IRS Practice and Procedure News Briefs for May 2020

Why this Case is Important: Taxpayers who owe restitution to the IRS as the result of a criminal conviction may mistakenly believe that once they pay their restitution, they will no longer have to deal with the IRS. However, like the taxpayer in Le, they will inevitably discover that is not the case.

 

Facts: In 2007, the IRS initiated an audit of the taxpayer’s 2004, 2005, and 2006 federal income tax returns. After discovering unreported income, the auditor referred the matter to the IRS’s criminal investigation division. That led to the taxpayer being indicted for tax evasion for these years in 2013. That same year, the taxpayer pled guilty to tax evasion for 2006 and agreed to pay restitution to the IRS of $33,332 related to income that he willfully failed to report on his 2006 return, which amount he paid in full. In 2015, the IRS completed its civil audit of the taxpayer’s 2004, 2005, and 2006 returns and issued a notice of deficiency assessing tax liabilities for those years of $23,958, $33,133, and $30,530, respectively, plus civil fraud penalties for each year totaling $65,715. The taxpayer filed a Tax Court petition asserting, among other arguments, that under the legal doctrine of collateral estoppel, the IRS was precluded from assessing additional liabilities for these years because they were addressed in his criminal case.

Law and Conclusion: Collateral estoppel prohibits the re-litigation of an issue where (1) the defending party in the second lawsuit was a party in a prior lawsuit; (2) the issue in the second lawsuit is the same as the issue in the prior lawsuit; (3) the issue was “actually litigated” in the prior lawsuit; (4) the issue was determined by a valid and final judgment; and (5) the determination in the prior lawsuit was “essential” to the prior judgment. The taxpayer argued that because his tax liabilities for 2004, 2005, and 2006 were at issue and litigated in his criminal case, resulting in the 2006 restitution order, the IRS could not assess additional liabilities for these years. However, the Court disagreed. First, it held that a restitution order is not “essential” to a criminal judgment, because judgment can be entered without ordering restitution. Second, case law makes clear that whether a criminal court orders restitution be paid to the IRS for a given year has no effect on the IRS’s ability to audit that same year and assess taxes, penalties, and interest for that year, even if that assessment exceeds the restitution liability. That being the case, the Court found in favor of the IRS and upheld the IRS’s assessments.

Why this Notice is Important: Businesses across the country have received Paycheck Protection Program (PPP) loans to help them stay afloat during the ongoing COVID-19 pandemic. As the government continues to issue guidance on the use and forgiveness of these loans, one question taxpayers have been asking is whether expenses paid with loan proceeds are tax deductible. Many businesses and tax professionals were not thrilled with the government’s response. 

Effect of Notice: On April 30, the IRS issued Notice 2020-32, in which it stated that otherwise-deductible expenses, which are paid with PPP loan proceeds that are later forgiven, are not deductible to the extent of the amount of forgiveness. The IRS’s reasoning was that, because the PPP loan proceeds are not taxable as income, to allow a tax deduction when the proceeds are spent would create a double benefit for taxpayers. Tax professionals have argued that disallowing the tax deductions merely offsets the benefit of the loan proceeds being tax-free – making the proceeds tax-free and not allowing related deductions is no different than making the loan proceeds taxable and allowing the deductions. They also contend that if the purpose of the PPP loan program is to benefit small businesses that are struggling due to the pandemic, the government should be looking to increase rather than limit tax benefits to loan recipients. While a group of senators recently introduced the Small Business Expense Protection Act, which would reverse Notice 2020-32 and allow deductions for expenses paid with PPP loan proceeds, the proposed legislation is still under review.

If you would like more details about these cases, please contact me at 312-888-4113 or jnesser@lavellelaw.com.