More than arithmetic: common errors in calculating interest on deficiencies.

• Author: Persky, Tom E.

During the past several years, tax executives have been forced to spend increasing amounts of time on matters relating to the calculation of interest on tax deficiencies. Although the mechanics of an interest calculation may seem trivial when compared with the complexity associated with the determination of an underlying tax liability, the issues are not simple. Perhaps more important, the amounts at issue are staggering. The Internal Revenue Service assesses and collects approximately $6 billion in interest each year. In the corporate context, the IRS collects as much interest as tax. Nonetheless, matters relating to interest computation attract precious little attention.

At the same time, it is widely known that both the IRS and taxpayers frequently make errors in the calculations. To deal with this problem, accounting firms, law firms, and others have actively marketed consulting services to assist taxpayers in (1) calculating interest with respect to current controversies, and (2) filing refund claims for previously settled years. In some cases, these services have been provided under contingent fee arrangements. As evidenced by the proposed changes to Circular 230, these contingent fee arrangements are the subject of some controversy. It is fair to conclude, however, that taxpayers owe a debt to those who initially identified the opportunities for correcting IRS calculation errors.(1) Without the successes of the pioneers in the field, taxpayers would simply be unaware of the potential for significant savings. Some practitioners, however, wrap their practices in mystery. While their clients appreciate the magic they perform in obtaining previously undiscovered refunds, neither the substantive nor procedural tax rules should be secret.

This article endeavors to explain and illustrate the rules on interest computation. In addition to identifying common interest problems, the article opens a forum on the subject. To the extent taxpayers or practitioners wish to provide additional examples of common problem areas, the author commits to respond to the submitted items.(2)

More than Getting the Arithmetic Right

At first glance, interest calculations are seemingly straightforward ministerial acts. In fact, if the correct starting and ending dates are known, commercially available tax interest software makes the matter relatively simple.(3) It is in identifying the correct starting and ending dates, however, that the problems and opportunities arise.

As in the case of the substantive rules, the rules regarding the calculation of interest are scattered throughout the tax law. Some of the rules are in sections 6601 and 6611 -- the specific Internal Revenue Code sections on underpayment ("debit") and overpayment ("credit")(4) interest. Some are found elsewhere in the Code. Some are in rulings and regulations, some in legislative history, and some are creatures of administrative practice. The more one looks at the interest rules, the more one becomes convinced that there may be as much complexity and uncertainty in these rules as exists in the substantive tax provisions.

Layered over the complexity of the interest rules is the complexity of a particular taxpayer's factual context. Large taxpayers rarely provide simple factual settings. Instead, it is common to see multiple years in an examination, carrybacks or carryforwards to years outside the audit cycle, partial agreements with waivers on assessment, and other complicating factors.

Owing to the complexity of the law and the facts, the IRS is frequently required to take the computation away from the computers in the various Service Centers. That is to say, they "restrict" the computers from making the computation. These so-called restricted interest problems require human intervention(5) in the calculation. With human intervention, of course, comes the opportunity for error.

Taxpayers are understandably concerned that the IRS may be making erroneous computations and sending bills for amounts that are not owed. The IRS is making significant strides to ameliorate these problems. Planned improvements to the IRS Masterfile system will enable the IRS to reduce the number of computations subject to error.(6) In addition, future systems and more comprehensive training are likely to further reduce errors. As long as human beings make manual restricted interest calculations, however, errors will continue to occur.

Classes of Common Errors

Interest errors come in all shapes and sizes, but the following are the general categories of errors:

* Underpayment interest charged for periods where

there was no true underpayment.

* Overpayment credit-elect and adjustment to

"overpayment" year.

* Overpayment refund paid without interest and

adjustment to "overpayment" year.

* Form 1139 refund and adjustment to the loss or

credit year.

* Form 1139 refund and adjustment to the carryback

year.

* Special statutory rules.

* Execution of Form 870 -- 30-day rule.

* Pre-TEFRA rules on carryback amounts.

* Special foreign tax credit rules.

* Certain employment tax adjustments.

* Interest on penalties.

* Inadequate netting of overpayments against underpayments.

1. No True Underpayment

   Generally, debit interest for a year runs from the due date for the return. The IRS sometimes charges interest, however, for periods during which a taxpayer was not actually underpaid. This occurs where the taxpayer was temporarily overpaid for some period, but the overpayment was refunded or credited without the payment of credit interest.(7) The following are four common instances of this problem.

   1. Overpayment Credit-Elect and Adjustment to "Overpayment" Year

      Under Treas. Reg. [section] 301.6402(b), a taxpayer may elect to credit overpayments shown on a return toward estimated tax liability for the following year.(8) If the year giving rise to the claimed overpayment is later adjusted(9) by the IRS, debit interest should not automatically run from the due date of the return. Instead, debit interest on the amount credited should run only from the date the credit is made. For corporate taxpayers, the result is a one-month, six-month, or longer delay before debit interest begins to run.

      Example 1.(10) For 1983, calendar-year corporate

      taxpayer shows estimated payments of $1,000,000.

      On March 15, 1984, taxpayer files a Form 7004,

      "Application for Automatic Extension of Time to

      File Corporation Income Tax Return." Taxpayer

      pays $1,200,000 with the Form 7004.

      On September 15, 1984, taxpayer files its Form

      1120, showing tax liability of $2,100,000, prior payments

      of $2,200,000,(11) and a resulting overpayment

      of $100,000. Taxpayer makes an election to credit

      the $100,000 overpayment to its 1984 estimated

      tax, but does not identify the installment to which

      the payment should apply. The taxpayer's first

      estimated tax installment for 1984 is April 15. On

      August 1, 1992, the taxpayer and the IRS agree

      that the amount of tax that should have been shown

      on the 1983 return was $2,150,000, with a resulting

      deficiency of $50,000.

      Without manual...