Taxes in your practice: Tax court denies innocent spouse fee recovery

Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.

In O’Nan v. Commissioner,¹ the court found the taxpayer, a widow who had been granted innocent spouse relief, could not recover litigation costs from the Internal Revenue Service because the IRS position was substantially justified in the context of an issue of first impression relating to a tax lien priority argument. 

Background and findings of fact

Sarah O’Nan was married to Jonathan O’Nan until his death in November 2014. The O’Nans purchased a home in 2012 as joint tenants with right of survivorship, which the court found was a “survivorship tenancy” under Ohio law. The home was eventually encumbered by two mortgages. The O’Nans both signed the first and second mortgages, but Sarah O’Nan did not sign the promissory note with respect to the first mortgage. 

The O’Nans filed joint tax returns for 2012 and 2013 but did not pay their reported tax liabilities for those years. The IRS assessed these liabilities prior to Jonathan O’Nan’s death. After his death, the IRS filed a notice of federal tax lien against the O’Nans in April 2015. 

Sarah O’Nan sold the home in June 2015. The title company for the sale remitted the sale proceeds first to closing costs, next to the two mortgage holders, next $123,200 to the IRS in full satisfaction of the federal tax lien, and then the final net proceeds were issued to Sarah O’Nan. 

Prior to the home sale, Sarah O’Nan submitted Form 8857 to the IRS requesting innocent spouse relief for 2012 and 2013. In February 2017, the IRS granted Sarah O’Nan partial relief from joint and several liability for 2012 and full relief for 2013, but the IRS denied her claim for a refund of the IRS lien payment from the home sale proceeds. 

The tax court previously made the following findings and holdings with respect to the innocent spouse and refund claims in O’Nan v. Commissioner²:

1. Sarah O’Nan inherited her spouse’s one-half interest in the home fully subject to the IRS liens.

2. When § 6015(f) innocent spouse relief is granted, the innocent spouse’s federal tax liability is recalculated as if the spouses had filed married filing separate tax returns. 

3. Given Sarah O’Nan’s § 6015(f) relief, the IRS lien on the family home only attached to $3,340 (plus interest) of her separate tax liability for 2012. 

4. Under Ohio survivorship tenancy law, only the one-half of the sale proceeds from the home attributable to Jonathan O’Nan’s former one-half interest was available to satisfy the liabilities encumbering his interest. 

5. Sarah O’Nan signed the first mortgage deed but not the associated promissory note, so she was only a surety for Jonathan O’Nan’s obligation under that note.

6. After splitting closing costs equally and allocating the first mortgage debt all to Jonathan O’Nan’s share of the proceeds, there was only a small remaining amount for the second mortgage holder and the IRS. 

7. Sarah O’Nan was not the sole signer of the second mortgage promissory note, so the second mortgage holder had priority over the IRS with respect to all remaining proceeds attributable to Jonathan O’Nan’s former one-half interest in the home. 

8. Therefore, the entire IRS lien payment had come from Sarah O’Nan’s separate funds, and she was due a refund under § 6015(g)(1) for all the proceeds previously paid to the IRS except for her remaining separate liability for 2012 of $3,340 (plus interest).

Following the 2023 tax court decision, Sarah O’Nan requested an award from the court under § 7430 of almost $87,000 for attorney’s fees and litigation costs. This 2024 decision addressed the § 7430 award request. 

Tax court decision 

The court first provided an overview and interpretation of the applicable statute. Section 7430 provides for an award of litigation or administrative costs to a taxpayer in a proceeding by or against the United States involving determination, collection, or refund of any tax, interest, or penalty where the taxpayer demonstrates they:

(1) are the prevailing party, 

(2) exhausted administrative remedies within the IRS,

(3) did not unreasonably protract the proceeding, and 

(4) claim reasonable costs.

A taxpayer is a “prevailing party” under § 7430 if they substantially prevail with respect to either the amount in controversy or the most significant issues and have a net worth of $2 million or less. The court noted that even if these requirements are met, a taxpayer will not be treated as a prevailing party if the commissioner establishes the IRS position in the proceeding was “substantially justified,” meaning it would satisfy a reasonable person or has a reasonable basis in both law and fact. 

The court further noted that even if a taxpayer does substantially prevail, or even if the commissioner’s position was substantially justified, the taxpayer will be treated as a prevailing party under § 7430 if the court’s determination of tax liability is not more than the liability amount of a taxpayer’s qualified offer. Section 7430(g) defines a qualified offer as a written offer that: 

(1) the taxpayer makes to the commissioner after the notice of deficiency and at least 30 days before the case is first set for trial, 

(2) specifies the offered amount of taxpayer liability, 

(3) is designated at the time as a qualified offer for purposes of § 7430, and 

(4) remains open until the earliest of the date the offer is rejected, and the trial begins or 90 days after the offer is made.

A qualified offer does not support prevailing party treatment if the court’s judgment is entered pursuant to a settlement agreement or if the amount of tax liability is not in issue in the proceeding. 

The court first addressed Sarah O’Nan’s requests for administrative costs incurred prior to the date the IRS Office of Appeals issued a final determination regarding her innocent spouse and refund requests. On these costs, the court summarily found that she could not recover administrative costs incurred before the final determination letter date, regardless of whether she otherwise qualified for a § 7430 award. 

The court next addressed Sarah O’Nan’s settlement proposals. The commissioner had conceded that Sarah O’Nan substantially prevailed, that her net worth did not exceed $2 million, that she exhausted her administrative remedies and that she had not unreasonably protracted the proceedings. So, if any of Sarah O’Nan’s settlement proposals were qualified offers, the court was prepared to award her costs even if the commissioner’s position was substantially justified. 

The court noted that the qualified offer provisions do not apply to proceedings where the amount of tax liability is not in issue. The case in question was instituted to dispute the commissioner’s refusal to issue a refund of amounts taken to satisfy undisputed tax liabilities of Jonathan O’Nan. Sarah O’Nan’s tax liability was not in issue before the IRS or in the prior tax court proceeding, so the court found that no amount of tax liability was in issue under § 7430. The court further found that none of Sarah O’Nan’s settlement proposals satisfied the procedural requirement to be a qualified offer because they did not reference § 7430 or purport to be a “qualified offer” as required by the statute. Therefore, the court held that none of the settlement offers qualified under § 7430.

Since no qualified offer was made but the commissioner had conceded the other requirements for § 7430 were met, the tax court then addressed whether the commissioner’s position was “substantially justified.” The court noted that in the prior proceeding, Sarah O’Nan’s initial positions focused on whether the IRS liens were valid, and the court had granted the IRS partial summary judgment concluding the commissioner was justified in rejecting Sarah O’Nan’s lien argument under applicable statutory and case law. 

After the partial summary judgment, Sarah O’Nan raised the argument that her equity in Jonathan O’Nan’s former one-half interest in the home was insufficient to account for the full IRS lien payment. This argument presupposed that when a federal tax lien attaches to property jointly owned by two spouses and one spouse is subsequently granted innocent spouse relief for tax liability secured by the lien, the lien then encumbers the relieved spouse’s interest in the property only to the extent of the liability for which she was not granted relief. The court considered this a concept of first impression, stating it was not aware of any statute, regulation, or case establishing this point of law prior to the court’s 2023 decision in this case. The court cited several cases for the proposition that the commissioner’s position is substantially justified when addressing a question of first impression. The court also found the commissioner’s position with respect to the lien was justified to a degree that would satisfy a reasonable person. 

Based on these findings, the tax court held that the commissioner’s position was substantially justified in the administrative and court proceedings and denied Sarah O’Nan’s motion for an award of costs under § 7430. 

Conclusion 

O’Nan v. Commissioner addresses a § 7430 request for costs in the context of innocent spouse relief, but it is a good outline of the statutory framework to request costs in other contexts that lawyers can use. The tax court emphasizes the importance of labeling settlement offers as qualified offers under § 7430 to support a later request for costs. Importantly, the court also confirms that the 2023 O’Nan decision was a case of first impression, establishing an important lien relief and refund consideration for innocent spouse cases that involve federal tax liens and IRS collection efforts.