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I am an attorney with 30 years of experience; I hope to provide you information that will help you in resolving your question.
I am very sorry that your cousin is in this situation. I wish I had good news for you, but the sad reality is that there is not very much relief available to him in this situation.
Unfortunately, even though the IRA distribution was used to pay restitution for the money your cousin was accused of embezzling, it is still income to your cousin. What is worse is that because the distribution was an early distribution under the IRS code he will be hit with penalties on top of the taxes due.
Based on your description he does not meet the criteria for an exception to the penalties. So he will have to pay those too. It is not going to hurt to go through the IRS appeal process and see if you can get some relief.
To do this you will assert that the distribution was a "Hardship Distribution." A hardship distribution is a withdrawal from an IRA account that is made because of an immediate and substantial financial need. The amount withdrawn must be limited to the amount necessary to satisfy that financial need.
The challenge he faces is persuading that the situation is a true hardship because they may coldly view that this is a situation of his own making. After the internal appeals process is exhausted you may seek relief from Tax Court. But honestly that is a long shot and will require the expenditure of more funds to pay for counsel. It is worth pursuing the internal appeal process however because there is no cost to that.
I am sorry if this information is not what you wanted to hear. I would not want to mislead you and have you expend time energy and resources pursuing something where there is little chance of success.
This article discusses hardship withdrawals. Note that the IRS asserts that they can not waive the 10 % penalty, but the hearing officer may (but truthfully the odds are not good for your cousin).
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