Justice Holmes famously said that people “must turn square corners when they deal with the government.” It is no coincidence that he said that in this 1920 tax case. Tax law has many sharp corners that frustrate both taxpayers and the IRS alike. For an example of where the sharp corners of procedure caused the IRS to lose a $10 million assessment, see Philadelphia-Reading Corp. v. Beck, 676 F.2d 1159 (3rd Cir. 1982).
But equity can sand down some of those sharp corners. Last week's post looked at the innocent spouse case of the Commie L. Minton a.k.a. Connie L. Keeney v. Commissioner, T.C. Memo. 2018-15 (Feb. 5, 2018). That case illustrated how Congress had inserted a statutory command for the IRS and the Tax Court to use equity to relieve a spouse of an otherwise jointly owed liability. This week, the case of Emery Celli Cuti Brinckerhoff & Abady, P.C. v. Commissioner, T.C. Memo. 2018-55 (Apr. 24, 2018), teaches another lesson about equity in the Tax Law. Here, there is no Congressional command to use equity. Instead, the Tax Court uses a long-standing principle of equity created and apply by the courts. It is called equitable recoupment.
There is a litigation boutique law firm in New York. Until mid-January 1999 it was called Emery, Celli, Brinckerhoff & Abady, LLP (“the LLP firm”). In mid-January 1999 it re-organized into Emery Cuti Brinckerhoff & Abady, P.C. (“the PC firm”) and obtained a new EIN. I have no idea why they ditched the commas in their title. I note they at least kept the reverse alpha order of names, probably so the name would still match their url (here's their current website) and so avoid having to invest in a new web presence. When the firm made the switch in 1999 it kept the LLP firm’s accounts active, to collect revenue, satisfy liabilities and distributed profits related to past work. Then in 2004, the law firm switched back to the LLP firm title and EIN (still leaving out the commas---must be a fashion thing), but still kept the PC firm’s accounts open and operational to wind up obligations related to past work.
For the first half of January 1999, employees were paid from the LLP firm’s accounts. After that, employees were paid from the PC firm’s account. In all cases, the law firm made the proper employment tax and trust fund tax payments. At the end of the first quarter of 1999, however, the firm’s payroll provider goofed up and filed a 941 using the LLP firm's EIN, reporting all payments as coming from that firm’s account. The provider did not file a 941 on behalf of the PC firm. That error caused the mess that resulted in an audit, a protest, Tax Court litigation...and this blog post!
To the IRS this looked as though there were two employers, one of whom properly filed returns and made payments and one of whom had not filed any 94’a for the first quarter of 1999 even though it had obtained an EIN. So, years later, in 2006, the IRS contacted the PC firm and asked why it had not filed a 941. The PC firm immediately filed the 941, reported its correct employment tax liabilities and claiming a credit for the payments it had made, but which had erroneously been reported to the IRS as having come from the LLP firm.
The IRS assessed the taxes reported on the PC firm’s 941 but refused to credit the PC firm with the deposits that had previously been credited to the LLP firm. From the IRS perspective, these were two separate employers and to credit the deposits made by the LLP firm would just create an unpaid liability based on the LLP firm’s 941. From the law firm’s perspective, it was just one employer and it had actually paid what it was supposed to pay. The error was an error in form, not substance.
Lest you think too badly of the IRS, remember that one really common move that non-compliant taxpayers make is to obtain multiple EINs for the same business. That way they can isolate the unpaid liabilities in a taxpaying entity that has no assets. And remember, this law firm was basically operating under two EINs during this entire time, one for the LLP firm and one for the PC firm. The LLP firm had resumed making payroll in 2004. While the law firm had legit reasons for doing this, that may not have been apparent to the IRS personnel charged with collected employment taxes.
In an attempt to fix the problem, the law firm went to the National Taxpayer Advocate who advised it to amend the LLP firm’s 941, using Form 941c (“Supporting Statement To Correct Information”). Turns out that was bad advice. The Form 941c Instructions themselves tell you: “Generally, you may make an adjustment only within three years of the return due date or the date the return was filed, whichever is later.” The three year limitation period to adjust first quarter 1999 returns started on April 15, 2000. §6501(b)(2). That means the period ended on April 15, 2003. So 2006 was waaaay to late to make adjustments. The first quarter 1999 was long closed.
The IRS proceeded to try and collect the PC firm’s outstanding liability for first quarter 1999. Being a litigation boutique firm, the PC firm knew better than to represent itself and so lawyered up with the noted tax controversy firm Kostelanetz & Fink. When the IRS sent out the CDP notice, you bet the PC firm properly invoked its Collection Due Process rights! It’s counsel told the sad story to the Settlement Officer and promised to substantiate the story with written submissions by a certain date. The date passed. Counsel then promised to get the materials to the SO a week later. That date also passed by. Ten days after the second missed deadline, the SO prepared a recommendation. One month after that, the SO’s supervisor approved the recommendation. Only then, after the approval but before issuance of the Notice of Determination (NOD), the PC firm dumped a bunch of information on the SO. The SO ignored that information, sent out the NOD, and the taxpayer petitioned Tax Court for review. They drew Judge Gale.
In Tax Court the taxpayer argued that the doctrine of equitable recoupment should allow the PC firm to be credited with the LLP firm’s payments. Judge Gale has an interesting discussion about the scope and standard of review here, but he ultimately concludes because the facts are so clear and could have been clear had the SO read the data dump, the SO’s decision should be reversed under even the abuse-of-discretion standard.
The most interesting aspect of the opinion is the discussion about equitable recoupment.
Equitable recoupment is a special type of setoff. It requires that the parties have mutual debts that arise from the same "transaction, item or taxable event" that is being subject to inconsistent tax treatment. United States v. Dalm, 494 U.S. 596, 608 (1990). See also Rothensies v. Elec. Storage Battery Co., 329 U.S. 296, 300 (1946)("amount of [the] tax collected on the wrong theory should be allowed in recoupment against an assessment on the correct theory").
Outside of tax, equitable recoupment is a defense which is usually raised by a debtor against a creditor pursuing collection. Since the special process for litigating tax claims forces the taxpayer to pay first and sue for refund rather than making the government sue to collect the tax, the doctrine is often invoked in tax cases in a refund suit. Here, however, the CDP process allowed this taxpayer to invoke the defense in what is the normal way outside of tax law.
Equitable recoupment is a judge made doctrine. It’s an equitable doctrine. Why does the Tax Court think it has the authority to apply it? For years, in fact, the Tax Court did not think it that equitable power because it could only decide the tax year before it and the defense required an evaluation of a time-barred tax year. The Tax Court changed it’s mind and gives really good explanations for why in a series of cases: Estate of Mueller v. Commissioner, 101 T.C. 551 (1993); Estate of Bartels v. Commissioner, 106 T.C. 430 (1996); and Estate of Branson v. Commissioner, T.C. Memo. 1999-231. Basically, the Court says that for any case over which it has jurisdiction, it has all the equitable powers of any other federal court. The 9th Circuit upheld that reasoning in In Estate of Branson v. Commissioner, 264 F.3d 904 (9th Cir. 2001) where it synthesized case law into the following elements for asserting the defense of equitable recoupment:
1. The same “transaction, item, or event” must be subject to two taxes;
2. The two taxes must be inconsistent in the sense that the Tax Code authorizes only one tax;
3. The tax sought to be recouped must be time barred;
4. The party seeking relief must be the same party or sufficiently related to the party who was subject to the first tax treatment of the transaction, item, or event;
In this case, Judge Gale does a nice job explaining the doctrine and applying it to the facts to conclude that equity here should not permit the IRS to collect a tax that it had, in substance, already collected from the same taxpayer for the same transaction. Judge Gale also finds that the law firm acted reasonably and so was entitled to abatement of penalties. However, there were some small discrepancies in the numbers and so Judge Gale concluded that to the extent the LLP firm’s first quarter PC firm’s reported payments were less than the PC firm’s actual obligations, the IRS could collect. He then told the parties to go figure that out under Rule 155.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.