Equitable recoupment doctrine applies to employment tax deposit

The Tax Court allowed a law firm to apply the equitable recoupment doctrine to an employment tax deposit that was erroneously applied to a related entity.

Facts: In mid-January 1999, a New York law firm, Emery Celli Brinckerhoff & Abady, operated as a limited liability partnership (Emery LLP). That month, the firm had a change of partners and reorganized as a professional corporation (Emery PC). Although the firm ceased operations under the LLP, it maintained the entity for collecting revenues, satisfying liabilities, and distributing profits for past work. The firm’s payroll service provider erroneously submitted employment tax deposits totaling $21,706 for the entire first quarter of 1999 under Emery LLP’s employer identification number (EIN).

In March 2006, after being notified by the IRS that it had no record of ever receiving a Form 941, Employer’s Quarterly Federal Tax Return, for Emery PC for the first quarter of 1999, Emery PC filed one, showing a credit for employment tax deposits of $21,706 in deposits made seven years earlier, against employment taxes due of $21,885. In response, the IRS assessed the $21,885 but did not allow the credit. It also assessed additions to tax under Secs. 6651(a)(1) and (2) for failure to file and failure to pay, as well as a penalty under Sec. 6656(a) for failure to deposit taxes.

Emery PC then submitted Form 941c, Supporting Statement to Correct Information, to the IRS Taxpayer Advocate Service, claiming an adjustment for Emery LLP’s overpayment of employment taxes. The IRS refused the adjustment and informed the law firm that it could not credit the LLP’s overpayment to the PC’s liability because the three-year statute of limitation for claiming a refund of the LLP’s tax payments had expired.

The IRS notified Emery PC of its intent to levy a deficiency, and Emery PC requested a Collection Due Process hearing. At the hearing, Emery PC again requested that the IRS offset its employment taxes owed with those that had been paid erroneously under Emery LLC’s EIN. The IRS settlement officer found it would not be appropriate to do so because both entities were still active. Upon hearing his decision, Emery PC’s counsel explained to the settlement officer the reasons for maintaining the active status of both entities and promised to provide a written explanation with supporting documentation. Ten days later, Emery PC’s counsel indicated that the written explanation and documentation would be provided in a week.

Emery PC’s counsel, however, did not submit the promised written explanations on time. A month after the deadline, the IRS settlement officer submitted a request to his supervisor to approve a notice of determination to sustain the levy, which was approved. After the approval of the notice of determination, but 11 days before it was issued, Emery PC’s counsel submitted two letters with extensive exhibits. The settlement officer did not review the letters. Emery PC timely petitioned the Tax Court for review.

Issues: Emery PC argued that the levy should not proceed because it was entitled to offset the employment tax liability with the overpayment by Emery LLC through equitable recoupment. Equitable recoupment, a judicially created doctrine, allows taxpayers to avoid the bar of an expired statutory limitation period. The doctrine prevents an inequitable windfall to a taxpayer or to the government that would otherwise result from the inconsistent tax treatment of a single transaction, item, or event affecting the same taxpayer or a sufficiently related taxpayer.

For equitable recoupment to apply, a taxpayer must establish that (1) the overpayment or deficiency for which recoupment is sought by way of offset is barred by an expired period of limitation; (2) the time-barred overpayment or deficiency arose out of the same taxable event as the overpayment before the court; (3) the taxable event has been inconsistently subjected to two taxes; and (4) there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.

Holding: The Tax Court held the settlement officer abused his discretion in failing to consider Emery PC’s letters and the supporting documentation it provided after the hearing even though they were submitted late. The court further held that Emery PC established all of the elements of equitable recoupment and could recoup Emery LLP’s employment tax overpayment for the first quarter of 1999 to offset its unpaid employment taxes for that period. However, to the extent that Emery PC’s underpayment exceeded Emery LLP’s overpayment of employment tax for that quarter, the IRS’s determination to collect the tax by levy was upheld.

• Emery Celli Cuti Brinckerhoff & Abady, P.C., T.C. Memo. 2018-55

— By Maria M. Pirrone, CPA, J.D., LL.M., associate professor of taxation, St. John’s University, Queens, N.Y.