1990 act compliance provisions may affect corporate litigation strategies.

• Author: Smith, Carlton M.

1990 Act Compliance Provisions May Affect Corporate Litigation Strategies

1. Introduction

   During the 1980s, Congress focused much of its attention in the tax compliance area on tax shelter investors. In an effort to make playing the audit lottery more painful for them, Congress adopted a series of increasingly severe penalties and applied an enhanced interest rate to tax deficiencies attributable to tax-motivated transactions.

   The tax shelter era was brought to an abrupt halt by the enactment of the passive activity loss provisions, and certain other provisions, in 1986. Consequently, in recent years Congress has had to look to new sources to fill its compliance revenue targets. Publicized reports of foreign corporations paying little tax on their U.S. earnings and U.S. corporations stripping out their earnings through transactions with related foreign entities have resulted in corporations succeeding tax shelter investors as the compliance revenue sources of the 1990s.

   The Revenue Reconciliation Act of 1990 (1*) embodied a number of new provisions designed to encourage corporate tax compliance. The 1990 Act also included provisions making it more expensive to dispute a proposed deficiency and easier for the Internal Revenue Service to gain access to information on audit. This article discusses some of the more significant new compliance provisions and suggests areas in which new audit or litigation strategies might be considered.

2. Enhanced Rate of Interest

   on Large Underpayments

   In 1986, individual taxpayers under audit suffered a blow when Congress amended section 163 to provide for the disallowance of the deduction for interest paid by noncorporate taxpayers on tax deficiencies. The disallowance of such "personal interest" was phased in over several years. (2) By 1990, when 90 percent of "personal interest" was no longer deductible, certain members of Congress averred that corporations similarly should not be allowed to deduct interest on their tax deficiencies. The allowance of the deduction in effect reduced the relative cost of paying interest. The Budget Summit Agreement (3) included a provision to deny deductions for interest paid by C corporations to the IRS on federal income taxes (and other federal taxes, if necessary to meet revenue targets). In the face of some stiff opposition from taxpayers and their advisors, the interest-disallowance provisions were dropped. Instead, the final 1990 tax bill took a different approach: increasing the rate of interest payable by C corporations on "large corporate underpayments." The new provision, in section 6621(c) of the Code, was patterned after the previous section 6621(c), which applied an increased interest rate to underpayments attributable to tax-motivated transactions. (Old section 6621(c) was repealed with respect to returns the due date for which, determined regardless of extensions, was after December 31, 1989.)

   Under new section 6621(c), interest on an underpayment of any federal tax that constitutes a "large corporate underpayment" will carry interest at a rate (the "enhanced rate") that is two percentage points higher than the regular floating rate of interest on tax deficiencies (the "regular rate"). (4) The enhanced rate can only apply for periods beginning after December 31, 1990. For the first quarter of 1991, the regular rate of interest on tax deficiencies is 11 percent per annum. (5) Thus, if section 6621(c) applies, the annual enhanced rate of interest will be 13 percent during that quarter.

   1. "Large Corporate Underpayment"

      A "large corporate underpayment" is defined as an underpayment of a tax by a C corporation for any taxable period if the amount of such underpayment exceeds $100,000. (6) On December 19, 1990, proposed and temporary regulations that elaborate on this definition were issued. (7) Temp. Reg. [section] 301.6621-3T(b)(2)(i) defines an "underpayment of a tax" as the excess of a tax imposed by the Code over the amount of such tax paid on or before the last date prescribed for payment. Thus, if a deficiency in tax is determined during an audit, that deficiency is an underpayment. Similarly, if tax is simply paid late (e.g., the tax shown on a late-filed income tax return is paid at the time of filing or a timely-filed return is not accompanied by the tax shown as due), the amount of tax paid late is also an underpayment. For purposes of this definition, Temp. Reg. [section] 301.6621-3T(b)(2)(i) provides that an underpayment of tax on which section 6621(c) interest is imposed includes tax, previously accrued interest, additions to tax, and penalties. There is substantial doubt, however, whether the regulations can provide for the accrual of section 6621(c) interest on additions to tax and penalties; litigation on this question should be expected.

      Temp. Reg. [section] 301.6621-3T(b)(2)(ii) provides that, in order for section 6621(c) to apply, there must be a "threshold underpayment of a tax" (excluding interest, additions to tax, and penalties) exceeding $100,000 for a single taxable period. In any event, once there is a large corporate underpayment, the enhanced rate applies to the full underpayment, not just amounts in excess of $100,000. In the case of income taxes, the taxable period is a single taxable year; for FICA taxes, it is the calendar quarter. (8)

      Under Temp. Reg. [section] 301.6621-3T(b)(2)(ii), different types of taxes (such as income tax and FICA tax) and amounts that relate to different taxable periods of the same tax are not added together in determining whether the $100,000 threshold is met. (9) Different underpayments of the same type of tax for the same period, however, are aggregated. Thus, based on Example 2 under Temp. Reg. [section] 301.6621-3T(d), if a corporation determines that it has an income tax liability for 1990 of $60,000, but pays the entire $60,000 late and the IRS later determines an additional income tax deficiency for 1990 of $50,000, there is an aggregate underpayment of $110,000 and section 6621(c) applies to the entire $110,000 tax underpayment, plus all accrued interest, additions to tax, and penalties thereon, to the extent not previously paid.

   2. "Applicable Date"

      Section 6621(c)(1) applies only to interest accruing on the underpayment after an "applicable date." Where the regular...