                     T.C. Memo. 2002-302



                UNITED STATES TAX COURT



PHILLIP LEE ALLEN AND CAROLYN F. ALLEN, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 243-97.                 Filed December 11, 2002.



     Ps were successful in this Court in showing that a
$130,000 payment received in settlement of an insurance
claim was not for punitive damages and that any gain
realized would not be recognized under sec. 1033,
I.R.C. Ps seek to recover litigation costs under sec.
7430, I.R.C. The parties disagree about one of the
prerequisites to recovery--whether Ps exhausted their
administrative remedies before the Internal Revenue
Service. Sec. 7430(b)(1), I.R.C.; sec. 301.7430-
1(b)(2), Proced. & Admin. Regs.
     Following the examination, Ps’, in the Appeals
conference, argued that repair costs exceeded the total
insurance recovery so that no portion was attributable
to punitive damages. R contends that Ps, in order to
have exhausted their administrative remedies, should
have submitted additional information to the Appeals
officer. Some of the information was in existence and
some was not available to Ps at the time of the Appeals
conference.
                               - 2 -

          Held: Ps exhausted their administrative remedies
     and are entitled to litigation costs. Held, further,
     sec. 7430(b)(1), I.R.C.; sec. 301.7430-1(b)(2), Proced.
     & Admin. Regs., interpreted.



     Joseph E. Mudd and Jeri L. Gartside, for petitioners.

     Louis B. Jack, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     GERBER, Judge:   In this opinion, the third one issued in

this case,1 we consider whether petitioners exhausted their

administrative remedies so as to be entitled to recover costs and

fees under section 7430.2

Prior History

     In our first opinion, Allen v. Commissioner, T.C. Memo.

1998-406, we found that a payment received by petitioners was not

paid by the insurance company to settle petitioners’ claim for

punitive damages.   We also held that petitioners were entitled to

nonrecognition treatment under section 1033 with respect to any




     1
       See Allen v. Commissioner, T.C. Memo. 1998-406; Allen v.
Commissioner, T.C. Memo. 1999-118.
     2
       All section references are to the Internal Revenue Code,
in effect when the petition was filed, and all Rule references
are to this Court’s Rules of Practice and Procedure, unless
otherwise indicated.
                               - 3 -

gain realized in connection with the settlement payment.3   After

their success in litigation, petitioners filed a motion seeking

to recover $46,419.11 of administrative and litigation costs

under section 7430.4   In the second opinion, Allen v.

Commissioner, T.C. Memo. 1999-118, we decided that respondent’s

position was substantially justified under the facts and

circumstances of this case.   Accordingly, petitioners’ motion for

litigation costs (attorney’s fees) was denied.

     Petitioners appealed the denial of their motion, and the

Court of Appeals for the Ninth Circuit, in an unpublished

opinion, held as follows:

     We affirm that part of the tax court’s determination
     that the respondent was reasonably justifiable in
     believing that the award was taxable, and accordingly
     that attorney fees incurred by the taxpayer through the
     pretrial discovery and negotiating period were not
     reimbursable. It was, however, an abuse of discretion
     to deny reimbursement of attorney fees actually
     incurred by the trial, which should have been abandoned
     by the Commissioner when all parties knew, three days
     before trial, that the Commissioner’s witness had
     recanted and that the [C]ommissioner could not
     reasonably expect to prevail in the ensuing trial.
          Accordingly, the order appealed from is vacated and the
     cause is remanded to the Tax Court to determine, (1) whether
     the taxpayers have otherwise satisfied the requirements of
     section 7430 with respect to exhaustion, and not
     unreasonably protracting the litigation, and (2) if the
     parties do not agree on the amount due for the costs of


     3
       Because our holding did not result in an underpayment of
tax, we did not have to consider the penalty determined by
respondent under sec. 6662(a).
     4
       Petitioners were also seeking additional attorney’s fees
incurred to pursue the motion.
                              - 4 -

     trial, to fix and award a reasonable sum. [Allen v.
     Commissioner, 246 F.3d 672 (9th Cir. 2000).]

     The holding of the Court of Appeals for the Ninth Circuit

limits any recovery of costs by petitioners to those incurred

during the period that began 3 days before trial.   Because this

Court decided that respondent’s position was substantially

justified, we did not have to consider the other prerequisites to

recovery of litigation costs under section 7430.5   The only

requirement of section 7430 that remains in controversy6 is

whether petitioners exhausted their administrative remedies as

required by section 7430(b)(1).   See also sec. 301.7430-1(b)(2),

Proced. & Admin. Regs.

                         FINDINGS OF FACT7

     Petitioners’ residence was damaged by a neighbor’s removal

of soil supporting the foundation under petitioners’ residence.

Petitioners’ insurance claim ended in disagreement, and suit was

filed against the insurance company.   In their pleading,

petitioners sought recovery on several grounds, including the



     5
       A taxpayer’s failure to meet any of the requirements of
sec. 7430 is fatal to their claim for litigation costs.
     6
       There is no remaining controversy with respect to the
amount of fees petitioners are entitled to if we decide that they
did exhaust their administrative remedies.
     7
       The parties’ stipulation of facts is incorporated by this
reference. To the extent relevant, our findings in Allen v.
Commissioner, T.C. Memo. 1998-406, and Allen v. Commissioner,
T.C. Memo. 1999-118, are incorporated herein.
                               - 5 -

claim that the insurance company had acted in bad faith (punitive

damages).

     After an arbitrator appraised the damage at $128,084, the

insurance company paid petitioners $102,000 during 1990.

Following negotiations, a global settlement was reached, and the

parties’ settlement agreement contained the statement that all of

petitioners’ claims, including the one for “bad faith”, were

being settled.   As part of that 1991 settlement, the insurance

company paid petitioners an additional $130,000, which was

intended to be in full settlement of petitioners’ claims against

the insurance company.   Following the final settlement,

petitioners amended their 1991 joint income tax return in order

to claim a $37,852 casualty loss and seek a $5,821 refund.     In

support of their refund claim, petitioners’ relied on the

casualty loss provisions of section 165.

     Petitioners’ 1991 tax return was examined by the Internal

Revenue Service.   The sole focus of the examination was the

$130,000 payment received during 1991.   Petitioners’

representative, an enrolled agent, argued that the cost to repair

the residence exceeded the total amount received from the

insurance company, so that no portion of petitioners’ settlement

recovery could have been a payment for punitive damages.

     During the examination, the enrolled agent presented a March

28, 1995, letter, to the examining agent.   The letter was from
                                - 6 -

the attorney who represented petitioners in the suit against the

insurance company.   The letter contained a list of checks paid to

petitioners in the total amount of $269,467.20 and the attorney’s

conclusion that “The appraiser’s award was $128,084.   Therefore

$25,616.80 of the $130,000 could logically be for damages due to

the removal of the berm with the remainder ($104,383.20) being

bad faith”.

     In a January 23, 1996, letter, to the examining agent,

petitioners’ attorney in the insurance case attempted to recant

his earlier letter, stating that, notwithstanding his March 28,

1995, letter, the settlement payment was for neither bad faith

damages nor punitive damages.   In addition, the enrolled agent

wrote to the examining agent reiterating that the attorney’s “bad

faith” characterization was a mistake.   Despite the attempts to

correct the attorney’s statement, the examining agent concluded

that $104,000 of the $130,000 payment from the insurance company

was for punitive damages and was therefore income taxable to

petitioners for 1991.

     Further, although petitioners’ claim for refund of 1991 tax

relied on the casualty loss provisions of section 165, during the

examination petitioners argued that some injury or sickness was

caused by the insurance company’s actions.   Under this argument,

petitioners contended that the $130,000 was excludable as payment

for physical injury under section 104.
                               - 7 -

     Following the examination, petitioners hired a tax lawyer to

represent them and to proceed to Appeals for further

consideration of the examining agent’s findings.    The lawyer

engaged by petitioners was qualified in litigation and tax

issues, and he assigned a law clerk to represent petitioners’

interests before Appeals.

     The law clerk and the Appeals officer focused upon the

examining agent’s findings; i.e., the question of whether the

settlement was for punitive damages.   The law clerk argued that

no portion of the $130,000 settlement was attributable to

punitive damages.   As support for this argument, the law clerk

attempted to show that the total amount received from the

insurance company was needed to repair petitioners’ residence.

The documents shown to the Appeals officer included receipts for

repair to petitioners’ residence and the insurance settlement

documents.   During consideration by Appeals, petitioners conceded

that they were not entitled to exclude any portion of the

settlement recovery under section 104.

     The Appeals officer concluded that petitioners had not shown

that the $130,000 recovery was not attributable to taxable

punitive damages.   The Appeals officer’s conclusion was based on

the examiner’s report, the underlying documents indicating that

petitioners were seeking punitive damages, and the insurance

settlement document referencing punitive damages.    The Appeals
                               - 8 -

officer was also aware of the initial letter from the attorney

who represented petitioners against the insurance company

containing the statement that $104,000 of the $130,000 was for

“bad faith”.   Although the primary focus was the question of

punitive damages, the Appeals officer’s report also contained

some discussion of section 1033.

     Following the Appeals conference, petitioners wrote to the

Appeals officer explaining, a second time, that they spent more

on repairing their residence than was received from the insurance

company.   In that same letter, petitioners cited section 165 and

sections 1.165-7(a)(2)(ii) and 1.123-1, Income Tax Regs.    In

response to petitioners’ letter, the Appeals officer explained

that the issue in controversy was whether any portion of the

$130,000 received represented taxable punitive damages.    In that

same letter, the Appeals officer acknowledged that the cost of

repairs could be used to determine a decrease in fair market

value.   The Appeals officer restated the conclusion that the

$130,000 was paid for punitive damages and that petitioners’

pleading and the insurance settlement agreement contained

statements to the effect that petitioners were seeking and/or

settling punitive damage claims.

     Petitioners, in response to the Appeals officer, requested

that a notice of deficiency be issued so that the matter would be

considered by respondent’s attorneys.   A notice of deficiency
                               - 9 -

issued, and a petition was filed with this Court during January

1997.   In the pretrial setting, petitioners’ attorney advanced

the same argument--that the settlement payment was not for

punitive damages because the total amount of the payments was

insufficient to cover the cost to repair the damage to the

residence.

     A substantial portion of the trial preparation by

petitioners’ attorneys occurred approximately 1 year after the

Appeals conference and during the 3-month period immediately

preceding the trial.   During their preparation for trial,

petitioners’ attorneys obtained the insurance company’s files,

and they contacted the attorney who represented the insurance

company.   Based on the information procured in preparation for

trial, petitioners developed evidence showing that the insurance

company did not intend any part of the $130,000 as payment for

petitioners’ claim that the company had acted in bad faith.

     Petitioners’ attorney’s billable time, when divided into

three periods representing the time in Appeals, the pretrial

period before extensive preparation, and the 3 months preceding

trial, is reflected in the following comparative schedule:

                                         Billable
Case pending in          Time period      amount     Percentage

 Appeals               Sept.-Dec. 1996     $1,848          5.2
 Tax Court              Jan.-Dec. 1997      5,884         16.4
 Tax Court              Jan.-Mar. 1998     28,147         78.4
     Totals                                35,879        100.0
                               - 10 -

                                OPINION

     We consider here, on remand from the Court of Appeals for

the Ninth Circuit, whether petitioners meet the requirements of

section 7430 so as to be entitled to recover a portion of their

litigation costs.    In an earlier opinion, Allen v. Commissioner,

T.C. Memo. 1999-118, we held that respondent’s position in the

proceeding was substantially justified.     Under our holding,

petitioners were not entitled to administrative or litigation

costs, and, accordingly, there was no need to decide whether the

remaining section 7430 requisites for recovery had been met.     The

Court of Appeals for the Ninth Circuit reversed our holding to

the extent that the Court of Appeals held that respondent’s

position in the proceeding ceased to be substantially justified

beginning 3 days before the trial.      The parties have resolved all

but one of the requirements necessary for the recovery of

litigation costs.8

     The question that remains in dispute is whether petitioners

exhausted their administrative remedies within the Internal


     8
       Sec. 7430(b) and (c) provides that prevailing parties, to
recover litigation costs, must establish that: (1) They
exhausted available administrative remedies; (2) they
substantially prevailed in the controversy; (3) the position of
the United States in the proceeding was not substantially
justified; (4) they meet certain net worth requirements; (5) they
did not unreasonably protract the proceeding; and (6) the amount
of costs is reasonable. Failure to meet any of the requirements
will defeat some part or all of a taxpayer’s recovery of
litigation costs.
                              - 11 -

Revenue Service.   Sec. 7430(b)(1).    In order to exhaust

administrative remedies, section 301.7430-1(b)(2), Proced. &

Admin. Regs., requires “participation” in an Appeals conference.

The parties dispute whether petitioners’ representative

“participated” in an Appeals conference within the meaning of the

statute and regulations.   The question of what constitutes

“participation” under section 7430 is one of first impression in

the context of an Appeals conference held prior to the issuance

of a notice of deficiency.

     Section 7430(b)(1) contains the general requirement that

“the court * * * [must decide] that the prevailing party has

exhausted the administrative remedies available to such party

within the Internal Revenue Service.”     The Secretary has

explained and interpreted the “exhaustion” requirement, as

follows:

     Exhaustion of administrative remedies. (a) In
     general. Section 7430(b)(1) provides that a court
     shall not award reasonable litigation costs in any
     civil tax proceeding under section 7430(a) unless the
     court determines that the prevailing party has
     exhausted the administrative remedies available to the
     party within the Internal Revenue Service. This
     section sets forth the circumstances in which such
     administrative remedies shall be deemed to have been
     exhausted.

          (b) Requirements. (1) In general. A party has
     not exhausted the administrative remedies available
     within the Internal Revenue Service with respect to any
     tax matter for which an Appeals office conference is
     available under §§ 601.105 and 601.106 of this chapter
     (other than a tax matter described in paragraph (c) of
     this section) unless–-
                              - 12 -

          (i)   The party, prior to filing a petition in the
     Tax Court or a civil action for refund in a court of
     the United States (including the Court of Federal
     Claims), participates, either in person or through a
     qualified representative described in § 601.502 of this
     chapter, in an Appeals office conference; or

               *    *    *     *    *      *      *

          (2) Participates. For purposes of this section,
     a party or qualified representative of the party * * *
     participates in an Appeals office conference if the
     party or qualified representative discloses to the
     Appeals office all relevant information regarding the
     party’s tax matter to the extent such information and
     its relevance were known or should have been known to
     the party or qualified representative at the time of
     such conference. [Emphasis supplied.]

Sec. 301.7430-1(a) and (b), Proced. & Admin. Regs.

     In this case, the question of whether petitioners’

administrative remedies were exhausted depends upon whether they

“participated” in an Appeals conference.       In common parlance,

petitioners, through their representatives, participated in an

Appeals office conference.9   Respondent, however, relying on the

above-quoted definition of “participates” in section 301.7430-

1(b)(2), Proced. & Admin. Regs., contends that petitioners did

not exhaust their administrative remedies.       Therefore, the

narrower question we must decide is whether petitioners disclosed

“to the Appeals office all relevant information * * * to the




     9
       The term “participate” generally means to take part in
some activity with others. Webster’s Third New International
Dictionary 1646 (1986).
                             - 13 -

extent such information and its relevance were known or should

have been known * * * at the time of such conference.”    Id.

     In an earlier case, concerning whether a taxpayer

participated in an Appeals conference, we held that the requisite

participation was present even though the taxpayer “failed to

answer all of the questions and to supply all of the * * *

documents [requested by the Appeals officer].”    Rogers v.

Commissioner, T.C. Memo. 1987-374.    The taxpayer’s attorney in

that case had provided some answers to the Appeals officer’s

questions, and, in order to avoid further costs, made an offer of

settlement, to which the Appeals officer made a counteroffer.

     The definition of the term “participates”, as set forth in

section 301.7430-1(b)(2), Proced. & Admin. Regs., was avoided in

Rogers because the Appeals conference took place after the

issuance of the notice of deficiency.   In Rogers v. Commissioner,

supra, the Court looked to section 301.7430-1(f), Proced. &

Admin. Regs.,10 which contains exceptions to the requirement that



     10
       At the time relevant to Rogers v. Commissioner, T.C.
Memo. 1987-374, the requirement was set forth in paragraph (f) of
sec. 301.7430-1 Proced. & Admin. Regs. Under the regulation at
that time, the definition of “participates” was “For the purposes
of this paragraph,” which was limited to pre-petition Appeals
conferences. Accordingly, the Court in Rogers v. Commissioner,
supra, distinguished situations where the conference occurred
after the issuance of a notice of deficiency and filing of a
petition. The revised version of that regulation is currently in
sec. 301.7430-1(b)(2) and uses the phrase “For purposes of this
section”. Accordingly, the pre- or post-petition distinction of
Rogers v. Commissioner, supra, may no longer pertain.
                              - 14 -

a taxpayer exhaust administrative remedies.    That subsection

provided that if no Appeals conference is made available to a

taxpayer prior to issuance of a notice of deficiency and the

taxpayer does not refuse to participate in an Appeals conference

during docketed status, the taxpayer will be treated as having

exhausted administrative remedies.     Accordingly, Rogers was not

based on the regulatory definition of the term “participates” as

contained in sec. 301.7430-1(b)(2), Proced. & Admin. Regs.

     The definition of the term “participates” in the (b)(2)

paragraph of the regulation requires that a taxpayer provide the

Appeals officer with information that is relevant at the time of

the conference.   Accordingly, the question of whether a taxpayer

has supplied relevant information depends upon the parties’

positions and the factual development of the case at the time of

the Appeals conference.   Our decision as to whether there was

“participation” must therefore focus on what information may be

relevant at the time and in the context of an Appeals conference.

In that regard, theories or evidence subsequently developed by

the parties are not necessarily relevant to the controversy as it

existed at the time of the Appeals conference.

     To better understand what information may be relevant at an

Appeals conference, we consider the overall purpose or goal of

section 7430 and the specific purpose of an Appeals conference.
                             - 15 -

     Section 7430 was enacted to permit taxpayers to recover

their litigation costs if they prevail in the litigation.    To

some extent, the enactment of section 7430 was intended to

encourage the Internal Revenue Service to take a reasonable

approach to settlement and/or litigation.   The House report for

section 7430, which was enacted as part of the Tax Equity and

Fiscal Responsibility Act of 1982, Pub. L. 97-248, 96 Stat. 324,

contains the following explanation:

        The committee believes that taxpayers who prevail in
     civil tax actions should be entitled to awards for
     litigation costs and attorneys’ fees up to $50,000 when
     the United States has acted unreasonably in pursuing
     the case. Fee awards in such tax cases will deter
     abusive actions or overreaching by the Internal Revenue
     Service and will enable individual taxpayers to
     vindicate their rights regardless of their economic
     circumstances. [Emphasis supplied.]

H. Rept. 97-404, at 11 (1981).

     Interrelated with and complementary to that goal, Congress

required that taxpayers exhaust their administrative remedies.

The exhaustion of taxpayers’ administrative remedies is intended

to ensure that the Commissioner will have an opportunity to

evaluate the quality of taxpayers’ positions.   In addition, the

exhaustion requirement is intended to prevent taxpayers from

intentionally presenting superficial information merely to enable

the recovery of costs under section 7430(b)(1).   Accordingly, the

exhaustion requirement is integrally tied to the question of

whether the Commissioner’s position is justified.
                                - 16 -

     The legislative history for the initial enactment of section

7430 contains the explanation that the exhaustion of the

administrative remedies provision was

     intended to preserve the role that the administrative
     appeals process plays in the resolution of tax disputes
     by requiring taxpayers to pursue such remedies prior to
     litigation. A taxpayer who actively participates in
     and discloses all relevant information during the
     administrative stages of the case will be considered to
     have exhausted the available administrative remedies.
     Failure to so participate and disclose information may
     be sufficient grounds for determining that the taxpayer
     has not exhausted administrative remedies and,
     therefore, is ineligible for an award of litigation
     costs.

H. Rept. 97-404, supra at 13.    Finally, section 7430 was not

intended “to permit awards for litigation costs which the

taxpayer could have reduced or avoided through full disclosure of

all relevant facts.”   Id. at 15.

     Accordingly, section 7430 was intended to motivate

respondent to consider and react reasonably to taxpayers’

evidence and arguments.   Consistent with that purpose is the

regulatory requirement that taxpayers provide respondent with

relevant information supporting their position.   Obviously, if

the theories and/or information presented to Appeals is

irrelevant, without substance, or unsupportable, the taxpayer

will not have exhausted administrative remedies and will not

likely be a prevailing party within the meaning of section 7430.

Triplett v. Commissioner, T.C. Memo. 1998-313.    As a result, such

a taxpayer will not be entitled to recover litigation costs.
                               - 17 -

Additionally, in such situations, respondent’s position in the

proceeding will likely be reasonable or justified so as to

preclude the recovery of administrative or litigation costs.

      The purpose or goal of Appeals has been generally described

in the following global statement of the Appeals mission:

      The Appeals mission is to resolve tax controversies,
      without litigation, on a basis which is fair and
      impartial to both the Government and the taxpayer and
      in a manner that will enhance voluntary compliance and
      public confidence in the integrity and efficiency of
      the Service. * * *

4 Administration, Internal Revenue Manual (CCH), sec. 8.1.3.2, at

27,037.11

      In this context, we consider the facts in the case before

us.   The parties’ positions and the information available to them

in this case continued to develop throughout the administrative

process and until trial.   Petitioners were examined concerning

whether the $130,000 payment they received was paid to settle

claims for punitive damages.   Petitioners, through their



      11
       The same perspective is shared by legal commentators, as
reflected in following commentary about the Appeals process:

      The Service encourages taxpayers who disagree with
      actions by district offices, such as adjustments in
      their tax liability, to resolve their disagreements
      through administrative appeal. The use of negotiation
      and settlement, rather than court litigation, is
      intended to minimize expenditures of time and money by
      the government and taxpayers alike. * * *

Saltzman, IRS Practice and Procedure, par. 9.01, at 2 (2d ed.
1991).
                               - 18 -

representative, an enrolled agent, contended that the entire

insurance recovery was used to repair their residence, so that no

part was attributable to punitive damages.   Petitioners, in their

amended return, had taken the position that the amount received

was a casualty loss under section 165.   It also appears that, at

the examination, petitioners argued that the $130,000 was not

taxable because it was due to personal injury within the meaning

of section 104.    Ultimately, the examiner concluded that $104,000

of the $130,000 payment was received in settlement of

petitioners’ claim for punitive damages.

     After the examination was complete, petitioners hired a law

firm to seek consideration of the examiner’s findings by Appeals

and to attempt settlement of the controversy.   They attempted to

show that the cost of repairing their residence exceeded the

total payments received from the insurance company.   Petitioners,

by using this approach, hoped to convince the Appeals officer

that no part of the settlement payment could have been for

punitive damages.   Petitioners chose this approach after

evaluating the available evidence and balancing the viability of

their position at the Appeals conference with the much larger

cost of obtaining information from third parties.   Petitioners’

approach to settlement did not result in an agreement with the

Appeals officer.    The Appeals officer concluded that the $130,000

was received in settlement of petitioners’ claim for punitive
                              - 19 -

damages.   The Appeals officer also considered the application of

section 1033 to the circumstances of petitioners’ facts.

     Accordingly, petitioners were forced to decide whether to

proceed to trial.   Approximately 3 months prior to trial,

petitioners proceeded to procure information from third parties

that would show that the insurance company’s payment was not

intended to settle petitioners’ claim for punitive damages.12    A

few days before trial, respondent’s attorney became aware that

the insurance company’s lawyer would testify that the $130,000

payment was not for “bad faith” or punitive damages.

Respondent’s attorney had expected that the insurance company’s

lawyer would testify otherwise.   In spite of that newly

discovered information, respondent proceeded to trial, and,

ultimately, respondent’s position in the litigation was held to

be unjustified, beginning 3 days before trial.

     Respondent, relying on sec. 301.7430-1(b)(2), Proced. &

Admin. Regs., contends that there was more information available

to petitioners at the time of the Appeals conference and that

petitioners’ failure to seek out and/or present that information

to the Appeals officer should result in a failure to exhaust

administrative remedies.   On the other hand, petitioners contend

that they provided the Appeals officer with relevant information


     12
       Subsequent to the Appeals conference, petitioners’ pre-
trial cost to develop third party information was $34,031. By
comparison, the amount of the income tax deficiency was $39,697.
                              - 20 -

in an attempt to settle the case in Appeals.   Petitioners’

contention is based on their understanding of the controversy and

the factual development of the case at the time of the Appeals

conference.   Petitioners argue that they made a good faith effort

to settle and thereby exhausted their administrative remedies.

     Respondent’s contentions that petitioner should have

provided Appeals with more information can be divided into two

general categories:   (1) Information already in petitioners’

possession concerning the damage to their residence, and (2)

information concerning the insurance company’s intent not to pay

petitioners for punitive damages.   Initially, we consider the

first category of information available to petitioners that was

not provided to the Appeals officer.

     In connection with their claim against the insurance

company, petitioners obtained two engineering reports concerning

the damage to the subsoil and to petitioners’ residence.    Those

reports were not provided to the Appeals officer, but they were

presented at trial in order to support petitioners’ position

regarding the repairs to the residence.   Although the reports

provided some support for petitioners’ contention that the

repairs exceeded the insurance recovery, the reports would not

have resolved the issue being considered by Appeals; i.e.,

whether the settlement payment was paid to petitioners in

satisfaction of their claim for punitive damages.
                              - 21 -

     Significantly, if respondent had been made aware of the

expert reports, that information would not have caused

respondent’s position in the deficiency notice or in the

litigation to be unreasonable or unjustified.     The evidence

already available to the Appeals officer sufficiently showed that

the cost to repair the residence exceeded the amount of the

insurance recovery.   In addition, the Appeals officer was in

possession of probative evidence supporting her conclusion that

the payment may have been made in satisfaction of the punitive

damages claim.   In that setting, additional evidence bolstering

petitioners’ argument regarding the cost of repairs was

cumulative.   Therefore, petitioners’ failure to provide the

expert reports did not result in a failure to exhaust their

administrative remedies.

     Respondent also contends that under the language of the

regulation--specifically “all relevant information that is known

or should have been known”, petitioners were required to seek out

and present evidence of the intent behind the insurance company’s

settlement payment.   We reject respondent’s contention.    It

appears that respondent is employing the “known or should have

been known” phrase out of context.     The regulation requires

disclosure of information, the relevance of which was “known or

should have been known to the party or qualified representative

at the time of * * * [the Appeals] conference.”     Sec. 301.7430-1
                              - 22 -

(b)(2), Proced. & Admin. Regs.   (Emphasis supplied.)   At the time

of the Appeals conference, petitioners were not aware of the

insurance company’s intent in making the settlement payment.

That information was discovered from third-party sources shortly

before trial and almost 1 year after the Appeals conference.

     The regulation requires disclosure of relevant information

“to the extent such information and its relevance were known or

should have been known to the party or qualified representative

at the time of such conference.”   Id.   In the context of the

settlement conference with Appeals, that requirement was met by

petitioners, who made a reasonable and good faith effort to

provide the Appeals officer with relevant facts and law in the

context and development of the case at the time of the

conference.

     In addition, under respondent’s view, taxpayers might be

required to seek out every possible piece of relevant evidence

and/or to postulate every plausible theory in order to exhaust

administrative remedies and to recover administrative or

litigation costs.   Respondent’s approach also disregards the

relative cost of developing all relevant information that is

known or should have been known.   Under respondent’s approach to

the regulation, few, if any, taxpayers might be able to present

all relevant evidence that could have been developed.
                              - 23 -

     The regulation does not require that petitioners present to

the Appeals officer all evidence later adduced at trial.

Instead, we are to consider whether petitioners exhausted their

administrative remedies by providing relevant information in an

attempt to settle the case in the context of the case development

at the time of the Appeals conference.

     At all pertinent times, petitioners were represented by tax

professionals.   They participated in the Appeals conference in a

manner that provided relevant information in an attempt to

resolve the case without litigation.     The standard with respect

to exhaustion of administrative remedies was intended to preserve

the important role that the administrative Appeals process plays

in the resolution of tax disputes.     It was not intended to

require taxpayers to adduce all possible arguments or evidence.

Petitioners’ approach to settlement was a reasonable attempt to

convince the Appeals officer that the examiner’s finding was in

error.

     In the circumstances of this case, we hold that petitioners

exhausted their administrative remedies and are entitled to their

litigation costs for the period commencing 3 days before trial,

as decided by the Court of Appeals for the Ninth Circuit.

     To reflect the foregoing,

                                      Decision will be entered

                                 under Rule 155.
