Interest on Federal Tax Deficiencies and Overpayments
Like many areas of our federal income tax laws, the computation of interest on tax deficiencies (1) and overpayments has become increasingly complex over the years. Fortunately, some of this increasing complexity has been offset by the availability of computers to help in the computations. Thus, the mechanics of making the computation -- which once involved an arcane "month-day" method peculiar to the computation of interest on taxes and still is complicated by frequently changing rates -- can be computerized to do in seconds what would otherwise take hours. (2) It remains necessary, however, for the person making the interest computation to know the rules that determine the period during which interest runs and whether, on the one hand, a single period applies to all of the amount of the deficiency or overpayment or, on the other hand, the aggregate underpayment or overpayment for a given year must be fragmented into separate elements with a different interest period for each element.
In years past, it was not uncommon to find mathematical errors in the interest computations made by the Internal Revenue Service. Consequently, prudent tax practitioners would verify the correctness of such computations. Such mathematical errors are much less likely to occur today, because the IRS itself uses computers to do the mathematical part of the computations. Verification is still important, however, because the IRS may have used the wrong starting date, the wrong ending date, or otherwise not have followed the rules prescribed by the law. (3)
The purpose of this article is two-fold: to provide taxpayers and practitioners with sufficient guidance to make interest computations that will conform to the IRS's interest computations if it is desired to pay additional taxes and interest before a bill for such interest is received from the IRS, and to enable taxpayers and practitioners to verify interest computations made by the IRS. Moreover, because interest has become an increasingly large factor in the cost of any resolution of tax disputes, (4) the correct computation of interest is important in evaluating potential dispositions of such disputes.
In general, interest is due to the government if there is an underpayment of taxes and, with certain exceptions, interest is due to the taxpayer if there is an overpayment of taxes. Before passage of the Tax Reform Act of 1986, interest on underpayments and interest on overpayments were computed at the same rates. This is no longer the case: the Code now provides that interest charged on underpayments is to be one percent more than interest allowed on overpayments.
Changes in the rate and method of computing interest on tax underpayments and overpayments have grown almost geometrically. For years, such interest was simple interest at the rate of six percent per year. It was computed on the basis of a peculiar "month-day" method that was seldom, if ever, used for other purposes. The method was easy to use in the days before computers, however, and most tax practitioners learned to live with it. (5)
In 1975, the first change in rate or method of computation in approximately 40 years occurred when the interest rate was increased from six percent to nine percent. Between that first change and the end of 1989, there have been 19 other changes in either the interest rate or the method of making the computation (e.g., simple interest on a daily method, compound interest, etc.) in even the most straightforward situations. In addition, numerous other special rules have been introduced, such as special rules for the computation of interest on substantial underpayments attributable to tax-motivated transactions. Is there any wonder that errors are made in such interest computations?
Where a computer program is used to assist in the interest computation, presumably these variations in rates and methods will be automatically taken into account. The principal concerns, therefore, become determining the amount on which interest is to be computed and the beginning date and ending date of the interest period. Those areas will be discussed first.
There are basically two types of interest that may be involved:
* interest that is charged to the taxpayer in the case of an asserted underpayment, which is frequently termed "assessed interest" because it is assessed and collected as a part of the tax; (6) and
* interest that is payable to the taxpayer in the case of an overpayment of tax or an overpayment of assessed interest, which is frequently termed "statutory interest."
The terms "assessed interest" and "statutory interest" will be used in this article to distinguish between the two types of interest. (7)
Assessed interest can be a part of the amount on which statutory interest is computed (i.e., whee there is an overpayment of assessed interest). When there has been an overpayment that is refunded, typically the government will send the taxpayer a single check that may contain three elements: (i) a refund of the overpayment of tax, (ii) a refund of the overpayment of assessed interest, and (iii) statutory interest on the overpayment of both tax and assessed interest. Unfortunately, there is often no indication of what portion of the single check is attributable to each of these elements, notwithstanding that each element has different tax consequences. (8)
Throughout this article, the amount on which interest is to be computed will be termed the "base amount." In simple situations, the base amount may be the entire amount of the tax underpayment or overpayment. In other situations, however, the base amount may be only a portion of the entire tax underpayment or overpayment, because interest runs on a part of the entire underpayment or overpayment for a period that is different from the period applicable to another part of the underpayment or overpayment; that is to say, the applicable interest period or periods may dictate or affect the determination of the base amount.
Where a single interest period applies to a tax underpayment on which interest is due, the tax base is the excess of the correct tax over the amount paid. Similarly, where a single interest period applies to a tax overpayment on which interest is due, the tax base is the excess of the aggregate tax paid over the correct tax.
Where different interest periods apply to different parts of the aggregate underpayment or overpayment on which interest is due, the practice is to make a separate interest computation for each part of the underpayment or overpayment that has a different interest period. This approach is graphically presented in Diagram 1, in which the interest period is represented by the horizontal axis and the amount of the underpayment or overpayment is represented by the vertical axis. Where different interest periods apply, the interest computation is made by fragmenting the amount of underpayment or overpayment "horizontally" and making separate interest computations for each element of the underpayment or overpayment.
Thus, the interest computation would properly not be made by fragmenting the interest periods "vertically" and making a separate interest computation for each element of the interest period having a different amount of underpayment or overpayment. See Diagram 2. A limited exception to this may arise in the case of certain interest computations that span December 31, 1982 -- the end of the period when simple interest computations applied.
After determining the amount of an tax underpayment or overpayment on which interest is due but before making any interest computation, there should be a determination whether a single interest period applies to the underpayment or overpayment. If it does, the entire amount of the underpayment or overpayment is the base amount. If it does not (because one interest period applies to one part of the underpayment or overpayment and another interest period applies to another part), the aggregate amount of the underpayment or overpayment must be fragmented into each element that has an interest period that is different from the other, with each such element becoming a base amount for a separate interest computation. The total of the amounts of interest computed in such separate interest computations is the total amount of interest on the underpayment or overpayment.
Statutory interest is payable on an overpayment of assessed interest. It may be necessary to make a computation of the correct amount of assessed interest to determine the amount of the overpayment of assessed interest. Thus, the excess of the assessed interest that was paid over the correct amount of the assessed interest is the overpayment of assessed interest. Such an overpayment is a base amount for a computation of owing statutory interest. Interest may also be due on additions to the tax and tax penalties after such amounts have been assessed, in which case the amount of the addition to the tax or the penalty is the base amount.
The interest period is the period between the time when interest starts to run and the time when interest ceases to run. Each of those times depends on the character of the base amount. If the base amount is an underpayment of tax, generally the interest starts to run on the payment due date; if it is an overpayment, generally the interest starts to run on the date the overpayment is made. The time when the interest ceases to run depends on a number of factors discussed below.
Section 6601(a) of the Code provides that if any amount of tax is not paid by the last date prescribed for payment, interest runs from such last date to the date paid. Thus, for a calendar-year corporation, interest on an underpayment of such tax generally starts to run on March 15 of the year following the year for which such tax is due. (9) In the case of an individual using...