On October 3, 2017, the United States Tax Court issued an opinion in Klein v. Commissioner, 149 T.C. No. 15,[1] which creates a potential roadblock for the Internal Revenue Service (“the Service”) in civil cases stemming from criminal matters.  In particular, the Tax Court held that the Service cannot use a criminal order of restitution as the sole basis for assessing penalties and interest.  Instead, the Service can use the restitution order to collect only the amount of restitution “as if” it was a tax.

In order to create a basis for assessing and collecting related penalties and interest, the Service must separately assess the amount of restitution as a tax – using statutory assessment procedures.  As a result, in some situations where the amount ordered as criminal restitution is greater than what is ultimately determined as the civil tax deficiency (e.g., where deductions are not properly calculated or are disallowed), taxpayers may be able to use the analysis set forth in Klein as a means to contest and reduce penalties or interest, even if they cannot reduce the amount of restitution itself.

Background.  The Kleins, a husband and wife, were criminally prosecuted for filing false tax returns for several years.  Mr. Klein ultimately pled guilty to one violation of 26 U.S.C. § 7206(1) and two non-tax violations.  Mrs. Klein pled guilty to one violation of 26 U.S.C. § 7206(1).  As a result of their guilty pleas, the Kleins were sentenced to a term of incarceration and significant restitution orders stemming from the 2003 through 2006 tax years.  The restitution orders were based upon the government’s calculation of federal tax loss, which was in turn calculated through a bank deposits analysis.

After the Kleins were released from prison, they fully paid the restitution; however, the Service then filed Notices of Federal Tax Lien (“NFTL”) claiming significant delinquency penalties and related interest were still due and owing to the Service as a direct result of the restitution orders.  Importantly, even though six years had elapsed since the criminal case concluded, no civil examination was ever conducted by the Service, no statutory notice of deficiency was ever issued to the Kleins, and no formal assessment was ever made against them.

The Kleins requested Collection Due Process hearings wherein they contested the collection of the penalties and interest contained within the NFTLs.  The Kleins essentially argued that the filing of the NFTLs was improper since the restitution order had previously been satisfied in full.  When the Service disagreed with the Kleins on the liability issue (i.e., finding that penalties and interest were due), the Tax Court reviewed liability on a de novo basis, as no statutory notice of deficiency had been issued and, hence, no opportunity for a challenge had previously been afforded to them.

In Tax Court, the Service argued that it could collect penalties and interest that were computationally based on a restitution order, pursuant to I.R.C. § 6201(a)(4)(A).  In the Service’s view, that statute authorized the Service to treat the restitution order as a tax for purposes of I.R.C. §§ 6601, 6651, and other provisions.  In response, the Kleins argued that I.R.C. § 6201(a)(4) only enabled the Service 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.  That is, an order of restitution did not conclusively determine tax due and could not, without more, serve as a basis for imposing interest or other addition, such as penalties.  In the Kleins’ view, I.R.C. § 6201(a)(4) was merely a collection mechanism.

The Tax Court agreed with the Kleins on the grounds of statutory construction principles.  It held that this statute did not intend to treat restitution as a tax assessment for all purposes.  Instead, the purpose of I.R.C. § 6201(a)(4) was to create a means by which the Service could administratively create an account for its own accounts receivable when restitution was ordered in a criminal case.  In other words, the Service could treat restitution orders as if they were tax assessments for purposes of collecting restitution; however, restitution orders do not constitute a tax assessment in other contexts of the tax code.  In passing the law, Congress related that the statute would mainly enable the Service to better track payments of restitution that were delivered by a taxpayer to the District Court, but related to restitution due to the Service.

In order for the Service to assess related penalties and interest (i.e., statutory additions to tax), the Service must first conduct a civil examination and issue a statutory notice of deficiency.  This principle applies even if the penalties and interest are merely computational.  Statutory additions must be based on the ultimate tax determined and cannot simply be based solely on a restitution order.  In so holding, the Tax Court dictated that the Service was free to assess penalties and interest once a civil determination of taxes was issued.

Practice Pointers.  Klein indicates that the Service must, or at least should, conduct a civil examination – sometimes referred to as a civil closing – in matters resulting from criminal tax prosecutions.  Without making an assessment (restitution-based or otherwise), the Service cannot assess penalties or interest against affected taxpayers.  Moreover, without such an assessment, the Service may not use any collection mechanisms to collect interest and penalties.

The holding in Klein potentially provides criminal tax defendants with a means for challenging penalties and interest.  Even though a restitution order may be used as a conclusive means for assessing tax – even if deductions were erroneously disallowed in the criminal context or the restitution otherwise overstates the deficiency – it is not conclusive for purposes of establishing liability for penalties, interest, and other tax-related matters.  The Service must first conduct a civil examination in order to assess penalties and interest relating to purported deficiencies.  During the civil examination, taxpayers can challenge the underlying tax due in an effort to reduce the potential assessment of penalties and interest even if they cannot attack the validity of the restitution order.  Taxpayers can also raise procedural challenges such as the expiration of the statute of limitations, if applicable.  In light of Klein, the Service may work with the Department of Justice to further limit taxpayers’ potential challenges in negotiated plea agreements.  Practitioners should be careful not to limit taxpayers’ ability to challenge the tax due in cases where restitution may overstate their actual liability, after accounting for deductions, credits, and other oversights.  Otherwise, taxpayers could be forced to pay exorbitant penalties and interest that are not appropriately due.

For taxpayers who have related state tax deficiencies, the holding in Klein may allow for similar challenges.  That is, if the Service does not conduct a civil examination and simply relies on a restitution order to collect tax, the Comptroller may not be able to assess tax or additions to tax.  For instance, pursuant to Maryland Annotated Code, Tax-General § 13-1101, the Comptroller is only permitted to assess tax within three years from the later of the due date of the tax return or the filing of the tax return.  If a taxpayer did not intend or attempt to evade taxes due to Maryland and no civil closing is conducted by the Service, additional assessments by the Comptroller may be time-barred due to the statute of limitations for assessment.  See TG § 13-1101(b) (no limitations period for assessments stemming from false returns or attempts to evade tax).  This may occur because if the Service simply relies on a restitution order and does not conduct a civil examination, no report of federal adjustment will be administratively issued by the Service to the Comptroller.  By statute, the Comptroller is not able to rely on the exception to the general three-year statute of limitations period without first receiving such a report.  See TG § 13-1101(c) (one year limitations period on assessments where the Service issues a report of federal adjustments).  Furthermore, the reasoning in Klein should support the notion that a restitution order (or any computation of unreported income in a criminal case) cannot be used as a deficiency assessment on a de facto basis.

These descriptions are intended for informational purposes only and should not be taken as legal advice on any particular set of facts or circumstances.  Rosenberg Martin Greenberg, LLP is experienced in all aspects of federal and state tax laws, including criminal tax matters, restitution orders, criminal tax sentencing, white collar criminal litigation, and more.  Please contact Brandon Mourges at 410.951.1149 or bmourges@rosenbergmartin.com for a free consultation.


[1] Available at: https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11428.