Case — Equitable Recoupment

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TL Case Summ

THE QUESTION

Can a taxpayer reduce his tax liability by applying overpayments from prior years under the doctrine of equitable recoupment?

THE DISPUTE

Taxpayer Says: He overpaid FICA taxes from 2002 through 2007 as a result of misclassification of his employee status. He would like to offset his 2008 tax liability with those overpayments using the doctrine of equitable recoupment.

Internal Revenue Service Says: Each year of reclassification is a separate taxable event. The overpayments from 2002 through 2007 were not part of the same transaction, item, or taxable event as the 2008 deficiency, and cannot be used to offset the 2008 liability. The doctrine of equitable recoupment does not apply.

THE LAW

From Internal Revenue Code Section 6214(b): Provides that the Tax Court may apply the doctrine of equitable recoupment to the same extent that it is available in civil tax cases before the District Courts and the U.S. Court of Federal Claims.

From Menard, Inc. v. Commissioner, 130 T.C. 54, 66 (2008): The doctrine of 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.

From United States v. Dalm, 494 U.S. 596, 604-605 (1990): In order to establish that equitable recoupment applies, a party 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.

THE CAUSE OF THE DISPUTE

When you file a tax return and later discover an error, you have specific period of time in which to correct the error. The time limitation is known as the statute of limitations, and for tax purposes is generally three years, though there are exceptions.

In some situations, such as when the statute of limitations results in an inequity—for example, if you pay tax twice on a single transaction—the doctrine of equitable recoupment can provide a remedy. Equitable recoupment was created by judicial decisions, so it’s not part of the tax code. A 1990 court case (Dalm, see “The Law” section above) spelled out the factors that must be present in order for equitable recoupment to apply.

In this case, the taxpayer, a computer technician who worked for a beauty products manufacturing company, was treated as an independent contractor from 2002 through 2007. He filed his tax returns as a sole proprietor, and paid self-employment tax.

When he was laid off in 2008, he applied for unemployment benefits, and the state determined he should have been treated as an employee for the years that he worked. In 2009, the taxpayer amended his 2008 federal income tax return to reflect that he had overstated his FICA tax by reporting self-employment income instead of wages. The IRS reduced his outstanding 2008 tax liability by the amount of the overstatement for that year.

In 2011, when the IRS moved to collect the remainder of the outstanding tax due for 2008, the taxpayer argued that he overpaid taxes from 2002 through 2007 as a result of his employer’s misclassification, and that he should be able to offset his 2008 tax liability with those (now closed) overpayments under the doctrine of equitable recoupment.

The IRS says each year of the taxpayer’s reclassification constitutes a separate taxable event. Therefore, the overpayments from 2002 through 2007 were not part of the same transaction, item, or taxable event as the 2008 deficiency, and the doctrine of equitable recoupment is not applicable.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

 

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

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This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. Although the taxes paid in the time-barred years were paid on the same type of transaction (i.e., compensation received) as in 2008, the overpaid FICA taxes from 2002 through 2007 are separate transactions, separate items, and separate taxable events from the 2008 tax deficiency. Income taxes are levied on an annual basis. Each year is the origin of a new liability and of a separate course of action. The Supreme Court has emphasized that a claim of equitable recoupment will lie only where the government has taxed a single transaction, item, or taxable event under two inconsistent theories, and that is not the case here. The taxpayer filed Form 1040X in 2009. The correct amounts of income tax and FICA tax were assessed by the IRS based on the amended return. As a result, the 2008 taxable income was not subject to two separate types of tax. The fact that a single tax determination may affect the taxes on two transactions does not convert the two transactions into a single one. Therefore, the taxpayer is unable to satisfy the requirement that the overpayment and the deficiency arise from the same transaction. The 2008 tax year is the only year before this court. The correct amount of income tax and the employee’s share of FICA tax were correctly assessed for 2008. No inconsistent legal theory was applied. Therefore, the taxpayer is unable to satisfy the requirement that the income be inconsistently subjected to two taxes, and equitable recoupment does not apply. (Editorial note: This case contains other issues.)
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