Written by Daniel Latto in Latest News

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December 26, 2013

The good news is that the IRS and the courts are uniformly recognizing that tax based restitution must be credited against a taxpayer’s civil tax liability. CC-2013-012. One of the often cited cases for this proposition is US v Hemsley, 941 F2d 71 (2nd Cir. 1991) which proclaims it is “self-evident” that criminal tax restitution for a particular tax year must be credited against the civil tax liability for the same tax year. Apparently it had not been so evident to Leona Hemsley, who had believed “only the little people pay taxes.” She was required to pay her taxes; albeit partially though the mechanism of criminal restitution in her criminal tax case.

The bad news is that the rule only applies to criminal tax restitution payments. Consequently, when faced with the unenviable option of a tax fraud criminal offense or another federal criminal violation, one must keep in mind restitution. Imagine being convicted of or pleading guilty to a non-tax federal law violation that includes un-reported income or overstated expenses as part of the scheme. Then imagine that not a penny of the criminal restitution is applied to the subsequent IRS bill for tax, penalties and interest. This is a very real scenario. Thus, the first trap for the unwary is to make  sure the plea is to a tax violation that separately includes the tax loss for each year involved in the scheme.

However, a tax plea or conviction is not the end of the story. Many taxpayers are  shocked to learn that despite the criminal judgment, interest runs on restitution.  Since, restitution is just the unpaid taxes, the interest runs back to the due date of the original return. The IRS has a section in Philadelphia that sends out these interest due notices in criminal tax cases much to the chagrin of taxpayers who thought they had already fully paid their debt to society.

The interest due notices relating to criminal tax restitution can result from a systemic problem inside the IRS that practitioners must include in their analysis. Even if all tax, penalty and interest has been paid, the IRS may still send out a restitution interest notice. How can this be? The answer is quite simple, the IRS may simply fail to give credit for the restitution paid. What is worse, the IRS transcript of account will often not show the credit for the restitution paid.

The second trap for the unwary is not looking past the initial IRS transcript of account for the restitution. In the same way the IRS maintains master and non-master files for taxpayers and their spouses in certain situations, the IRS has perpetuated this practice for restitution payments.

Practitioners must request all transcripts, master and non-master, to find the restitution that the IRS failed to provide credit for on the master income tax account transcript. Once both sets of transcripts of account are in hand, proving that the restitution and all associated interest have previously been paid in full should be an easy task.

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