Hazards of Litigation: How IRS Appeals Prices a Settlement

The examiner who audited you had one job: apply the law to the facts and propose an adjustment. If the documents did not satisfy the examiner, the deduction was disallowed. There was no room for "probably."

Appeals works differently. It is allowed to settle based on how the case would likely come out in court, and to split the difference when the outcome is genuinely uncertain. That idea has a name inside the IRS. It is called hazards of litigation, and it is the engine of every Appeals settlement.

What hazards of litigation means

IRM 8.6.4.2 describes the goal of an Appeals settlement as a fair resolution that reflects the probable result in the event of litigation. The Appeals Officer looks at the facts, the evidence that would be admissible, the credibility of witnesses, the applicable law, and the burden of proof, and then asks how a court would likely rule.

If the government would probably win, the settlement should look like a government win. If the taxpayer would probably win, the government should concede. If it is a genuine toss-up, the settlement should reflect that uncertainty.

The settlement tools Appeals uses

Split-issue settlements

IRM 8.6.4.2.2 defines a split-issue settlement as the settlement of an issue for a percentage or a stipulated amount. If Appeals believes the government has a 60 percent chance of sustaining a disallowance, it can settle that issue by conceding 40 percent of it. The result is one a court would never actually reach, because judges do not rule in percentages. That is the point.

Mutual-concession settlements

IRM 8.6.4.2.1 describes case dispositions involving concessions by both the government and the taxpayer for the purpose of settlement. You give up one issue; the government gives up another. Each concession should still be grounded in the merits of the issue being conceded.

Full concessions

Sometimes the analysis is not close. Appeals can concede an issue entirely when the government's position is weak, and it can sustain an issue entirely when yours is.

What Appeals will not do

IRM 8.6.4.2.4 is blunt: no settlement will be made if it is based on nuisance value to either party. A nuisance value concession is one made only to avoid the cost or inconvenience of further negotiation or litigation. Appeals cannot knock 20 percent off a solid adjustment just to close the file, and you should not expect it to.

The settlement approach also does not depend on whether the case is docketed in Tax Court. IRM 8.6.4.2.7 says the elements of evaluation are not affected by the status of the case. An unacceptable settlement does not become acceptable just because a petition was filed. What a petition does change is the calendar and who is watching; see docketed cases in Appeals.

How to move the hazards number

The Appeals Officer is estimating your odds at trial. Everything you do should be aimed at that estimate.

• Prove the facts the way a court would require. Contemporaneous records, third-party documents, and credible witnesses. A judge cannot rely on assertions, and neither will Appeals.
• Know who has the burden. The taxpayer generally carries the burden of proof in Tax Court under Rule 142, but IRC 7491 shifts it in some situations, and the government bears the burden of production on penalties for individuals under IRC 7491(c). See burden of proof at trial.
• Cite the law that controls in your circuit. For a Florida individual, an appeal from Tax Court goes to the Eleventh Circuit under IRC 7482(b), so Eleventh Circuit precedent matters to the hazards analysis.
• Address the bad facts. Appeals already sees them. Explaining why they do not change the result is more persuasive than ignoring them.
• Separate the issues. A weak issue argued hard can drag down a strong one. Concede what you should and concentrate on what you can win.

A simple illustration

Consider a hypothetical. An examiner disallows a $40,000 deduction for payments the taxpayer says were to an independent contractor. The taxpayer has bank records showing the payments and a written agreement, but no invoices, and the contractor cannot be located to testify.

The examiner's view is binary: no invoices, no deduction. An Appeals Officer asks different questions. Would a judge believe the taxpayer's testimony? Do the bank records and the agreement corroborate it? Is there any evidence the payments were personal? Who has the burden, and could the taxpayer carry it?

If the Appeals Officer concludes the government has a meaningful but not overwhelming chance of sustaining the disallowance, the issue might settle with the taxpayer allowed a substantial portion of the deduction. The exact percentage depends entirely on the evidence. The point is the method: the settlement tracks the litigation risk, and better evidence moves the number.

Now change one fact. Suppose the contractor appears, testifies credibly, and produces copies of the invoices. The hazards shift sharply toward the taxpayer, and a full concession becomes realistic. The law did not change. The proof did.

Penalties are a separate negotiation

Penalties have their own hazards. Reasonable cause, reliance on a professional, and the government's burden of production on individual penalties all factor in. It is common for an Appeals settlement to resolve the tax issue one way and the penalty another. Do not let the penalty ride along with the tax as an afterthought.

Signing the deal: Form 870-AD and its cousins

Settlements are documented on Appeals agreement forms. Under IRM 8.6.4.2.1 and IRM 8.6.4.4, a special form such as Form 870-AD is generally used for mutual-concession settlements or when a taxpayer wants greater finality. IRM 8.6.4.4.1 contrasts the forms directly: the special forms carry a pledge against reopening the case; the general forms do not.

Read the form before you sign it. Understand what you are agreeing to, which periods it covers, and whether you are giving up the right to claim a refund later for the same items. Here's the part most people miss: the agreement form is where a good settlement can quietly become a bad one if the computation is wrong. Check the numbers.

When there is no deal

If you and Appeals cannot agree, Appeals issues a Notice of Deficiency. You then have 90 days to petition the U.S. Tax Court. Most docketed cases go back to Appeals for another settlement look, now with IRS Chief Counsel involved and a trial date on the horizon. The hazards analysis is the same; the pressure is not.

Let's talk

Settlement in Appeals is a negotiation about trial risk, so it rewards people who prepare as if trial is real. If you have a protest pending or a conference coming up, call (813) 229-7100. Let's talk.