Law Firm Can Equitably Recoup Employment Taxes Erroneously Paid by Related Entity

(Parker Tax Publishing May 2018)

The Tax Court held that a law firm was permitted to offset an employment tax liability by the amount of employment taxes paid on the same wages for the same time period by a related firm due to an error by the firm's payroll services provider. The court held that the firm established the elements of equitable recoupment because an action for the overpayment was time barred, both the overpayment and the IRS's levy arose from the payment of wages to the same employees during the same time period, the payment of wages would otherwise be subject to tax twice on inconsistent theories, and there was sufficient identity of interest between the taxpayer and the related entity. Emery Celli Cuti Brinckerhoff & Abady, P.C. vs. Comm'r, T.C. Memo. 2018-55.

Background

In 1998, four attorneys practiced together in a firm called Emery, Celli, Brinckerhoff & Abady, LLP (Emery LLP). As of January 1, 1999, Andrew Celli ceased to be a partner and John Cuti was admitted as a partner. For the first 15 days of January, the firm continued as Emery LLP. On January 16, 1999, the firm began operating through a new entity, Emery Cuti Brinckerhoff & Abady, P.C. (Emery PC). The firm stopped conducting operations through Emery LLP as of January 16, 1999, but the LLP was maintained for the purpose of collecting revenues, satisfying liabilities, and distributing profits.

Emery LLP paid wages to employees totaling around $13,400 for the first quarter of 1999, and the balance of the employees' wages for that quarter were paid by Emery PC. Emery PC paid over $45,000 in wages and made employment tax deposits with the Electronic Federal Tax Payment System during the first quarter of 1999 (1Q 1999). However, the firm's payroll services provider erroneously made the deposits under Emery LLP's employer identification number (EIN). Emery PC's records showed six deposits totaling approximately $26,000, which were essentially identical the IRS's records for deposits by Emery LLP. The IRS's records showed no deposits by Emery PC for 1Q 1999.

Emery LLP timely filed a Form 941, Employer's Quarterly Federal Tax Return, reporting an employment tax liability for 1Q 1999 of approximately $26,000. Emery PC did not file a Form 941 for 1Q 1999 until 2006, after having been contacted by the IRS. For the three remaining quarters of 1999, Emery LLP filed no Forms 941 and reported no employment tax liabilities. For those quarters, Emery PC filed Forms 941 and made deposits exceeding $25,000 for each quarter.

In March 2006, the IRS notified Emery PC that it had no record of Emery PC having filed a Form 941 for 1Q 1999. Emery PC's accountant, David Grant, prepared a Form 941 for 1Q 1999, which he submitted on March 24, 2006. The Form 941 reported employment tax due of around $21,800 and claimed a credit for deposits of $21,700 by Emery PC. The IRS assessed the $21,800 in employment taxes, but did not credit Emery PC with the $21,700 of deposits claimed. The IRS also assessed additions to tax for failure to file a return, failure to pay, and failure to deposit tax due. The IRS began sending collection notices to Emery PC for these amounts.

Grant submitted to the IRS Taxpayer Advocate Service a Form 941c, Supporting Statement To Correct Information, for Emery LLP's 1Q 1999, claiming adjustments for Emery LLP's overpayment of employment taxes. The Form 941c reported that Emery LLP had previously reported wages of just over $80,000 for 1Q 1999, but that its correct wages and liability for that period were $13,400 and $3,800 respectively. Grant therefore requested that a $22,100 credit be applied to Emery PC's employment tax liability for 1Q 1999. The IRS responded that no credit could be applied because the three year statute of limitations period for a refund had expired.

The IRS then issued a Letter 1058, Final Notice - Notice of Intent to Levy and Notice of Your Right to a Hearing. Emery PC requested a hearing. It contended that the 1Q 1999 tax liability had previously been paid by Emery PC or a related entity and it was therefore entitled to either a credit, refund, setoff or equitable recoupment. Emery PC also argued that the penalties should be abated for reasonable cause. A settlement officer (SO) determined that, because Emery PC and Emery LLP were both still active entities, an offset would not be appropriate.

Emery PC explained to the SO its reasons for maintaining the active status of both entities and promised to provide a written explanation with supporting documentation within a week. Ten days after that deadline, with no explanation provided, the SO concluded that the proposed levy should be sustained. Emery PC's attorney eventually submitted two letters with extensive exhibits explaining the payroll services provider's error and the reasons for maintaining both Emery LLP and Emery PC as active entities. The SO did not review these letters and issued a notice of determination sustaining the levy.

The notice concluded that Emery PC had not shown that employment tax deposits had been misapplied to Emery LLP because Emery LLP was still active, and Emery PC failed to explain or provide supporting documentation for the continued active status of Emery LLP. The notice explained that Emery PC's claim for a credit for the time barred refund of Emery LLP's employment tax overpayment through equitable recoupment was not considered. The notice did not address penalty abatement. Emery PC petitioned the Tax Court for review.

Analysis

The doctrine of equitable recoupment allows a taxpayer to raise a time barred claim of a tax overpayment as an offset to reduce or eliminate an amount owed if certain elements are established. The taxpayer must show that (1) the overpayment is time barred, (2) the time barred overpayment arose out of the same taxable event as the deficiency before the court, (3) the taxable event has been inconsistently subjected to two taxes, and (4) if there is more than one taxpayer involved, there is sufficient identity of interest between them that they should be treated as one.

Emery PC argued that it was entitled through equitable recoupment to offset its employment tax liability with the overpayment by Emery LLP for the same period, the refund of which was now time barred. According to Emery PC, the IRS would otherwise be entitled to twice collect the employment taxes for 1Q 1999. The IRS argued that equitable recoupment did not apply because Emery LLP's overpayment and Emery PC's underpayment for 1Q 1999 did not arise out of the same taxable event. According to the IRS, the assessment of employment taxes in 1999 based on Emery LLP's payment and the assessment based on Emery PC's liability it reported on Form 941 in 2006 were two separate taxable events.

The Tax Court held that Emery PC was entitled to equitably recoup Emery LLP's employment tax overpayment for 1Q 1999 to offset Emery PC's unpaid employment taxes for that period. First, the court found that there was a time barred overpayment because Emery LLP paid $13,400 of wages and $26,000 of employment taxes for 1Q 1999, and the overpayment occurred more than three years ago.

Next, the court found that there was a single taxable event - the payment of wages. In the court's view, the taxable event in an employment tax case was not the assessment but rather the payment of wages because the payment of wages triggered the employment tax obligations. The court found that in this case the taxable event was the payment of wages to the firm's employees during the latter 75 days of 1Q 1999 (i.e., wages paid after January 15, 1999). In the absence of equitable recoupment, the IRS would have collected tax twice on the same wages, as all of the wages were paid to the same employees during the same period.

The Tax Court then found that the third and fourth elements were also satisfied. The payment of wages would be taxed twice on inconsistent theories because Emery LLP paid employment taxes as the payor of wages, and the IRS was seeking to collect employment taxes from Emery PC on the theory that it was the payor of those same wages during the same period. Identity of interest was also present because the court found that, although Emery LLP and Emery PC were separate legal entities with distinct EINs, each was owned by the same four individuals. Consequently, the burden of double taxation would be borne by the same individuals.

With respect to penalties, the Tax Court concluded that there was reasonable cause for abatement because Emery PC exercised ordinary business care and prudence to ensure that a Form 941 for 1Q 1999 was timely filed and its employment taxes were paid, albeit under an incorrect EIN.

For a discussion of the doctrine of equitable recoupment, see Parker Tax ¶261,180.50.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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