A Policy Analysis of Fee-Shifting Rules under the Internal Revenue Code

Until recently, the costs of litigating federal tax cases were borne exclusively by the parties who incurred them, regardless of whether the government or the taxpayer prevailed in the litigation. This practice reflects the application to tax disputes of the ‘American rule’ against fee shifting. Although the American rule continues to be predominant in the tax area, it has been modified in important respects. An explicit fee-reimbursement rule, benefiting prevailing taxpayers in cases in which the government is found to have acted unreasonably, was added to the Internal Revenue Code (IRC) by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). TEFRA also increased substantially the penalties that could be imposed on taxpayers who are found to have instituted tax litigation on frivolous grounds, or primarily for delay. The provisions are not precise counterparts of each other: one is a true fee-reimbursement rule, while the other is a penalty provision that is not directly tied to litigation costs. Nevertheless, the rules are similar in their effects on incentives to litigate tax cases. This article begins with a brief description and history of these provisions, followed by an analysis of their impact on litigation decisionmaking in the tax area. We argue that the present mix of fee-shifting rules in tax cases represents an attractive hybrid of the American rule and the ‘English rule,’ which normally allows recovery of costs by the prevailing party. The hybrid rule seems likely to deter parties from bringing poorly grounded cases to court without discouraging litigants with sounder positions. It thus combines the best features of each of the more traditional rules. After analyzing the hybrid rule, we discuss the recent changes to the rule made by the Tax Reform Act of 1986 and argue that those changes, on balance, do not represent improvements over the original TEFRA rules, and may indeed prove troublesome in the coming years.