We have alluded to equitable recoupment in a few posts but not written much about it. In EMERY CELLI CUTI BRINCKERHOFF & ABADY, P.C., v. Commissioner, T.C. Memo 2018-55, the issue arises in the collection context. The application of the principle here seems so clearly equitable that I am a bit surprised that the IRS argued against its application. The Court applied equitable recoupment to credit one entity with the employment taxes paid by another. It also relieved the entity of the penalties related to the non-payment of the employment taxes, placing the entity in the same situation it would have been had it made the payments itself.
Read the opinion for the precise details of how it happened, but a law firm lost a partner and gained a partner. In the process, it moved from one business entity to another. Although the new business began operating at the beginning of 1999 (yes, this case goes back to a quarter of employment taxes payable almost 20 years ago), an existing entity paid employment taxes for the quarter that should have been paid by the new entity. In 2006, the IRS questioned the new entity on the non-payment of the employment taxes for the quarter at issue. The entity tried to explain the overlap in entities and the payment by a related entity of the taxes; however, its explanation failed to stop the IRS from making an assessment.
The taxpayer eventually received a CDP notice and requested a hearing. At the hearing, it explained to the Appeals employee what had happened. The Appeals employee wanted a more detailed explanation of the two entities and how they overlapped. It gave the taxpayer 10 days to provide the explanation. The entity failed to provide it within 10 days and the Appeals employee set up the case for issuance of a determination letter sustaining the IRS decision to levy. A detailed letter arrived at Appeals shortly after the Appeals employee set up the case to have the determination letter issued and 11 days before the determination letter was issued. The Appeals employee did not look at the letter, considering the matter closed from their perspective, and the determination letter issued. The taxpayer filed a petition in Tax Court.
In Court, the IRS argued that the standard of review of the determination letter should be abuse of discretion. The taxpayer argued the review should occur on a de novo basis. The Court side-stepped the issue holding that the outcome would be the same under either type of review. The Court found that the principle of equitable recoupment applied and the payments by the overlapping entity should be applied to the entity before it. In discussing the standard of review before getting to the merits of the argument, the Court chastised Appeals for not looking at and considering the detailed explanation provided by the taxpayer. It stated:
First, we note that the administrative record includes not only material that the settlement officer reviewed but also material that was available for his review. See Thompson v. U.S. Dept. of Labor, 885 F.2d 551, 553-556 (9th Cir. 1989); West v. Commissioner, T.C. Memo. 2010-250, slip op. at 11 n.11. Moreover, at the time of Emery PC’s CDP hearing, the Internal Revenue Manual (IRM) instructed Appeals employees conducting such hearings to “[c]onsider information received after the due date for supplying information but prior to issuance of the Notice of Determination/Decision Letter.” IRM pt. 18.104.22.168.4.11(1)(c) (Oct. 30, 2007); see Shanley v. Commissioner, T.C. Memo. 2009-17, slip op. at 15 (noting the de facto extension of time for submitting information arising from the requirement in IRM pt. 22.214.171.124.4.11(1)(c) that an Appeals employee consider information submitted before the issuance of a notice of determination). It is undisputed that Emery PC submitted substantial information and supporting [*22] documents 11 days before the notice of determination was issued and that the settlement officer did not consider the submission. The submission included two letters with extensive attachments. In view of the fact that these materials were available for the settlement officer’s review, and that IRM guidelines instructed him to review them, we find that the two letters and their attachments are part of the administrative record.
The Court then applied the principles of equitable recoupment to the facts of this case.
Element 1: time-barred overpayment
The Court found that the record established that the related entity overpaid its employment taxes and that, at the time of this case, its ability to obtain a refund for the overpaid taxes was barred by the statute of limitations.
Element 2: same transaction, item, or taxable event
The taxpayer argued that the overpayment by the overlapping entity and its own underpayment arose out of the same transaction. The Court commented on the position of the IRS regarding this argument:
Respondent misconstrues what constitutes a taxable event for this purpose. In our view, the taxable event in the case of employment taxes is not the [*27] Commissioner’s assessment of tax but instead the employer’s payment of wages, which in general triggers the employer’s obligation to withhold and/or to pay Social Security taxes, hospital taxes, and income tax withholdings — the employment taxes at issue in this case. See generally secs. 3102, 3111, 3402, 3403. Thus the taxable event here was the payment of wages to the eight employees of the law firm during the latter 75 days of 1Q 1999 (i.e., wage payments made after the first payment of wages on January 15, 1999). The law firm’s employees received wages biweekly and accordingly there were five such payments to seven and then, after the first two payments, eight employees during this 75-day period. Each of the five payments of wages by Emery PC was a separate taxable event triggering an employment tax liability. Thus, strictly speaking, there were 5 taxable events (or 38, if the seven, then eight, employees are disaggregated) in which Emery PC incurred an employment tax liability that was paid by Emery LLP, and for which respondent both seeks to retain the tax paid by Emery LLP and also to collect it from Emery PC. For each of these 5 (or 38) taxable events, in the absence of equitable recoupment, respondent will have collected employment tax twice on the same payment of wages — albeit with respect to 5, or 38, separate taxable events. All of the wage payments were to the same employees during the same taxable period. Cf. Rothensies v. Elec. Storage Battery [*28] Co., 329 U.S. 296 (declining to treat excise taxes paid on battery sales in different taxable years as arising from the same transaction for purposes of equitable recoupment). Thus, the components of the time-barred overpayment and the employment tax liability that respondent seeks to collect in each instance arose from the same taxable event, albeit 5 or 38 of them. Because the employment taxes that respondent seeks to retain and to collect, respectively, arose from the same payments of wages to the same employees during the same taxable period, we conclude that the requirement that the two taxes arise from the same taxable event has been satisfied.
Element 3: inconsistently subjected to two taxes
The Court found that the taxation of the employment tax had occurred twice under inconsistent theories in a manner that satisfied this element.
Because the Court found that all of the elements of equitable recoupment applied, it granted the taxpayer relief on this basis.
After doing so, the Court went on to address the penalties applied and determined that the taxpayer should not be subjected to penalties for failure to pay the employment taxes since the overlapping entity had made those payments. Because the Court was unsure if an exact match existed between the payments made by the overlapping entity and the payments due from the taxpayer, it did not completely rule for the taxpayer. It reserved the possibility that the IRS could show some of the employment taxes remained unpaid.
The application of equitable recoupment to these facts seems logical and prevents an injustice to the taxpayer who otherwise would have had to pay these taxes twice. The objection of the IRS to this outcome is not immediately clear to me but I have not read its briefs. I would have hoped that under these circumstances the IRS would have looked for a way to assist the taxpayer rather than to tax it twice.