New guidance on computing underpayment interest.

• Author: Stein, Ronald A.
• Position: IRS guidance

In Rev. Rul. 99-40, the IRS explains the computation of underpayment interest for a year in which the taxpayer originally reported an income tax overpayment. The ruling modifies the Service's position on the subject and promises to alleviate future disagreements between taxpayers and the IRS over interest charges. Nonetheless, issues remain unresolved.

Background

In the 1970s, the Service argued that underpayment interest runs from the statutory due date for payment of the tax. The Second Circuit rejected that view in Avon Products, Inc., 588 F2d 342 (1978), holding that underpayment interest starts only when tax is both due and unpaid. In other words, the taxpayer owes interest only when and while it has the use of money rightfully belonging to the government.

In 1983, the IRS announced that it would follow Avon; see Rev. Rul. 83-112, modified and superseded by Rev. Rul. 88-98. Rev. Rul. 88-98 analyzed the use-of-money principle under various scenarios. In one of these, a calendar-year corporation elected to credit a year 1 overpayment to its year 2 estimated tax liability but did not specify the installment to be credited. The Service later determined a year 1 deficiency. The issue was the start date of underpayment interest. The ruling held that interest on the deficiency, to the extent of the overpayment, began to run as of the due date of the first installment. In reaching this conclusion, the ruling assumed that the overpayment would be applied as of that date (thus, the year 1 tax would no longer be unpaid), in accordance with Rev. Rul. 84-58. Rev. Rul. 84-58 provided that when a taxpayer makes an election, under Sec. 6402(b), to credit an overpayment to the next year's estimated taxes, the overpayment will be applied to the first installment for that year unless the taxpayer designates a different installment on its return.

The reasoning of Rev. Rul. 88-98 came under attack in May Dept. Stores Co., 36 Fed. Cl. 680 (1996), acq.; accord, Kimberley-Clark Tissue Co., DC Pa 1997; and Sequa Corporation, DC NY 1998. In May (as in the ruling), the taxpayer elected to credit a year 1 overpayment to year 2 estimated taxes without designating which installment to credit. Although the taxpayer had already paid its first and second installments at the time of the election, the IRS applied the overpayment to the first installment under Rev. Rul. 84-58; subsequently, it determined a year 1 deficiency.

Consistent with Rev. Rul. 88-98, the Service...