## Facts

- David and Suzanne Allen sued their homeowner’s insurer to recover the cost of repairing damage to their residence and sought punitive damages based on the insurer’s alleged bad faith.
- The insurer paid the Allens $102,000 in 1990.
- In 1991, the parties settled all claims, and the insurer paid the Allens an additional $130,000.
- The IRS concluded that approximately $104,000 of the 1991 payment represented taxable punitive damages.
- The Allens challenged that conclusion through the IRS administrative process, submitting evidence to an IRS appeals officer concerning their repair costs and the compensatory nature of the settlement.
- The appeals officer rejected the Allens’ position, relying largely on insurance-litigation materials reflecting that the Allens had demanded punitive damages.
- The Allens petitioned the United States Tax Court.
- In preparing for trial, the Allens’ new counsel learned from the insurer’s attorney that the insurer did not attribute any portion of the 1991 settlement payment to punitive damages.
- The Commissioner learned about the insurer’s attorney’s expected testimony three days before trial but still proceeded to trial; the Allens prevailed.
- The Allens sought litigation costs under I.R.C. § 7430. The Tax Court initially denied costs, finding the Commissioner’s position substantially justified.
- The Ninth Circuit reversed in part, holding the Commissioner’s position was substantially justified until three days before trial but not after that point, and remanded for the Tax Court to determine whether the Allens could recover costs for the post-cutoff period.
- On remand, the Commissioner argued no costs should be awarded because the Allens allegedly failed to exhaust administrative remedies under § 7430(b)(1), citing (among other things) the Allens’ failure to provide certain engineering reports to Appeals and their inability to obtain the insurer’s allocation information until shortly before trial.

## Issues

1. Whether the Allens exhausted “administrative remedies available . . . within the Internal Revenue Service” under I.R.C. § 7430(b)(1) even though they did not provide certain engineering reports during the Appeals process and did not obtain the insurer’s view of the settlement allocation until shortly before trial.
2. Whether, consistent with the Ninth Circuit’s remand, the Allens were entitled to recover reasonable litigation costs under I.R.C. § 7430 for the period beginning three days before trial (the point after which the government’s position was no longer substantially justified).

## Decision

- The Tax Court held the Allens satisfied § 7430(b)(1)’s exhaustion requirement because they used the IRS Appeals process and participated meaningfully by presenting their position and supporting information during the administrative phase.
- The court rejected the Commissioner’s argument that exhaustion failed simply because the Allens did not supply every potentially helpful document (such as engineering reports) during Appeals or because they obtained the insurer-related information close to trial.
- Applying the Ninth Circuit’s ruling on when the Commissioner’s position ceased to be substantially justified, the Tax Court allowed recovery of reasonable litigation costs limited to the period beginning three days before trial.
- The Tax Court limited any award to costs that were reasonable and attributable to the post-cutoff period identified by the court of appeals.

## Legal Principles

- Under I.R.C. § 7430(b)(1), a taxpayer seeking litigation costs generally must exhaust administrative remedies available within the IRS, which commonly includes pursuing review through the IRS Appeals Office.
- Exhaustion focuses on whether the taxpayer used the available IRS administrative channels in a meaningful way; it does not require a perfect administrative record or submission of every conceivable item of evidence.
- A taxpayer’s failure to provide additional reports during Appeals does not necessarily establish non-exhaustion when the taxpayer otherwise presented the dispute to Appeals and participated in the conference process.
- Information not reasonably obtainable through IRS administrative channels, including certain third-party information, is not necessarily a prerequisite to showing exhaustion under § 7430(b)(1).
- When an appellate court fixes a time period during which the government’s position lacked substantial justification, the trial court on remand may award § 7430 costs only for the portion of the case within that period, and only to the extent the claimed amounts are reasonable and tied to that portion.

## Conclusion

Allen v. Commissioner, 84 T.C.M. 636 (2002), addresses entitlement to litigation costs under I.R.C. § 7430 after a Ninth Circuit remand that set a three-days-before-trial cutoff for substantial justification. On remand, the Tax Court held the Allens had exhausted IRS administrative remedies by participating in the Appeals process and allowed recovery of reasonable litigation costs incurred only after the point when the Commissioner continued to litigate despite learning facts that undercut the punitive-damages characterization.
