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Arm yourself for IRS battles

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in Small Business Tax

Can you recover court costs and legal fees when you battle with the IRS? Possibly, but it’s not enough to simply win on the merits. Essentially, you must prove that the IRS was unreasonable in standing its ground. If the IRS was “substantially justified” in maintaining its position, you must pay the expenses, regardless of the outcome.

Case in point: The IRS issued a deficiency notice relating to unreported income the taxpayer had received from his parents and his sister. The IRS evidenced the taxpayer’s bank statements showing numerous deposits that he did not include in his taxable income. Thus, the IRS took the position in the administrative and judicial proceedings that it was justified and reasonable, based on the information available to it at the time.

At trial, the taxpayer established that the transfers from the family members constituted gifts and loans, not taxable income. But this did not undo the fact that the IRS had acted reasonably under the circumstances. The Tax Court also pointed out that the taxpayer:

  • Failed to report interest income.
  • Could not claim certain losses.
  • Was liable for self-employment tax.
  • Did not make any estimated tax payments.
  • Failed to file tax returns.

Finally, the taxpayer did not keep adequate records for the tax years in question. (Demetree, TC Memo 2007-210)

Moral of the story: Don’t back away from taking the IRS to court when you’re convinced that you’re right. But, even if you eventually prevail, you probably will have to pay legal fees and court costs.

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