Tax restitution isn’t always simple

The IRS must follow a corporation’s designation of voluntary payments toward the income tax liabilities of its owner/employees, according to a recent Tax Court ruling.

However, because the payments did not represent taxes withheld at the source, the IRS was allowed to levy on the assets of the owner/employees to collect applicable interest and penalties. Likewise, the corporation remained liable for interest and penalties attributable to its failure to remit taxes on a timely basis (James R. Dixon, et. ux. v. Commissioner, 141 TC No. 3, Sept. 3, 2013 and James R. Dixon, et. ux. v. Commissioner, TC Memo 2013-207, Sept. 3, 2013).

James and Sharon Dixon served as officers and employees of Tryco. After a number of successful years, Tryco stopped filing and remitting employment taxes, and the Dixons stopped filing individual income tax returns.

Later, the Dixons were criminally prosecuted for failure to file individual income tax returns. As part of a settlement, they agreed to make restitution to the IRS for taxes in the amount of $61,021.

The Dixons contributed this amount to Tryco, and Tryco submitted it to the IRS, accompanied by a letter stating that the payment represented Tryco’s withholding taxes to be applied to the withheld income taxes of the Dixons.

When accountants prepared the individual income tax returns for the Dixons’ missing years, they determined that the couple owed an additional $30,202 in taxes. The Dixons contributed this additional amount to Tryco, and the corporation in turn submitted it to the IRS with a letter similar to the earlier one.

On the advice of legal counsel, the Dixons chose not to pay their individual income tax liabilities directly, believing that the indirect payments through Tryco would reduce both the portion of the company’s withholding tax liability attributable to themselves and their own income tax liabilities. They also hoped to avoid interest and penalties because the tax law treats withholding at the source as paid in the year of the withholding irrespective of the employer’s date of remittance.

The IRS initially credited Tryco’s payments to the Dixons’ income tax liabilities, which settled their tax obligations but not the related interest and penalties. Later, the IRS reversed itself and applied the payments to Tryco’s general unpaid employment tax liabilities.

The IRS then issued a notice to the Dixons of intent to levy on their assets in satisfaction of their now unpaid income tax liabilities. The Dixons petitioned the Tax Court.

The Dixons contended first that they were entitled to a withholding credit for the amounts submitted by Tryco on their behalf. Second, they asserted that the IRS was obligated to honor Tryco’s designation of the payments as withheld income taxes and to credit the amounts toward the Dixons’ income tax liabilities.

The IRS argued that its policy of honoring designations of voluntary payments does not extend to designations of delinquent employment tax by one party toward the income tax liability of another.

The Tax Court concluded that the funds submitted by Tryco to the IRS were not withheld at the source and, accordingly, the Dixons were not entitled to a credit against their individual income tax liabilities. Regarding the Dixons’ second argument, the majority determined that the IRS was obligated to follow its published administrative position regarding designations of voluntary payments.

The IRS was therefore directed to credit the $91,223 payments to the Dixons’ account, discharging their income tax obligations. The IRS was allowed, however, to levy on the Dixons’ assets to collect applicable interest and penalties. Tryco likewise remained liable for interest and penalties.