If employment taxes are paid by one legal entity but incorrectly reported to the IRS for another legal entity, can the entity that paid the taxes get credit for the payment? The IRS said ‘no;’ the U.S. Tax Court said ‘yes.’ The case is E.C.C.B.A. v. Commissioner, T.C. Memo. 2018-55.
Facts & Procedural History
The case involved a law firm. It originally operated as a partnership through Jan. 15, 1999 and was taxed as a partnership. Beginning on Jan. 16, 1999, it operated under a corporate entity and elected to be taxed as a professional corporation.
The former partnership entity was maintained for the purpose of collecting revenues, satisfying liabilities, and distributing profits related to past work. The new corporation carried on the firm business beginning on Jan. 16, 1999.
The new corporation made employment tax payments for the first quarter of 1999, but its payroll tax returns were reported using the old partnership entity’s employer identification number. Thus, the IRS credited the corporations employment tax payments to the former partnership entity.
In 2006, nearly a decade later, the IRS asked the corporation to file its first quarter employment tax return for 1999. The taxpayer provided the return and sought a credit for the employment taxes credited to the partnership in error.
The IRS steadfastly refused to credit the corporation for its payments and even imposed penalties. This led to the tax dispute in the court case.
IRS: No Credit Due to Ongoing Business
The IRS Office of Appeals sustained the collection for these taxes despite the clear evidence that the case involved a simple error. Appeals even sustained the penalties.
The taxpayer raised the equitable recoupment defense during the appeals process. Appeals rejected the equitable recoupment defense believing that it would not be appropriate to offset the employment tax liability for one entity given that the other entity, the partnership in this case, was still an active business.
The IRS raised a different theory during the litigation and the court did not decide the case based on whether the partnership business was ongoing. The court based its decision on equitable recoupment.
Equitable Recoupment, Generally
Equitable recoupment is a judicial doctrine that can be used to correct an error from a prior year that cannot not be fixed given the time period for fixing the error having passed.
As explained by the court, equitable recoupment 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.
It is intended to prevent an inequitable windfall to a taxpayer or to the government resulting from the inconsistent tax treatment of a single transaction, item, or event affecting the same taxpayer or a sufficiently related taxpayer.
This is not a new concept. It is however one that is sometimes difficult to apply. The “single transaction, item, or event” can be particularly difficult to apply. The court case address this very issue.
The Single Taxable Event Requirement
What counts as a single taxable event?
The IRS argued that this case involved two taxable events: (1) the assessment of employment taxes in May 1999 based on the partnership’s voluntary payment and (2) the assessment of employment taxes in May 2006 based on the corporation self-reported liability on the Form 941 it filed in March 2006. Thus, according to the IRS, the focus is on the assessment or recording the amounts on the IRS’s books. With this view, the taxpayer would not qualify for equitable recoupment.
The court reached a different conclusion. It concluded that there was only one taxable event–namely, the wages paid to the employees that were subject to employment taxes. Thus, the action that triggered the tax is what is to be considered. With this view, there was only one taxable event and the taxpayer was entitled to equitable recoupment.
Time barred overpayments can be difficult to fix with the IRS. This court case is evidence of that. But beyond the hassle of fixing these issues, the court case provides an opportunity to reconsider cases were equitable recoupment could apply.