The Tax Court held that a group of lawyers who changed their firm entity type from a limited liability partnership (LLP) to a professional corporation (PC) were entitled, under the doctrine of equitable recoupment, to apply an overpayment of employment taxes made by the LLP for a quarter to an underpayment of employment taxes by the PC for the same quarter.
Background
In May 1998, four attorneys started a law firm as an LLP named Emery, Celli, Brinckerhoff & Abady LLP (Emery LLP). Effective Jan. 1, 1999, Andrew Celli ceased to be a partner, and another attorney, John Cuti, was admitted as a partner. For the first 15 days of January 1999, the firm continued to conduct its operations through the Emery LLP entity, but on Jan. 16, 1999, reflecting the change in the composition of its partners, the firm began operations through a new entity, a professional corporation organized as a C corporation named Emery Cuti Brinckerhoff & Abady PC (Emery PC).
In the first half of January 1999, Emery LLP paid its employees $13,451 in wages. For the rest of the first quarter of 1999, Emery PC paid its employees $45,037. However, the firm's payroll company submitted all the payroll tax deposits for the quarter under Emery LLP's employer identification number (EIN).
The firm timely filed a Form 941, Employer's Quarterly Federal Tax Return, for Emery LLP for the first quarter of 1999 but did not file one for Emery PC. In March 2006, the IRS notified Emery PC that it had not received a Form 941 for the PC for the first quarter of 1999. Emery PC then filed a return for that period, reporting a tax due of $21,885 and claiming a credit for deposits it made of $21,706.
Because all the deposits the firm made in the first quarter had been made under Emery LLP's EIN, the IRS did not credit any of the deposits to Emery PC and assessed a tax due of $21,885 and penalties for failure to file and failure to pay. Through the Taxpayer Advocate Service, the firm's accountant requested that the payments that had been made mistakenly under the LLP's EIN be applied to the PC's liability, but the IRS refused because the limitation period for claiming a refund of the employment taxes had expired.
The IRS afterward issued a notice of intent to levy, and Emery PC requested a Collection Due Process hearing. An IRS settlement officer and Emery PC's attorney had a face-to-face meeting, in which the attorney argued that Emery PC was entitled to a credit, refund, setoff, or equitable recoupment for the asserted liability. The settlement officer, however, found that it would not be appropriate to allow an offset of the LLP's payment deposits against the PC's liability because he had ascertained through his own research that both the LLP and the PC were still active entities.
Upon hearing this, the PC's attorney explained that the LLP had been maintained as an active entity for the purposes of collecting revenues and paying liabilities arising from past work. He also promised to submit a written explanation with supporting documentation. However, the attorney tarried in providing the explanation and documents, and eventually the settlement officer concluded that the proposed levy should be sustained, and he submitted a notice of determination to his manager, who approved it.
After the notice was approved, but before it was issued, the attorney finally submitted to the settlement officer two letters of explanation with extensive exhibits. The settlement officer did not review the letters and exhibits. Instead, he simply issued a notice of determination sustaining the levy 11 days later. The notice stated that Emery PC had failed to provide an explanation and supporting documentation for the continued active status of Emery LLP and that, because Emery PC had not provided an explanation, equitable recoupment was not considered. Emery PC petitioned the Tax Court to review the determination.
The parties' arguments
Emery PC argued that it was entitled, through equitable recoupment or other means, to offset the employment tax liability that the IRS sought to collect with an overpayment of employment tax made by Emery LLP for the same period, even though a refund was time-barred. Without an offset, it claimed that the IRS would have collected the employment taxes for the first quarter of 1999 twice — once through the employment tax deposits made under Emery LLP's EIN and a second time from the proposed levy on Emery PC's property. The IRS countered that the levy was proper because the PC never provided the settlement officer with any proof of its claim that the employment taxes sought from it were duplicative of those already paid by the LLP.
Equitable recoupment
Equitable recoupment is a judicially created doctrine that, under certain circumstances, allows a litigant 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. Equitable recoupment operates as a defense that a taxpayer may assert to reduce the IRS's timely claim of a deficiency, or that the IRS may assert to reduce the taxpayer's timely claim for a refund. When applied for the benefit of a taxpayer, the equitable recoupment doctrine allows a taxpayer to raise a time-barred claim of a tax overpayment as an offset to reduce or eliminate the amount owed on the IRS's timely claim.
Generally, the party claiming the benefit of an equitable recoupment defense must establish that it applies. To do this, the party 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 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 (Menard, Inc., 130 T.C. 54, 62 (2008), rev'd on another issue, 560 F.3d 620 (7th Cir. 2009)).
The Tax Court's decision
The Tax Court held that under the doctrine of equitable recoupment, Emery PC could use Emery LLP's employment tax overpayment for the first quarter of 1999 to offset Emery PC's unpaid employment tax liability for that quarter, finding that the PC had established the four elements for the application of equitable recoupment.
Time-barred overpayment: The court stated that it was "obvious" that Emery LLP had an overpayment of tax for the first quarter of 1999 because it paid nearly twice as much in tax as it had paid in wages. It further found that since the LLP had not filed a refund claim at the time of trial, and, for the first quarter of 1999, the LLP had deposited the employment tax and filed the Form 941 in 1999, the time limitations (the later of two years from the payment of the tax or two years from the filing of the return for the period) in Sec. 6511(a) clearly barred a refund for the first quarter of 1999.
Same transaction, item, or taxable event: Emery PC contended that Emery LLP's time-barred overpayment and Emery PC's underpayment of employment tax for the first quarter of 1999 arose out of the same transaction or taxable event. The IRS, to the contrary, maintained that there were two taxable events: (1) its assessment of employment taxes in May 1999 based on Emery LLP's "voluntary payment"; and (2) its assessment of employment taxes in May 2006 based on Emery PC's self-reported liability on the Form 941 it filed in March 2006.
The Tax Court stated that the IRS had misconstrued what a taxable event is for the purposes of employment taxes, finding that the event is not the IRS's assessment of tax but instead the employer's payment of wages, because the payment of wages generally triggers the employer's obligation to withhold and/or pay employment taxes. Therefore, the taxable event in this case was the payment of wages to the eight employees of the law firm during the latter 75 days of the first quarter of 1999 (i.e., the wage payments made after the first payment of wages on Jan. 15, 1999).
Thus, the court determined that, since there were five payments of wages during this period, there were five separate taxable events. In addition, all the wage payments were to the same employees during the same tax period. Consequently, the components of the time-barred overpayment and the employment tax liability that the IRS sought to collect in each instance arose from the same taxable event. According to the court, because the employment taxes that the IRS sought to retain and to collect, respectively, arose from the same payments of wages to the same employees during the same tax period, the requirement that the two taxes arise from the same taxable event had been satisfied.
Wages inconsistently subject to two taxes: The Tax Court concluded that this element was met because the IRS was attempting to make the law firm pay tax twice on the wages paid during the latter 75 days of the first quarter of 1999 on inconsistent theories. The court found that Emery LLP had paid employment taxes on the wages on the theory that it had paid the wages to the law firm's employees during the period, and the IRS sought to collect employment taxes on the same wages again from Emery PC on the inconsistent theory that Emery PC was the payer of the wages.
Identity of interest: Under the doctrine of equitable recoupment, a taxpayer will in some instances be permitted to recoup an erroneously paid tax that the taxpayer did not pay. However, for this to be allowed, the actual payer of the tax and the person recouping the tax must have a sufficient identity of interest that they may be treated as a single taxpayer.
The court determined that there was an identity of interest because, although Emery LLP and Emery PC were separate legal entities with their own EINs during the first quarter of 1999, they were owned by the same four individuals, who would bear the burden of the double taxation.
Reflections
While the IRS may have been in the right from a purely legal standpoint, it seems unjust that the taxpayers, after 10 years, would have to pay such a steep price for an innocent mistake. This case demonstrates perfectly why the courts have developed equitable remedies to alleviate the unfairness that a mechanical application of the law can sometimes cause.
Emery Celli Cuti Brinckerhoff & Abady, P.C., T.C. Memo. 2018-55
