Ninth Circuit rejects SOL exception.

The Ninth Circuit, in Parker, 110 F3d 678 (1997), ruled that the IRS could not use the doctrine of equitable recoupment to tax the estate of a surviving spouse when the estate of the first spouse to die incorrectly escaped taxation on a related item and was closed to adjustment due to the statute of limitations (SOL).

Equitable recoupment is the doctrine created by the Supreme Court in Bull, 295 US 247 (1935), which prevents double taxation when invoked by the taxpayer and prevents tax avoidance when invoked by the Service. Equitable recoupment applies when a claim is barred by the SOL: it allows the taxpayer or the IRS to use the time-barred claim as a defense against a timely claim arising from the same transaction. Also, the single transaction must be subject to two taxes based on inconsistent legal theories and must involve a single taxpayer or taxpayers with an identity of interest.

In Bull, estate tax was incorrectly paid on partnership income earned after a partner's death. Later, the Service correctly assessed income tax on the income; the SOL had expired on the estate tax refund claim. Nevertheless, the court applied equitable recoupment to allow the estate tax refund claim to offset the IRS's income tax deficiency, emphasizing that the two claims were part of a single transaction.

The Supreme Court and lower courts have held that if there are two transactions, equitable recoupment cannot apply, even if there is "a factual and arithmetic link" between them (Est. of Harrah, 77 F3d 1122 (9th Cir. 1995)). The scope of equitable recoupment relief must be narrow so as to preserve the time limitations inherent in the SOL; without these limitations, there could be a lifetime adjustment of a taxpayer's taxes.

Parker died in 1971. After she died, her children sued their stepfather, alleging embezzlement of her separate assets prior to her death. Under the parties' settlement, the stepfather created a $325,000 trust, with income to himself for life and the remainder to her children. The stepfather died in 1985 and his estate paid $90,000 in estate tax on the trust's value. The children filed a refund claim in district court, arguing that the trust was not includible in his estate because it was created to settle hostile litigation. Therefore, it was a bona fide sale excludible under Secs. 2036 and 2038.

The Service argued that the trust should have been included in Parker's estate even if it was excludible from the stepfather's estate, because at her death she possessed the claim against him for embezzlement. Since assessment of Parker's estate was time-barred, the IRS claimed equitable recoupment should apply to offset the refund claim from the stepfather's estate against the time-barred assessment of estate tax from Parker's estate. The district court agreed, ruling that there was a single transaction, the taxation of the trust. Also, there was an identity of interests because the children were seeking the $90,000 refund and benefited from a larger inheritance when Parker's estate was not taxed.

The Court of Appeals reversed, ruling that the equitable recoupment requirements were not satisfied and the children were entitled to the refund. The court pointed out that Parker's death and her claim against the stepfather were not the same transaction as his death and the erroneous taxation of his estate. Also, the stepfather, as executor of Parker's estate, never considered the claim against himself. The failure to tax this claim in her estate did not affect the includibility of the trust in his estate. Therefore, there were no inconsistent legal positions taken on the two estates. The court contrasted this situation with Bull, in which the same income was properly includible in the gross estate or as income to the estate, but not both.

In order to not unduly weaken the SOL provisions, the Ninth Circuit in Parker narrowly interpreted equitable recoupment. There must be a single transaction subject to inconsistent legal theories that involves a single taxpayer. Although these requirements are subject to interpretation by the courts, in light of Parker, neither the IRS nor taxpayers can rely on equitable recoupment to claim an amount time-barred by the SOL to offset a timely claim. Consequently, equitable recoupment is an argument of last resort.