Payment strategy to reduce interest costs on IRS settlements.

• Author: Rogers, W. Scott

Introduction

The Internal Revenue Service normally examines several income tax years simultaneously in the course of a corporation's periodic federal income tax examination. It is not uncommon for the IRS to propose overpayments in the earlier years and deficiencies in one or more of the later years included in the cycle (or vice versa). When the deficiencies occur in the later years included in the examination cycle, the IRS routinely applies the overpayments to the deficiency years as of the due date of the deficiency years' returns.

The movement of funds between different tax periods is referred to as offsetting. Such transactions are authorized by section 6402(a) of Internal Revenue Code, which states that "[i]n the case of any overpayment, the Secretary, within the applicable period of limitations, may credit the amount of such overpayment, including any interest allowed thereon, against any liability in respect of an internal revenue tax on the part of the person who made the overpayment." If the deficiency amount exceeds the overpayments, the taxpayer will remit the remaining amount due to the IRS.

Most taxpayers are content to allow the IRS to use the offset method to eliminate deficiencies agreed to in an examination. After all, it makes more sense at first glance to allow the IRS to net out the accounts to the extent possible as opposed to issuing refunds for overpayment years while simultaneously remitting payments with respect to any deficiency years included in the cycle. Given the intricate rules for determining how interest is computed on tax adjustments, however, taxpayers may overlook a significant savings opportunity by agreeing to the offset method. This article sets forth an alternative.

Understanding the Authorities

To optimize a company's position in respect to the computation of interest on refunds and deficiencies, a tax executive must understand the somewhat contradictory court decisions and IRS rulings. In Rev. Rul. 99-40, 1999-2 C.B. 441, the IRS ruled that interest on a tax deficiency assessed for a period shall not begin to run until the deficiency is both due and unpaid. This ruling creates an opportunity where either a refund requested on an original tax return was issued without allowable interest after the return was filed or an overpayment reported on the return was credited to the subsequent year's tax.

Example 1: XYZ Corp. filed Form 1120 for tax year 1999 under a timely extension on September 15, 2000, reporting an overpayment of $50 that XYZ requested the IRS to refund. The IRS refunded the $50 without allowable interest on October 27, 2000, within 45 days of the return's filing. (Section 6611(e)(1) of the Code sets forth the 45-day interest free period for issuing refunds.) Subsequently, the IRS examined XYZ's 1999 return and determined that additional tax of $25 was due. Pursuant to Rev. Rul. 99-40, the start date for deficiency interest on the $25 assessment will be October 27, 2000, the date on which the overpayment reported on the return was refunded without allowable interest. Since the government had benefited from interest free use of XYZ's $50 overpayment from March 15, 2000 (the original due date of the return) to October 27, 2000 (the date on which the $50 refund was issued without interest), it would be inequitable to allow the government to later charge interest for that same period on any deficiency up to the amount of the refund. In...