George S. Nalle III and Carole Nalle, and Charles A. Betts and Sylvia I. Betts ("Nalle 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. Sec. 7430 (1988). The Tax Court decided that Nalle and Betts had failed to establish as required by Sec. 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.

* This appeal concerns the second phase of litigation between Nalle and Betts and the Commissioner over the Commissioner's denial of rehabilitation tax credits claimed by Nalle and Betts for the substantial rehabilitation of several houses in Austin, Texas. Pursuant to Treasury Regulation Sec. 1.48-12(b)(5),1 the Commissioner disallowed credits which Nalle and Betts had claimed under 26 U.S.C. Sec. 48 (1988)2 because they had moved the houses prior to rehabilitating them.

Nalle and Betts contested the Commissioner's decision. On appeal from the Tax Court,3 this Court held the Treasury Regulation invalid because it contradicted the plain meaning of Sec. 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 Sec. 48. Id.

Having won on the merits, Nalle and Betts petitioned the Commissioner for reimbursement of their attorney's fees. The Commissioner denied the petition, and the Tax Court upheld the Commissioner's decision. Nalle v. Commissioner, 67 T.C.M. (CCH) 2747, 1994 WL 146090 (1994) [Nalle II ]. Nalle and Betts now appeal from the Tax Court's ruling.

Nalle 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. Bouterie v. Commissioner, 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.' " Id. (quoting Lennox v. Commissioner, 998 F.2d 244, 248 (5th Cir.1993)). 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 Internal Revenue Code provides that parties who prevail in tax proceedings may recover their attorney's fees. See Bouterie, 36 F.3d at 1367 ("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 respect to the amount 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. Sec. 7430(c)(4)(A). The only element at issue in this case is whether the Commissioner's position was not substantially justified. Substantially justified means "justified to a degree that could satisfy a reasonable person" and having a "reasonable basis both in law and fact." Pierce v. Underwood, 487 U.S. 552, 565, 108 S. Ct. 2541, 2550, 101 L. Ed. 2d 490 (1988); see also Bouterie, 36 F.3d at 1367 (noting that substantial justification equates to satisfaction to a reasonable person and reasonable basis both in law and fact); cf. In re Graham, 981 F.2d 1135, 1139 (10th Cir.1992) ("In order to be 'substantially unjustified,' the litigation must have been initiated unreasonably, without a reasonable basis in law or in fact.").

In determining whether 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. See 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 several earlier courts had rejected it,4 when the IRS had ignored state law that clearly supported the taxpayer,5 and when the IRS had failed to conduct a reasonable investigation that would have revealed the flaw in its position.6 The Commissioner's loss in the underlying litigation is not determinative of whether she was not substantially justified; it is only a factor.7 Therefore, if at the onset of litigation the error was not obvious, the Commissioner may still be substantially justified in defending an ultimately unsuccessful position. Sher 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.9

In this case, the validity of Regulation 1.48-12(b)(5) under 26 U.S.C. Sec. 48 presented an issue of first impression. Although other courts have held that the Commissioner was substantially justified in defending her position when 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); see also Portillo, 988 F.2d at 29 (rejecting reliance on "new rule" argument where Commissioner's decision to assess tax was " 'naked and without any foundation' " (quoting United 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.11 Also, if a regulation was "manifestly 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 Commissioner'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." Portillo, 988 F.2d at 29; see also Hanson, 975 F.2d at 1155 ("The issue in this case was clear as light shining on water."); Beaty v. United States, 937 F.2d 288, 292-93 (6th Cir.1991) (holding that government's position not substantially justified because "[n]one of the arguments offered by the IRS during the various stages of the litigation had even a chance of succeeding").

Nalle and Betts argue that this is one of those cases--that is, that Sec. 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 Nalle I, this Court held that the Commissioner's interpretation of Sec. 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. Id. Given this Court's findings in Nalle I, Nalle 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 Sec. 48, we did not hold that her interpretation as promulgated in Regulation 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 the 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 Sec. 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." Nalle II, 67 T.C.M. at 2750, 1994 WL 146090.

Nalle 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. Cf. Federal Election Comm'n v. Rose, 806 F.2d 1081, 1089 (D.C.Cir.1986) (discussing varying degrees of invalidity of agency action, "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"); Griffon, 832 F.2d 52 ("Merely because the government's underlying action was held legally invalid as being 'arbitrary and capricious' does not necessarily mean that the government acted without substantial justification...."). Simply put, our adopting of Nalle and 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 Sec. 48 was in error, her interpretation of Sec. 48 was "not entirely without foundation." Nalle I, 997 F.2d at 1137.13 Consequently, we hold that the Tax Court did not abuse its discretion in finding that "the disputed regulation is not manifestly in conflict with Sec. 48" and that Nalle and Betts had failed to demonstrate that the Commissioner was not substantially justified in defending Regulation 1.48-12(b)(5).14

For the foregoing reasons, we AFFIRM the judgment of the Tax Court.15