1 United States Court of Appeals,

Fifth Circuit.

No. 94-40661.

George S. NALLE, III and Carole Nalle and Charles A. Betts and Sylvia I. Betts, Petitioners—Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

June 20, 1995.

Appeal from a Decision of the United States Tax Court.

Before POLI TZ, Chief Judge, REAVLEY and EMILIO M. GARZA, Circuit
Judges.

EMILIO M. GARZA, Circuit Judge:

George S. Nalle III and Carole Nalle, and Charles A. Betts and

Sylvia I. Betts (the "Nalles and Betts") appeal from the Tax

Court's denial of their request for an award of attorney's fees as

provided by 26 U.S.C. § 7430 (1988). The Tax Court decided that

the Nalles and Betts had failed to establish as required by § 7430

that the position of the Commissioner of Internal Revenue

("Commissioner") in the underlying litigation was not substantially

justified. Finding no abuse of discretion, we affirm.

I

This appeal concerns the second phase of litigation between

the Nalles and Betts and the Commissioner over the Commissioner's

denial of rehabilitation tax credits claimed by the Nalles and

Betts for the substantial rehabilitation of several houses in1 Regulation 1.48-12(b)(5) states that:

A building ... is not a qualified rehabilitation building unless it has been located where it is rehabilitated for the thirty-year period immediately preceding the date physical work on the rehabilitation began in the case of a "30-year building" or the forty-year period immediately preceding the date physical work on the rehabilitation began in the case of a "40-year building."

2 This section defines a "qualified rehabilitated building"

as:

[A]ny building (and its structural components)—

(i) which has been rehabilitated;

(ii) which was placed into service before the beginning of the rehabilitation; and

(iii) 75 percent or more of the existing external walls of which are retained in place as external walls in the rehabilitation process.

26 U.S.C. § 48(g)(1)(A).

3 The Tax Court upheld the regulation. Nalle v. Commissioner, 99 T.C. 187, 1992 WL 184967 (1992).

2 Austin, Texas. Pursuant to Treasury Regulation § 1.48-12(b)(5), 1

the Commissioner disallowed credits which the Nalles and Betts had

claimed under 26 U.S.C. § 48 (1988) 2 because they had moved the

houses prior to rehabilitating them.

The Nalles and Betts contested the Commissioner's decision.

On appeal fr om the Tax Court, 3 this Court held the Treasury

Regulation invalid because it contradicted the plain meaning of §

48. Nalle v. Commissioner, 997 F.2d 1134 (5th Cir.1993) [ Nalle I

]. In doing so, we rejected the Commissioner's interpretation of

and reliance on selected legislative history of § 48. Id.

Having won on the merits, the Nalles and Betts petitioned the3

Commissioner for reimbursement of their attorney's fees. The

Commissioner denied the petition, and the Tax Court upheld the

C ommissioner's decision. N alle v. Commissioner, 67 T.C.M. (CCH)

2747, 1994 WL 146090 (1994) [ Nalle II ]. The Nalles and Betts now

appeal from the Tax Court's ruling.

II

The Nalles and Betts contend that the district court should

have granted their petition for attorney's fees. We review the Tax

Court's determination of whether the Commissioner's position was

not substantially justified for abuse of discretion. B outerie, 36

F.3d 1361, 1367. (5th Cir.1994) Thus, we reverse " "only if we

have a definite and firm conviction that an error of judgment was

committed.' " B outerie, 36 F.3d at 1367 (quoting Lennox v.

Commissioner, 998 F.2d 244, 248 (5th Cir.19 93)). Moreover, the

burden is on the petitioner to prove that the Commissioner was not

substantially justified in defending the underlying litigation.

See Lennox, 998 F.2d at 248 ("The burden of proving no substantial

justification is with the taxpayers.").

Section 7430 of the Inte rnal Revenue Code provides that

parties who prevail in tax proceedings may recover their attorney's

fees. S ee Bouterie v. Commissioner, 36 F.3d 1361, 1367 (5th

Cir.1994) ("Section 7430 allows a "prevailing party' ... in tax

proceedings to recoup reasonable litigation costs, including

attorney's fees."). Parties "prevail" if:

(1) The position of the United States in the proceeding was not substantially justified;

(2) they have substantially prevailed with respe ct to the4 am ount in controversy or with respect to the most significant issue or set of issues presented; and

(3) they meet applicable net worth requirements.

26 U.S.C. § 7430(c)(4)(A). The only element at issue in this case

is whether the Commissi oner's position was not substantially

justified. Substantially justified means "justified to a degree

that could satisfy a reasonable person" and having a "reasonable

bas is both in law and fact." P ierce v. Underwood, 487 U.S. 552,

565 , 108 S.Ct. 2541, 2550, 101 L.Ed.2d 490 (1988); s ee also

Bouterie, 3 6 F.3d at 1367 (noting that substantial justification

equates to satisfaction to a reasonable person and reasonable basis

both in law and fact); c f. In re Graham, 981 F.2d 1135, 1139 (10th

Cir.1992) ("I n order to be "substantially unjustified,' the

l itigation must have been initiated unreasonably, with out a

reasonable basis in law or in fact.").

In determining wh ether the Commissioner's position was not

substantially justified, the question is whether the Commissioner

acted unreasonably—that is, whether she knew or should have known

that her position was invalid at the onset of the litigation. S ee

Bouterie, 36 F.3d at 1373 (concluding that Commissioner's position

was not substantially justified because IRS knew or should have

known of its error before entering litigation). In answering this

question of reasonableness, we consider all the facts and

circumstances surrounding the dispute. Portillo v. Commissioner,

988 F.2d 27, 28 (5th Cir.1993). For example, courts have held that

the Commissioner unreasonably defended her position after several4 See, e.g., Underwood, 487 U.S. at 569, 108 S.Ct. at 2552

(finding string of court decisions persuasive as to whether agency was substantially justified in taking a contrary position, because "a string of losses can be indicative; and even more so a string of successes"); Allbritton v. Commissioner, 37 F.3d 183, 184-85 (5th Cir.1994) (holding that Commissioner's position was not substantially justified when two courts of appeals and several district courts had rejected it); Bouterie, 36 F.3d at 1371 (finding IRS' position not substantially justified when taxpayer had provided many state court decisions demonstrating error of IRS' interpretation of state law).

5 See, e.g., Bouterie, 36 F.3d at 1372-73 (rejecting IRS' position where it deliberately ignored settled law); Hanson v. Commissioner, 975 F.2d 1150, 1154 (5th Cir.1992) (holding that government's position was not substantially justified when deficiency claim was clearly barred by statute of limitations and taxpayer "repeatedly called the government's attention to its

error"); see also Miller v. Alamo, 983 F.2d 856, 860 (8th Cir.1993) (holding that government's position was not substantially justified where state law clearly demonstrated error of government's position); Pate v. United States, 982 F.2d 457, 460 (10th Cir.1993) (holding that government not substantially justified in defending its position because proper application of state law made correctness of taxpayer's position
obvious).

6 See, e.g., Estate of Johnson v. Commissioner, 985 F.2d 1315, 1319-20 (5th Cir.1993) (holding that government's position was not substantially justified because all relevant information was available at onset of litigation and would have demonstrated after a reasonable investigation that taxpayer was correct); cf. Heasley v. Commissioner, 967 F.2d 116, 121 (5th Cir.1992) (holding that government's position on negligence penalty was not substantially justified because reasonable person would have found taxpayer not negligent).

7 See Lennox, 998 F.2d at 248 ("Of course, the ultimate failure of the government's legal position does not necessarily

5 courts had rejected it, 4 when the IRS had ignored state l aw that

clearly supported the taxpayer, 5 and whe n the IRS had failed to

conduct a reas onable investigation that would have revealed the

flaw in its position. 6 The Commissioner's loss in the underlying

litigat ion is not determinative of whether she was not

substantially justified; it is only a factor. 7 Therefore, if atmean that it was not substantially justified. It is, however, a

factor to be considered."); Information Resources, Inc. v.
United States, 996 F.2d 780, 785 (5th Cir.1993) ("The government's failure to prevail on a liability issue does not mandate a determination of lack of substantial justification.");

Hanson, 975 F.2d at 1153 ("[A]lthough the fact that the government lost in the underlying litigation does not compel an
award of costs, the outcome of the lawsuit remains a factor to be
considered.").

8 See, e.g., Heasley, 967 F.2d at 121 (holding that petitioner had failed to show that government's position on valuation penalty was not substantially justified because legal issue "was in flux" and "IRS simply argued for one of two plausible interpretations of the statute"); see also Sharp v. United States, 20 F.3d 1153, 1154 (Fed.Cir.1994) (affirming finding that petitioner had not proven that no substantial justification existed where, at the time appeal was filed, two courts that had ruled on issue were split); Marcus v. Shalala, 17 F.3d 1033, 1037 (7th Cir.1994) ("We agree that uncertainty in the law arising from conflicting authority or the novelty of the question weighs in the government's favor when analyzing the reasonableness of the government's litigation position.").

9 See, e.g., Smith v. United States, 850 F.2d 242, 246 (5th Cir.1988) (holding that taxpayer had not demonstrated that government's position was not substantially justified because underlying decision turned on difficult appraisal); Griffon, 832 F.2d at 52-53 (concluding that petitioner had not shown that

6 the onset of litigation the error was not obvious, the Commissioner

may still be substantially justified in defending an ultimately

unsuccessful p osition. S her v. Commissioner, 861 F.2d 131, 135

(5th Cir.1988) (holding that government's position was

substantially justified because information, both factual and

judicial, available at the time gave "no reason to believe" that

basis for government's position was in error). Thus, courts have

held that petitioners had failed to show that the government's

position was not substantially justified when judicial decisions on

the issue left the status of the law unsettled, 8 or when the issue

was difficult or novel. 9government's position was not substantially justified because

issue of first impression was both novel and difficult); see also In re Rasbury, 24 F.3d 159, 168 (11th Cir.1994) (holding that district court's decision that taxpayer had not met burden of showing that Commissioner's position was not substantially justified was not abuse of discretion when questions at issue
were difficult for court to determine); TKB Int'l, Inc. v. United States, 995 F.2d 1460, 1468 (9th Cir.1993) (affirming denial of attorney's fees where the "government's arguments both at trial and on appeal are based on supportable interpretations

of federal tax statutes and case law."); Zinniel v.
Commissioner, 883 F.2d 1350, 1357-58 (7th Cir.1989) (holding that government's position was reasonable where new statute gave "incomplete directions with respect to the manner in which [compliance with statute was] to be made" and underlying decision required complex analysis of statute, legislative history and regulations), cert. denied, 494 U.S. 1078, 110 S.Ct. 1805, 108
L.Ed.2d 936 (1990).

10 See TKB Int'l, 995 F.2d at 1468 (holding that litigation of question of first impression was substantially justified);
Stebco Inc. v. United States, 939 F.2d 686, 688 (9th Cir.1990) (holding that taxpayer not entitled to attorney's fees because issue was "a question of first impression"); Trahan v. Brady, 907 F.2d 1215, 1219 (D.C.Cir.1990) (holding that government's position was substantially justified when it used plausible interpretation of statute and had not had "the advantage of this Court's subsequent pronouncement on the actual meaning of the

law").

7 In this case, the validity of Regulation 1.48-12(b)(5) under

26 U.S.C. § 48 presented an i ssue of first impression. Although

other courts have held that the Commissioner was substantially

justified in defending her position w hen her interpretation of a

relevant statute had not previously been ruled on, 10 this Court has

held that "[w]hen Congress adopts a new law the clear and

unequivocal language of which unmistakably [excludes the

Commissioner's position], the absence of a new decision recognizing

the obvious does not equate with unsettled law or first impression

in the context of this matter." Estate of Perry v. Commissioner,

931 F.2d 1044, 1046 (5th Cir.1991); s ee also Portillo, 988 F.2d at11 See Commissioner v. Acker, 361 U.S. 87, 92-94, 80 S.Ct.

144, 147-48, 4 L.Ed.2d 127 (1959) (holding regulation invalid when it added restriction for which the law did not provide); accord Iglesias v. United States, 848 F.2d 362, 366 (2d Cir.1988) ("A regulation, however, may not serve to amend a statute, or to add to the statute "something which is not there.' " (citations
omitted)); id. at 367 (holding that regulation amended statute because it altered the scope of the statute).

12 See also City of Tucson v. Commissioner, 820 F.2d 1283, 1290 (D.C.Cir.1987) (rejecting regulation that "forged, not a reasonable implementation of the legislative mandate, but rather an impermissible enlargement by an unnatural construction of the
statutory language").

8 29 (rejecting reliance on "new rule" argument where Commissioner's

decision to assess tax was " "naked and without any foundation' ")

( quoting U

nited States v. Janis, 428 U.S. 433, 96 S.Ct. 3021, 49

L.Ed.2d 1046 (1976)). Accordingly, if a regulation obviously

altered the scope of the relevant statute, the Commissioner should

have known that such a regulation was invalid. 1 1 Also, if a

regulation was "m anifestly contrary" to the plain meaning of the

relevant statute, Marcus, 17 F.3d at 1038, 12 the Commissioner would

not be substantially justified in defending it. We have found the

language of a statute to be "clear and unequivocal" on an issue of

first impression, such that the C ommissioner's interpretation of

that statute was clearly unreasonable , only where the

Commissioner's interpretation " "lacked any ligaments of fact' and

was "clearly erroneous' as a matter of law." P ortillo, 988 F.2d at

29; s ee also Hanson, 975 F.2d at 1155 ("The issue in this case was

clear as light shining on water."); a ccord Beaty v. United States,

9 37 F.2d 288, 292-93 (6th Cir.1991) (holding that government's

position not substantially justi fied because "[n]one of the9

arguments offered by the IRS during the various stages of the

litigation had even a chance of succeeding").

The Nalles and Betts argue that this is one of those

cases—that is, that § 48's language was clear and unequivocal and

that the Commissioner's position was so clearly contrary to that

language that its invalidity should have been obvious. In N alle I,

this Court held that the Commissioner's interpretation of § 48 was

"logical[ly] incoherent," 997 F.2d at 1139, and stated that:

The Commissioner cannot explain away th[e] ultimate incompatibility of his regulation with the statute by reference to the legislative history; where a plain reading

of the statute precludes the Commissioner's interpretation, no legislative history—be it ever so favorable—can redeem it.

Id. at 1140. Consequently, we rejected the Commissioner's reliance

on the legislative history. I d. Given this Court's findings in

Nalle I, the Nalles and Betts accordingly argue that the Tax Court

abused its discretion in finding that they had failed to prove that

the government's position had a unreasonable basis and consequently

was not substantially justified.

The Commissioner responds that, although this court in Nalle

I rejected her interpretation of § 48, we did not hold that her

interpretation as promulgated in Regu lation 1.48-12(b)(5) had no

basis in the legislative history. Indeed, we noted that:

[T]he Tax Court's conclusion that the ... regulation

vindicated the statute's intent to revitalize depressed areas, stated most forcefully in the legislative history appended to

the 1981 amendments, is not entirely without foundation;

Congress undoubtedly considered the bill's revitalizing potential as among its more attractive features.

Id. at 1137 -38. Nevertheless, we rejected her interpretation in

favor of "[a] better reading of the legislative history" and the10

plain wording of the statute. Id. at 1138.

Based on these holdings in Nalle I, the Tax Court determined

that the legislative history gave enough support to the

Commissioner's interpretation of § 48 to make her defense of

Regulation 1.48-12(b)(5) reasonable: "Given the gradual

development of the law respecting eligibility for the investment

tax credit for rehabilitation costs under section 48 and the known

facts concerning petitioners' activities, we conclude that it was

reasonable for [the Commissioner] to both enforce [the regulation]

and defend its validity in this case." N alle II, 67 T.C.M. at

2750, 1994 WL 146090.

The Nalles and Betts suggest that the holdings in Nalle I

require us to hold that the Tax Court abused its discretion because

reliance on a regulation that conflicts with the plain language of

a federal statute is necessarily unreasonable. However, whether

the Tax Court abused its discretion in denying attorney's fees

turns not on the existence of a conflict between the regulation and

the statute, but on how obvious that conflict was at the onset of

litigation. C f. Federal Election Comm'n v. Rose, 806 F.2d 1081,

1089 (D.C.Cir.1986) (discussing varyi ng degrees of invalidity of

agency ac tion, "including sensible but legally flawed actions as

well as outrageous ones"); Trahan, 907 F.2d at 1220 (noting that

"mere failure to conform" to statute did not mandate

unreasonableness finding unless "patently unreasonable agency

action"); G riffon v. United States Dept. of Health and Human

Services, 832 F.2d 51, 52 (5th Cir.1987) ("Merely because the13 Accordingly, while the Commissioner's use of legislative

history may have been " "the equivalent of entering a crowded cocktail party and looking over the heads of the guests for one's
friends,' " Nalle I, 997 F.2d at 1137 (quoting Conroy v. Aniskoff, --- U.S. ----, ----, 113 S.Ct. 1562, 1567, 123 L.Ed.2d 229 (1993)), the legislative history in this case yielded several friends and no one in the crowd was actively hostile.

14 Compare Portillo, 988 F.2d at 29 (reversing Tax Court's judgment in government's favor where underlying opinion held that assessment did not provide a rational foundation for government's position); Mearkle v. Commissioner, 838 F.2d 880, 883 (6th Cir.1988) (holding that "the Commissioner cannot be said to have reasonably relied upon a proposed regulation which he knew, or should have known, was patently invalid").

Because we maintain the requirement that the Commissioner have some rational basis for her regulations even on issues of first impression, we avoid the Nalles and

11 government's underlying action was held legally invalid a s being

"arbitrary and capricious' does not necessarily mean that the

government acted without substantial justification...."). Simply

put, our adopting of the Nalles a nd Betts' proposition would

collapse Congress' explicit distinction between the legal standard

applicable in fee petition evaluations and the standard applicable

to the underlying merits, and we decline the invitation to adopt

their suggestion.

In this case, although the Commissioner's reliance on selected

legislative history of § 48 was in error, her interpretation of §

4 8 was "not entirely without foundation." N alle I, 997 F. 2d at

1137. 13 Consequently, we hold that the Tax Court did not abuse its

discretion in finding that "the dis puted regulation is not

manifestly in conflict with § 48" and that the Nalles and Betts had

failed to demonstrate that the Commissioner was not substantially

justified in defending Regulation 1.48-12(b)(5). 14Bettses' dire prediction that the first challenge to any

regulation will be "free of charge" to the Commissioner no matter how egregious the regulation. See Mearkle, 838 F.2d at 883 (rejecting position under which "the Commissioner could thwart the intent of Congress through the device of promulgating a proposed regulation which has no reasonable support in the unambiguous statute upon which it is said to be based, but instead, is manifestly in conflict with that

statute").

15 Given that we base our conclusion on the statute and legislative history, we do not reach either (1) the Nalles and Bettses' arguments that the Tax Court improperly relied on whether the Commissioner acted in good faith or (2) the Commissioner's contentions that she was substantially justified in defending her position because she relied on a final regulation rather than a proposed regulation.

12 III

For the foregoing reasons, we AFFIRM the judgment of the Tax

Court. 15