IRS Must Refund Penalties Despite Tax Malpractice Recovery

In Ervin v. United States, No. 4:13-CV-00127-JHM (W.D. Ky. 2017), the court considered whether the government can withhold or set off a penalty refund owing to a taxpayer if the taxpayer has already recovered the amount in excess of the penalty from its tax advisor for malpractice. While the case does not create any new law, it is worth considering as clients do ask about this issue from time to time.

The facts in the case were as follows:

  • Ervin participated in a tax shelter was promoted by its tax advisor.
  • The IRS discovered and challenged the position and ultimately imposed the valuation misstatement penalty.
  • Ervin sued his tax advisor and received a sizeable settlement.
  • In addition, Ervin filed a refund claim for, paid, and litigated the penalty. The jury determined that Ervin qualified for reasonable cause for the penalty, presumably based on reliance on a tax advisor, and that no penalty was due.
  • The government refused to refund the amount Ervin paid for the penalty. In court, the government argued that it did not have to refund Ervin’s penalty payment as “a refund will result in a windfall and double recovery since the Plaintiffs have already received a large settlement from their tax advisors.”

The court had to answer the question as to whether the government could keep a tax refund that a jury had determined was due and owing to the taxpayer based on the idea that the taxpayer had already received compensation in excess of the penalty.

An affirmative answer would make pursuing tax refund claims in court somewhat meaningless if they could be disregarded by the government. It would also raise the question as to whether taxpayers could simply ignore the jury’s findings. Naturally, the answer is that the jury’s findings cannot be ignored.

The court did not have to spend a lot of time writing its opinion in this case. It noted that the government did not cite “a single instance in which a court has excused the government’s obligation to repay the improperly assessed and collected tax in a refund suit.” It simply noted that the tax refund was due and the government had to pay it to the taxpayer.

So the answer to the question in the case is, “no,” the government cannot keep a tax refund that it was ordered to pay back to a taxpayer, even though the taxpayer had already received an award in excess of the penalty amount from its tax advisor.