Lesson From The Tax Court: Restitution Overpayment Does Not Reduce Penalties On Deficiencies

Today’s lesson teaches that a taxpayer’s payment of criminal restitution does not lower penalties associated with the repaid tax.  In Monty Ervin v. Commissioner, T.C. Memo. 2021-75 (June 23, 2021) (Judge Lauber), the taxpayer was subject to a criminal restitution order.  The IRS assessed the restitution amount and the taxpayer fully paid it.  The IRS later sent an NOD proposing deficiencies smaller than the already-paid restitution, as well as §6651 penalties-by-another-name for failure to file and failure to pay.  In affirming the IRS’s ability to assess and collect these associated amounts, Judge Lauber gives a good lesson in the difference between restitution assessments and deficiency assessments.

My colleagues over at Procedurally Taxing have given extensive coverage to restitution assessments and associated case law.  For those who want the deeper dive, I highly recommend plunging into Keith Fogg’s excellent 2019 post, “Interest and Penalties on Restitution-Based Assessments.”  Keith also blogged today’s case last week, where he gives his always useful insights.  And, for those who want the cutesy-cutesy version of today's case, there is this amusing summary given by Lew ("Don't Contact Me") Taishoff.

Still, I think the following lesson may be useful for readers unfamiliar with the area.  The key takeaway is to see how and why IRS assessments of criminal restitution orders are different from tax assessments, even though the payment of criminal restitution is treated as a payment of a tax obligation.  Confused?  Details below the fold.

Law: Criminal Restitution Assessments Are Not Tax Assessments
When a taxpayer is referred to the IRS Criminal Investigation Division (CID), the IRS policy is to halt any related civil examinations.  See IRM 25.1.3.3.  I have never fully understood the reason for requiring a total halt to the civil examination, but it has to do with a concern that information gathered as part of a purported civil examination can damage the potential criminal prosecution by giving the taxpayer a basis for successful suppression motions.  See e.g. United States v. Tweel, 550. F.2d 297 (5th Cir. 1977).

As we saw in last week’s Lesson, resolution of the criminal investigation can take years.  Sometimes, the criminal investigation results in the conviction of the taxpayer for tax crimes and sometimes not.  Either way, the resulting delay in the civil examination drastically reduces the chances of actual collection.  Only after the criminal case is concluded does the IRS start the process to assess and collect taxes.

When the criminal tax case results in a conviction, a court will often order the convict to pay restitution.  The amount of restitution is based upon an estimate of civil tax liability.  Crucially, however, a restitution order is not itself either a determination of the tax nor a judgment of tax liability.  It’s a separate liability.  See Morse v. Commissioner, 419 F.3d 829 (8th Cir. 2005); United States v. Tilford, 810 F.3d 370, 372 (5th Cir. 2016) ("[c]riminal restitution, even as a penalty for a failure to pay taxes, is not a tax.").  As a separate liability, the restitution order creates its own lien, see 18 U.S.C. §3613, and primary collection responsibility is with the Department of Justice’s Financial Litigations Unit (FLU) not the IRS (at least not until after 2010).

Even though a restitution order is not a tax liability, courts have found it “self-evident” that it is, in fact, a payment of a tax liability.  United States v. Helmsley, 941 F.2d 71, 102 (2d Cir.1991)(yes, that Helmsley).  Accordingly, courts treat payment of a restitution order as a payment of a tax debt.  See United States v. Clayton, 613 F.3d 592 (5th Cir. 2010)(garnishment to collect restitution order was not subject to limitations on garnishment in 15 U.S.C. §1673(a) because it was a collection of a “debt due for any State or Federal tax” within the meaning of 15 U.S.C. § 1673(b)(1)(C)’s exception to those limitations).

Thus, when the IRS receives a restitution payment, it must apply such payments to any related assessment of tax.  That is because restitution is partly to compensate the government for lost revenue, so collecting both the restitution and then again the full amount of tax owed would be a double collection of tax.

Before 2010, it was awkward for the IRS to properly apply restitution payments to the relevant tax debt because it would not have assessed the actual tax liability until it had concluded the civil tax determination process.  That could be years after a criminal case concluded.  Meanwhile, there was not good way to account for the payment.

To remedy that problem, Congress created §6201(a)(4) in the Firearms Excise Tax Improvement Act of 2010, 124 Stat. 2497.  That provision authorizes the IRS to "assess and collect the amount of restitution...for failure to pay any tax...in the same manner as if such amount were such tax."  (emphasis supplied, for reasons evident shortly).

The Tax Court has steadfastly recognized that the statutory authorization did not change the underlying rule: an assessment of restitution obligation is separate from assessment of tax.

Sometimes, the distinction between a restitution liability and a tax liability hurts taxpayers.  For example, restitution payments do not operate to reduce any later determinations of deficiencies of tax.  See Rozin v. Commissioner, T.C. Memo 2017-52 (“A deficiency must first exist before restitution remittances for taxes owed can be applied to reduce that deficiency. In other words, the restitution assessment, which is assessed "as if" it were a tax, cannot offset a tax assessment until a tax assessment of the deficiency has been made. The amount of a deficiency turns not on what payments have been applied to an account, but rather on what assessments have been made with respect to that account.”).

Sometimes, however, the distinction between a restitution liability and a tax liability helps taxpayers.  In the leading case of Klein v. Commissioner, 149 T.C. 341 (2017), the IRS sought to apply the interest and penalties provisions that would apply to an assessment of tax to its assessment of the restitution.  The Tax Court said no because the restitution was still a separate liability than a tax liability.  The §6201(a)(4) authority to assess a restitution obligation “as if” it were a tax did not transform a restitution order into a tax liability.  The interest and penalty provisions apply only to “taxes” imposed by Title 26 and the restitution assessment was different than a tax assessment.

The Klein Court emphasized, however, that the IRS “is free to commence a civil examination of those returns at any time. Upon final determination of petitioners' ... civil tax liabilities, interest will arise automatically under section 6601(a), and additions to tax (if appropriate) may be imposed under section 6651(a)(3).  But the interest and additions to tax would then be computed, not by reference to the [amount of the restitution assessed under §6201(a)(4)] but by reference to whatever petitioners' actual tax liabilities are ultimately determined to be.”  Id. at 362.

And that's what we learn today.

Facts
In June 2012 Mr. Ervin and his wife were convicted of tax evasion for tax years 2000-2009.  During that time they had filed no tax returns despite enjoying beaucoup income from their various real estate management companies.  And I mean beaucoup income.  They were ordered to pay $1.4 million as restitution for the harm they caused the federal government and, by extension, the people of the United States.  The IRS assessed the restitution amount per its authority in §6201(a)(4).

After the criminal case dust had settled, the IRS prepared §6020(b) substitutes for returns for the unfiled years and sent out Notices of Deficiencies in October 2014.  The NODs proposed to assess deficiencies of tax totally some $524,000 for the years at issue.  The NODs also proposed various additions to tax: $51,000 under §6651(a)(1) for Mr. Ervin’s failure to file returns; $159,000 for his fraudulent failure to file; $211,000 for his failure to pay; and, finally, to add insult to injury, $8,000 under §6654 for his failure to make proper estimated tax payments.  It all adds up to about $923,000.  Notice, however, that the $1.4 million restitution payment was more than the proposed deficiency of tax, even assuming Mr. Ervin received credit for only half of the restitution payment (with the other half credited to his wife’s liability—the opinion is not clear on which of the proposed 2000-2009 deficiencies were joint and several).

From prison, Mr. Ervin timely petitioned the Tax Court, pro se.  In 2016, while the case was pending, the DOJ FLU certified to the District Court that the restitution order has been paid in full.

At some point Mr. Ervin hired counsel.  His Tax Court petition did not contest the amounts contained in the NODs.  Instead, it asked the Tax Court to redetermine the amount of his deficiency by taking into account his full payment of the prior assessment of his criminal restitution obligation.  That is, Mr. Ervin argued that since he had paid his restitution and since the restitution payment was indubitably the payment of a tax and was greater than the proposed  debt, there were no remaining deficiencies to be assessed.  In addition, he argued that the additions to tax were improper because he had, actually, fully paid the restitution four years after the restitution assessment so with that full payment made before the IRS assessed any deficiency, there was no "tax" left on which to base the "additions to tax."

Lesson: Restitution Payments Do Not Affect IRS Ability to Later Assess Penalties On Now Paid Deficiency
Judge Lauber relies on Klein and the distinction between restitution assessments and deficiency assessments to reject Mr. Ervin’s argument that payment of his restitution assessment precluded the IRS from proposing a deficiency that was actually less than the restitution paid.  Judge Lauber explains that since a restitution assessment is not the assessment of a tax, it cannot affect the determination of a “deficiency” within the meaning of §6211.  Because Mr. Ervin was a non-filer, there was no tax due shown on any returns for the year at issue.  Nor had the IRS made any previous assessment of tax, because the restitution assessment was not an assessment of tax.  Therefore, the amounts reflected in the NODs (uncontested by Mr. Ervin, remember) were the proper deficiencies and could be assessed.

So Judge Lauber green-lighted the proposed assessment of the deficiencies.  He notes, however, that “because the deficiencies have been full paid via restitution, the IRS cannot collect the deficiencies again.  Determination of the deficiencies in these circumstances is chiefly relevant for purposes of determining applicable additions to tax.” Op. at 11.

As to the penalties—excuse me, I mean additions to tax—for failure to file and failure to pay, Judge Lauber shows how this case is very different than Klein.  Unlike Klein, the IRS was not seeking here to collect failure to pay amounts based on the restitution assessment.  It was instead proposing such additions based on the proposed assessment of a tax deficiency for each of the years in question.  Judge Lauber approved all of the additions, pointing out that they started running from the due date of each year’s return and thus had topped out long before the restitution payments were completed in 2016, except maybe for a “tiny sliver” of the failure to pay for 2007.

Comment: Does Mr. Ervin Have An Overpayment?
Readers may wonder whether Mr. Ervin might be entitled to a refund.  It appears that his criminal restitution payment exceeded the eventual tax liability that the IRS determined was due for the years in question.  Since criminal restitution payments are treated as payments of federal tax debts, would that not mean he would be entitled to claim a the excess as an overpayment and therefore, if otherwise appropriate, file a claim for refund?

I don’t think so, for two reasons.  First, and most straightforwardly, the restitution liability (and its assessment) remains a separate liability from the tax liability (and its assessment).  You see that, I think, in §6201(a)(4) which says that the IRS shall both assess and also collect the restitution amount assessed "as if" it was a tax, regardless of whether the IRS makes any future effort to assess a civil tax liability.

Second, as a policy matter, allowing the restitution payment to count as an overpayment would convert punishment into no more than an estimated tax payment.  Here, for example, the criminal restitution order of $1.4 million was the back-of-the-envelope guesstimate of how much the evasion had cost the government.  Sure, part of that cost was lost revenue, but part of the cost was also the cost of investigating and prosecuting the crime.  So while the IRS will apply the restitution payment as needed to satisfy the correct tax as eventually determined—to avoid double taxation—any excess restitution payment should not be treated as an overpayment of tax.  It’s still part of the punishment for a crime.   Mr. Ervin is an adjudged criminal and full restitution is part of the price he must pay for that, even if it exceeds the actual tax liability.