Equitable Recoupment a Timeless Remedy

An amendment to IRC § 6214(b) included in the Pension Protection Act of 2006 empowers the Tax Court to apply equitable recoupment to offset overpayments of hospital insurance taxes (the Medicare portion of FICA) against income tax deficiencies, according to the court’s ruling in Menard Inc. v. Commissioner . Although the Tax Court lacks original jurisdiction over deficiency and overpayment claims for Medicare taxes imposed under IRC §§ 3101 and 3111, its power to use equitable recoupment is ancillary to its original jurisdiction over a deficiency redetermination.

In earlier rulings, the court agreed with the IRS that compensation paid by Menard Inc. to President and CEO John Menard, who was also an 89% shareholder, was unreasonable and actually a disguised dividend. The corporation owed an income tax deficiency to the extent that Mr. Menard’s compensation was not deductible as an ordinary business expense. Mr. Menard was assessed personal deficiencies on reimbursed expenses that were found unreasonable and on constructive receipt of interest income on loans he made to the corporation.

The deficiency against the corporation totaled $5,720,334 plus a penalty of $188,295, and Mr. Menard was assessed a deficiency of $921,491 plus a penalty of $184,298. The taxpayers objected to the final computation of tax due, contending the corporation and Mr. Menard were each due a credit of $196,845, the amount of Medicare taxes each paid on the wage income now recharacterized as constructive dividends. By the time rulings were issued in Menard I (TC Memo 2004-207) and Menard II (TC Memo 2005-3), the statute of limitations for filing a refund claim on the overpaid Medicare taxes had expired with respect to both taxpayers

The doctrine of equitable recoupment allows a litigant, under certain circumstances, to avoid the bar of a statutory limitations period. The factors outlined in Estate of Mueller (101 TC 551) require: (1) that the otherwise time-barred overpayment is sought as an offset; (2) the overpayment arises out of the same transaction, item or taxable event as the overpayment before the court; (3) the transaction, item or taxable event has been inconsistently subjected to two taxes; and (4) if the transaction, item or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.

The IRS did not dispute the amount of the overpayment or whether the elements of an equitable recoupment claim were present. The court rejected the Service’s contention that the court lacked authority to apply the doctrine. The court said legislative history of the amendment to section 6214(b) showed a clear intent to empower the Tax Court to use equitable recoupment. The Service’s “narrow construction” of the statute would be inconsistent with the policy of preventing “an inequitable windfall to a taxpayer or the Government that would otherwise result from the inconsistent tax treatment of a single transaction, item, or event.”

Menard Inc. v. Commissioner , 130 TC no. 4

Prepared by JofA staff member Jeffrey Gilman , J.D.