Equitable Recoupment Applied in Collection Due Process Case

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. (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. 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.




Summary Opinions for the weeks of July 4th and July 11th

Special double feature this week.  Summary Opinions will cover items we did not otherwise cover in the previous two weeks.

  • IRS has announced that ITINs will now only expire if not used on tax returns for five consecutive years.  They used to expire after five years.
  • From Accounting Today, a story on the TIGTA Report regarding the Service’s poor handling of amended tax returns.   TIGTA found about 20% of the amended returns had erroneous refunds issued.  On the bright side, four out of five didn’t .  That would have landed you a solid B- in college; enough to return the following semester and continue drinking.
  • From Jack Townsend’s Federal Tax Crimes Blog, a write up of US v. McBride, where a lawyer was indicted for tax obstruction, and the prosecution requested the indictment be sealed.  Jack uses the word skullduggery, which is pretty awesome, but the post generally covers when indictments should be sealed and the reasons that, in general, they should not.
  • In Public.Resource.org v. US, the Northern District of California has dismissed the Government’s motion to dismiss the FOIA request of Public.Resource.org for all types of nonprofits’ Form 990s in machine readable format.  The Feds claimed that FOIA is trumped by the Code sections dealing with the release of Forms 990.  The Yes We Scan organization is able to fight another day as the Court found that there was no basis for the Service’s position, and the position would undermine FOIA.
  • The Frank Sawyer Trust of May 1992, which we very briefly mentioned in SumOp before, requested the Tax Court reconsider its prior holding that it was liable as a transferee for tax debts of entities it had held.  The two items in dispute were whether the IRS should apply equitable recoupment for estate tax overpayments in the settlor’s wife’s estate, and if the trust should be responsible for the penalties imposed on the entities.  Terribly oversimplified, the same income tax issue giving rise to the tax debt also caused the trust to be able to sell the entities at higher prices.  Those entities were in the spouse’s estate, and the resulting tax inflated the entities value and arguably a refund of estate tax due on that amount.  The Court stated the test for recoupment as:


[t]o apply equitable recoupment, the taxpayer must prove the following elements: (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 transaction, item, or taxable event as the overpayment or deficiency 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.


Only points two and three were in dispute.  The Court found that income and estate tax can be imposed on the same item and that the Service was inconsistently treating the two taxes arising from that same item.  As to the penalties, the actions giving rise to the penalties occurred months after the sale by the trust.  The Court found the Service failed to evidence the connection between the trust and the inappropriate acts, and declined to impose the penalties on the taxpayer.  An interesting case, and one that I suspect will be appealed – again (it has already gone up to the First Circuit at least once).

  • In Heckman v. Comm’r, the Tax Court has held that the extended six year statute of limitations applies for assessment on a taxpayer when the taxpayer receives a distribution from a disqualified ESOP in an amount exceeding 25% of his gross income for the year.  Section 6501(a) imposes the general three year statute, but that can be extended under Section 6501(e)(1)(A) to six years when a taxpayer makes an omission on his return in an amount that is greater than 25% of the amount of gross income stated on the filed return (As I’m sure you will all remember, this provision has received a lot attention over the last few years regarding inflated basis transactions).  If you adequately disclose the transaction or item, the normal three year statute still applies.  The disclosure must be legit though, and can just be you yelling it at an IRS building as you drive by.  The Court found the possible verbal disclosure some years later, and the return of a related entity that had some clues as to the ESOP termination were insufficient disclosure, and allowed the six year statute.  This situation was fairly egregious, and the same individual controlled all aspects of the entities, ESOP and his personal returns.  But what about the situation where the individual did not know his ESOP distribution was not properly tax deferred, or perhaps were an IRA rollover is not valid for reasons outside the taxpayer’s control?  Probably the same result, as the statute speaks only to “omits from gross income”, and has no language regarding knowledge or intent.  See Benson v. Commissioner.  I would still research the issue, and try to come up with a good argument, especially if there was no reason your client should have known about the omission.
  • Big Mo Vaughn has struck out with the Tax Court (much like all his plate appearances with the Mets at the end of his career – horrible acquisition by then GM Steve Phillips, almost as bad as Mr. Phillips decision to have an affair with a twenty-something-year-old intern at ESPN). The Court found he did not show reasonable cause for failure to file his tax return and failure to pay his taxes where there was not evidence if he even asked his accountant or financial advisor if it had been done.  Unfortunately, Mo’s financial advisor apparently stole close to $3MM from him during this same time period.  In a clever argument, Mo argued this caused him to be “disabled”, which was in line with a bankruptcy case, Am. Biomaterials Corp, 954 F2d 919, out of the Third Circuit.  Unfortunately, the Tax Court sided with Valen Mfg. Co. v. US, 90 F3d 1190, out of the Sixth Circuit, which held  in Am. Bio the CEO and CFO were the bad actors, making it impossible for the corporation to comply.  Whereas in Valen, the bookkeeper failed to file, but the executives remained able to review the bookkeepers actions.  The Tax Court said Mo was more like the executives in Valen, who could have questioned his crook of a financial planner.