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Old Laws, New Analysis, & 3 Yrs for a Tax Court Opinion

April 01, 2010 | Written by: Mark D. Olander, EA, USTCP
United States Tax Court Building
Tax laws are constantly changing, and they can be subject to divergent interpretations. Never assume that an expense is not deductible solely because that is the generally accepted view. Research should always be done to confirm that the law hasn’t changed, or that new interpretations have not replaced old ones. This month’s case shows how having an audit representative who stays current with latest tax developments can be essential to winning your case.

The deduction under audit was medical expenses. The member had receipts that exceeded the amount reported on the tax return, so there was no lack of documentation to support the deduction. The sticky issue was that member’s expenses related to a gender transition.

Historically, the IRS had disallowed expenses relating to sex change operations as nondeductible elective cosmetic surgery expenses. Internal Revenue Code section 213 defines cosmetic surgery as any procedure that is directed at improving a patient’s appearance and that does not promote the proper function of the body or prevent or treat illness.

In August of 2007, when TaxResources was first called on to defend the audit, there were no court cases of precedential value that provided a differing interpretation. However, the representative assigned to the audit had been following the O’Donnabhain case, the outcome of which had the potential to change all that. Rhiannon O’Donnabhain had sued the IRS because it had disallowed her deduction for medical expenses relating to her sex change operation. The case had been tried in Tax Court, but a decision had not yet been released.

The Audit Representative got to work right away. She called the member and guided her in putting the needed documents together. She explained that there was a similar case pending in Tax Court and that the expenses could be disallowed, depending on the outcome. The Audit Representative submitted the documents to the IRS and waited for a response.

As expected, the expenses that appeared to be cosmetic, such as electrolysis, were disallowed by the IRS, and further information was requested for the surgical bills. The Audit Representative helped the member get started on the next step, which was to obtain letters from her physicians and psychologists stating that the procedures were medically necessary for the treatment of a physical or mental defect or illness, namely: gender identity disorder.

In early February of 2008, as the member gathered the letters, a Notice of Deficiency arrived in the mail. This meant we had 90 days to file a tax court petition, a necessary step if we wanted to protect our right to be able to continue to argue the member’s case at the conclusion of the 90-day period. The Audit Representative hoped that the tax court decision would be released before the 90 days was up. Meanwhile, she posted a bond on behalf of the member to stop interest from accruing on the proposed balance due.

As the NOD deadline approached, there was no sign of a decision on the O’Donnabhain case. At the end of April we filed a tax court petition, and it wasn’t until the following September that the Audit Representative received a telephone call from the Appeals Officer. Although the Appeals Officer seemed sympathetic to our member’s case, under General Counsel’s order she had to wait for the outcome of the Tax Court case before proceeding. She said the expectation was that the Tax Court decision would be released the following February, five months away.

In December of 2008 we received a letter setting a trial date for May. As the court date approached, TaxResources requested that the IRS District Counsel file a Joint Motion for Continuance on the grounds that the primary issue was similar to the primary issue recently tried before the court. The Joint Motion for Continuance was granted by the judge. A week later a new trial date was set for mid-October. By the time September rolled around there was still no decision on the O’Donnabhain case, and another Joint Motion for Continuance was filed and granted. A third court date was assigned for April.

On February 3, 2010, the U.S. Tax Court issued its decision on O'Donnabhain v. Commissioner of Internal Revenue, ruling that medical treatment for gender identity disorder (GID) qualifies as medical care under the Internal Revenue Code, and is therefore deductible. However, the court also ruled that O’Donnabhain’s breast augmentation was “cosmetic” and therefore not deductible.

The next day the Audit Representative received a call from IRS appeals. The Appeals Officer requested detail for certain surgery invoices. Specifically, she was looking to find out what surgeries were performed and if there was breast augmentation.

The Audit Representative asked the Appeals Officer if she would consider allowing the expenses for the breast augmentation with the right documentation. The Appeals Officer acknowledged that this was a gray area and left the door open. The member was able to provide letters from her doctors stating that after hormone treatment there was still “evidence of clinically significant distress or impairment in social, occupational, or other important areas of functioning,” making the breast augmentation surgeries part of the medically necessary treatment of her gender identity disorder.

The Appeals Officer accepted the letters as valid support and allowed the deduction for all of the expenses reported on the original tax return, plus a few more. The case was finally closed in March of 2010, almost three years after the member first called TaxResources for help. Instead of owing money, the taxpayer received a refund.

The member was relieved to be finished with the long ordeal and pleased to receive her deposit back, with interest. Below is an excerpt from an email the Audit Representative received from the member:

Thanks, I really appreciate all the work you did for me. I couldn't have asked for a better advocate, you were awesome.

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