Equitable Recoupment
By The doctrine of equitable recoupment applies to both assessment by the IRS (in Section 6501) and refunds by taxpayers (in Section 6511) where the IRS or taxpayer may characterize a transaction, item, or event in a different way in open tax years than it was characterized in a closed year. Inconsistencies between open and closed tax years may whipsaw either the government or the taxpayer. The courts, recognizing potential abuse, have provided a defense against this potential inconsistent treatment through the doctrine of equitable recoupment.
Equitable recoupment was established in the Supreme Court case Bull v. United States, 295 U.S. 247 (1935). As explained in Menard, Inc. v. Commissioner, 130 T.C. 54 (2008), the doctrine of equitable recoupment “allows a litigant to avoid the bar of an expired statutory limitation period [by preventing] an inequitable windfall to a taxpayer or 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.” Id. at 62. To establish equitable recoupment as a defense, a taxpayer must prove:
(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 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. Id. at 62-63.
For example, in Rogers v. United States, 76 F. Supp. 2d 1159 (D. Kan. 1999), the owner of a major league baseball team was denied a bad debt deduction after a co-owner failed to repay a purported loan. The estate of the owner sought a refund of tax paid resulting from the transaction previously treated as a loan. The taxpayer had paid tax on interest payments received in connection with the purported loan. The determination that the purported loan was not a loan meant the taxpayer was whipsawed, having been required to pay tax on amounts that were ultimately determined not to be interest. Accordingly, the court permitted the tax refund despite the expiration of the statute of limitations.
The doctrine of equitable recoupment is a defense to an additional assessment of tax. It cannot be used affirmatively unless an assessment of tax has been made against the taxpayer. Additionally, as noted above, the IRS is able to invoke the doctrine where the government rather than the taxpayer is whipsawed due to the expiration of the statute of limitations.
John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.