examination Division and assigned to Revenue Agent Robert Taurchini. Morreale submitted delinquent returns for 2011 and 2012 to Taurchini. After reviewing these returns. Taurchini identified two primary issues in dispute: (1) whether Morreale appropriately substantiated his basis in Sketch, and (2) whether Morreale was improperly using the accrual method of accounting and should be switched to the cash method.

In July 2016, Morreale's accountant emailed to Taurchini a spreadsheet which provided a detailed summary of Morreale's basis in Sketch. However, it was unclear whether Taurchini considered the calculations set out in the accountant's spreadsheet. In response to Taurchini's contention that Morreale's businesses should have reported on a cash basis, Morreale's counsel provided financial statements that purported to show Morreale's consistent use of the accrual method. Additionally, Morreale's counsel argued that the businesses carried inventory and therefore were required under Reg. Sec. 1.446-1(c)(2)(i) to use the accrual method. Taurchini rejected these arguments and, instead, determined that Morreale should have used the cash method. He based this determination on a single-third party discussion with Morreale's former return preparer who stated that he recalled preparing Morreale's returns on the cash basis.

The IRS issued a notice of deficiency and Morreale took his case to the Tax Court. The IRS adopted the same position as that determined in the notice of deficiency. The IRS then referred the case to the IRS Appeals Office. After a 10-month review, Appeals concluded that there was insufficient evidence to establish that Morreale had ever used the cash method and that the "accrual books" appeared to clearly reflect income and expenses. Appeals also determined, based on the July 2016 email from Morreale's accountant, that Morreale had substantiated his basis in Sketch. Based on these conclusions, the parties filed a stipulation of settled issues, ending the substantive dispute between Morreale and the IRS.

In February 2019, Morreale filed a motion for reasonable litigation or administrative costs under Code Sec. 7430. In March 2019, the Tenth Circuit (the court to which this case would be appealable) issued its opinion in U.S. v. Johnson, 2019 PTC 112 (10th Cir. 2019), which addressed the proper methodology for determining whether the position of the United States is "substantially justified" within the meaning of Code Sec. 7430. In May 2019, the IRS filed its opposition to Morreale's motion for costs, but did not discuss the impact of the Johnson decision. The Tax Court ordered the parties to brief the impact of Johnson, and both parties filed responses. The court also directed Morreale to file an affidavit regarding his claimed costs that complied with Rule 232(d). Morreale filed his Rule 232(d) affidavit but the filing did not include sufficient detail with respect to the billing records. Accordingly, the court issued yet another order requiring Morreale to supplement his Rule 232(d) affidavit with billing records. Morreale filed a supplement to his Rule 232(d) affidavit in September 2020.

Code Sec. 7430(a) authorizes an award for reasonable administrative and litigation costs to the prevailing party. However, under Code Sec. 7430(c)(4)(B)(i), a party that otherwise qualifies as a prevailing party will not be entitled to an award if the IRS can prove that the position of the United States in the proceeding was substantially justified. Under Code Sec. 7430(c)(7)(B), the United States is considered to take a position at the earlier of (1) the date a taxpayer receives a notice of decision from the Appeals Office, or (2) the date of a notice of deficiency. If the government's position is not substantially justified, then the taxpayer bears the burden of proving the reasonableness of his or her claimed costs under Tax Court Rule 232. Under Pierce v. Underwood, 487 U.S. 552 (S. Ct. 1988), a position is substantially justified if it has a reasonable basis both in law and fact. In addition, Code Sec. 7430(c)(4)(B)(ii) provides that if the IRS did not follow applicable published guidance (including regulations), then the government's position is presumed not to be substantially justified. In Johnson, the Tenth Circuit interpreted the meaning of "position of the United States" in Code Sec. 7430 and concluded that the term should be understood as a singular, holistic position rather than multiple itemized contentions.

The IRS argued that, even though the Appeals Office conceded both the basis and method of accounting issues, the position of the United States was substantially justified because the IRS made the substantive adjustments based on the best information available at the time. For the adjustments relating to the accounting method dispute, the IRS further argued that they were made on the basis that Morreale failed to adequately substantiate items underlying the claimed deductions at the time of the notice of deficiency.


The Tax Court held that the position of the United States was not substantially justified. However, the court also found that Morreale failed to carry his burden of establishing the reasonableness of his claimed costs, so it made its own determination as to his reasonable costs.

According to the Tax Court, the IRS took a position for purposes of Code Sec. 7430 when it issued the notice of deficiency, a position it repeated when it filed its answer in the Tax Court. The court said that under Johnson, the focus should not be on the government's success or failure on a particular issue but on the reasonableness of its position in bringing about or continuing the litigation. The court thus examined the "building blocks" of the position of the United States to determine whether that position was, on the whole, substantially justified. Specifically, the court found that its analysis had to take into consideration the IRS's contentions - relating to Morreale's basis in Sketch and his method of accounting - asserted during the examination, because they formed the basis of the notice of deficiency and were later adopted in the IRS's answer.

With regard to the basis dispute, the court found that Morreale's July 2016 email provided documentation sufficient to substantiate his 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 the case. The court therefore concluded that this contention lacked a reasonable basis in fact. Regarding the method of accounting issue, the court found that Morreale's restaurant businesses carried inventory during the years issue, that the notice listed an adjustment to beginning inventory, and that Appeals concluded there was insufficient evidence that, in prior years, the restaurant businesses had used the cash method of accounting. Based on these circumstances, the court could find no reasonable legal or factual basis for the IRS's determination relating to the proposed change in method of accounting determined in the notice and adopted in the answer. Moreover, the court found that this contention did not follow applicable published guidance, specifically, Reg. Sec. 1.446-1(c)(2)(i). For these reasons, the court concluded that the IRS failed to prove that the position of the United States was substantially justified under the Johnson standard.

Addressing the reasonableness of Morreale's claimed costs, the court noted that Morreale had submitted billing records for various legal and accounting firms that assisted him during his bankruptcy proceeding, with respect to state tax disputes, and in the instant proceeding. However, the court found that Morreale could not recover costs incurred in connection with his bankruptcy or any proceeding other than the instant one. The court noted that the bankruptcy court was empowered to adjudicate Morreale's tax liabilities and award costs, but Morreale chose not to pursue his claims in that court. Thus, the court could not say that those costs were incurred in the instant proceeding. The court also subtracted out the time it took for Morreale's counsel to supplement his initial Rule 232(d) affidavit after finding that Morreale's failure to adhere to the court's rules was unreasonable. In addition, the court found that there were no special factors justifying an enhancement to the statutory rate ($200 per hour for the years at issue). The court stated that, while Morreale claimed he could not hire competent counsel at the statutory rate, that alone was not enough to establish a special factor permitting an enhancement. In addition, the court said that the issues in the case were not so complex as to justify an upward departure from the statutory rate.

For a discussion of recovering litigation and administrative costs, see Parker Tax ¶263.540.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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