Corporations frequently settle examination cycles with the IRS in which some included years are found to have overpayments and others to have tax deficiencies. When the tax deficiencies arise in the later years included in the examination, tax executives are usually content to allow the IRS to apply the earlier years’ overpayments to the deficiency years to simplify the settlement process. Unfortunately, this approach often results in a higher overall settlement cost than that which might be realized through the strategic application of prevailing interest rules.
The IRS normally examines several income tax years simultaneously in the course of a corporation’s periodic federal income tax examination (the examination “cycle”). 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. When this fact pattern arises, the IRS routinely applies the overpayments to the deficiency year(s) 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 the taxpayer simultaneously remits payments with respect to any deficiency years included in the cycle. However, given the present status of the various authorities that determine how interest is computed on tax adjustments, taxpayers often overlook a significant savings opportunity by agreeing to the offset method.
Understanding the Authorities Applicable To Interest Computations
The payment strategy set forth herein takes advantage of the present state of case law and statutes governing interest computations for both deficiencies and overpayments. The tax executive needs to have a basic understanding of the somewhat contradictory court decisions that give rise to payment optimization if he or she is to minimize the overall costs of an examination or appeals settlement. We could dedicate many pages to explaining the evolution of the prevailing interest rules, but such discussion would not be fruitful to the executive whose only concern is minimization of his prospective costs. Thus, we opt to limit our discussion to presently applicable rulings to the extent practical.
We begin by explaining certain rulings applicable to deficiency interest computations. The decision in May Department Stores Co. led the IRS to issue Rev. Rul. 99-40 in 1999. Pursuant to the ruling, interest on a tax deficiency assessed for a period shall not begin to run until the deficiency is both due and unpaid.
The deficiency interest fact patterns that are compatible with our payment strategy include scenarios in which 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. The impact of such transactions on the start date of subsequently assessed tax deficiencies is explained in the examples below.
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. See section 6611(e)(1), which 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 short, since XYZ wasn’t compensated for the period of time during which the government held its money before issuing the refund, the government is precluded from subsequently charging XYZ interest on a deficiency up to that amount for the same period. Thus, the tax deficiency was not both due and unpaid before October 27, 2000, on which date deficiency interest shall begin running.
Example 2: ABC Corp. filed Form 1120 for tax year 1999 under a timely extension on September 15, 2000, reporting an overpayment of $50 that ABC elected to have applied to the subsequent year’s estimated tax payments (the “credit elect”). Pursuant to section 6513(d), the IRS did not allow interest on the credit elect transferred to tax year 2000. ABC timely deposited all estimated tax payments due for tax year 2000, so the credit elect from 1999 was not needed to satisfy any of ABC’s estimated payment liabilities for the year. Subsequently, the IRS examined ABC’s 1999 return and determined that additional tax of $25 was due. Since the credit elect was not needed to satisfy any of ABC’s tax year 2000 estimated payment liabilities, the government had interest free use of the credit elect amount until at least March 15, 2001, the due date of the 2000 return. Thus, the 1999 deficiency is not both due and unpaid until at least March 15, 2001, on which date deficiency interest shall begin to accrue.
We now turn our attention to refund interest, commonly referred to as allowable interest. Section 6611(b)(1) states that allowable interest on an overpayment that is offset to pay an amount due in another tax account will be paid “from the date of the overpayment to the due date of the amount against which the credit is taken.” The issue that gives rise to our payment strategy is the presently recognized definition of the due date of a deficiency as determined by the IRS to identify the ending date of allowable interest on overpayment amounts that are offset to pay deficiencies.
The IRS determined in Technical Advice Memorandum 9443007 (“TAM 9443007”) that the due date of a deficiency was the date on which the deficiency was both due and unpaid. Consequently, the IRS concluded that allowable interest on an overpayment offset to pay an outstanding deficiency would accrue, not to the due date of the deficiency year’s return, but to the date on which the deficiency was also considered to be unpaid. Note that although the facts set forth in the ruling varied somewhat from our fact pattern, the interest theory applied by the IRS in its analysis is not distinguishable from our facts. The following example sets forth the method by which the IRS would compute allowable interest on an overpayment offset to pay a deficiency during the period in which TAM 9443007 was the prevailing authority.
Example 3: We return to XYZ Corp.’s 1999 tax year, with respect to which a $50 overpayment was refunded on October 27, 2000. Once again, the IRS subsequently examines XYZ’s 1999 return and determines that additional tax of $25 is due. The IRS recognizes that deficiency interest on the tax increase shall begin running on October 27, 2000. However, pursuant to the examination of tax year 1998 in the same cycle, IRS determines that there is a tax overpayment of $100 in that tax year. The IRS decides to offset a portion of the 1998 overpayment to the 1999 deficiency and refund the balance of the overpayment to XYZ. Applying TAM 9443007, the IRS computes allowable interest on $25 of the 1998 overpayment from the overpayment date to October 27, 2000, the date on which the 1999 deficiency becomes due and unpaid for purposes of deficiency interest. The IRS then offsets $25 from 1998 to 1999 effective October 27, 2000. The balance of the 1998 overpayment is refunded with allowable interest.
The IRS reversed its position several years after TAM 9443007 was released, developing a stricter interpretation of section 6611(b)(2). Reasoning that “the due date of the amount against which the credit is taken” should be interpreted narrowly as the due date of the deficiency year’s tax return without regard to extensions, the IRS began disregarding situations in which the deficiencies were not due and unpaid until some later date, instead computing allowable interest on offset overpayments only to the original return due date of the liability years’ returns. Consider the application of this computational method to Example 3 above; under the new policy, the IRS would pay allowable interest on the $25 that it offset from 1998 to 1999 only to March 15, 2000, the due date of the 1999 return. Consequently, XYZ would lose the benefit of the deferred deficiency interest start date that was previously preserved by TAM 9443007, under which the allowable interest would have accrued to October 27, 2000, not March 15, 2000.
Several taxpayers later filed suit requesting the courts to apply the use of money theory established in the prior deficiency interest cases equally to allowable interest transactions. Unfortunately, the courts in AT&T Corporation & Subsidiaries and Marsh & McLennan Companies, Inc. disregarded TAM 9443007, choosing rather to agree with the government’s interpretation of section 6611(b)(2). In distinguishing their decisions from the more equitable “use of money” decisions handed down in the deficiency interest cases, the courts pointed out that the language set forth in section 6611(b)(2) with respect to the stop date for allowable interest on offsets lacked the ambiguity of language in section 6601(a) applicable to the start date of deficiency interest.
The Payment Strategy
We now turn to an example which will aid the tax executive in both grasping the importance of understanding the above interest rules and appreciating the magnitude of savings that can be obtained by using the rules to the taxpayer’s advantage. For purposes of this exercise, we will assume that the IRS has completed the examination cycle for DEF Corporation’s 1999 and 2000 income tax years. The agreed-to tax changes consist of an overpayment of $20,000,000 for tax year 1999 and a deficiency of $10,000,000 for tax year 2000.
First, we will address the method by which the IRS will pay off the deficiency and refund the remaining overpayment unless DEF intervenes. Table 1 below utilizes actual IRS interest rates computed to hypothetical dates to arrive at a net refund amount. As set forth in the table, DEF has an overpayment of $20,000,000 effective March 15, 2000, the due date of the 1999 tax year. The IRS will offset $10,000,000 of the overpayment to tax year 2000 effective March 15, 2001, the due date for the tax year. The remaining overpayment is refunded with allowable interest computed on the full $20,000,000 from March 15, 2000 to March 15, 2001, plus additional interest that accrues on the remaining overpayment after the $10,000,000 offset to a hypothetical refund date of June 15, 2005. The total amount refunded on that date is $12,906,198.
Table 1: DEF Corporation – Customary IRS Offset Method
1999 overpayment at March 15, 2000 – $20,000,000
Offset to pay 2000 deficiency at March 15, 2001 ($10,000,000)
Principal balance at March 15, 2001 – $10,000,000
Allowable interest on $20,000,000 to March 15, 2001 – $1,330,871
Total overpayment at March 15, 2001 – $11,330,871
Allowable interest to June 15, 2005 – $1,575,327
Refund issued on June 15, 2005 – $12,906,198
Next, we determine whether our net refund may be enhanced by paying off the tax year 2000 deficiency, plus interest thereon, and having the IRS refund the full 1999 overpayment instead of offsetting $10,000,000 to 2000. In Table 2, we assume that DEF reported an overpayment in excess of $10,000,000 on its tax year 2000 return and had the overpayment credited to tax year 2001, in which year the overpayment was not needed to satisfy any estimated payment liabilities. As we recall from Example 2 above, in this scenario the tax year 2000 deficiency is not considered both due and unpaid for interest purposes before March 15, 2002, the due date of the tax year 2001 return.
In Table 2, we assume that DEF makes a payment of $11,677,732 on April 15, 2005, paying off the tax year 2000 deficiency plus interest accrued thereon from March 15, 2002 to the payment date. Since the 2000 deficiency is paid off, the IRS will refund the full 1999 overpayment of $20,000,000 plus interest thereon. The IRS will not schedule an overpayment refund under most circumstances until outstanding deficiencies have been paid off. Thus, we assume a two-month delay occurs between the date on which the deficiency was paid and the date on which IRS issues the refund check. We project that a refund of $24,297,189 will be issued on June 15, 2005.
Table 2: DEF Corporation- Alternate Payment Strategy
2000 deficiency as of March 15, 2002 – ($10,000,000)
Deficiency interest to April 15, 2005 – ($1,677,732)
Payment remitted on April 15, 2005 – ($11,677,732)
1999 overpayment at March 15, 2000 – $20,000,000
Allowable interest to June 15, 2005 – $4,297,189
Refund issued on June 15, 2005 – $24,297,189
DEF must now recognize that the 1999 and 2000 years are available for interest netting as set forth in section 6621(d). In simple terms, interest netting is used to eliminate the interest rate differential that arises when interest accrues on deficiencies at a higher rate than that accruing on overpayments during overlapping periods of time. Since the 1999 overpayment overlapped the 2000 deficiency during the period of time on which deficiency interest was accruing in tax year 2000, DEF needs to file an interest netting claim to recoup the difference. We assume that DEF filed a netting claim on June 15, 2005, the date on which the 1999 refund was issued. We project that the interest netting refund was received one year later, on June 15, 2006. The one year period we projected for the IRS to process the netting claim is consistent with the average period of time the IRS normally takes to process such claims.
At this point in our analysis, we have determined that DEF will receive a refund of $12,906,198 on June 15, 2005, if the company allows the IRS to use the offset method to eliminate the tax year 2000 deficiency. Conversely, by remitting a payment for the 2000 deficiency to preserve the one-year deficiency interest deferral available for the year, DEF will receive net refunds totaling $13,528,865 as follows:
1999 refund on June 15, 2005 – $24,297,189
Less 2000 Payment on April 15, 2005 – ($11,677,732)
Plus interest netting refund on June 15, 2006 – $909,409
Net refunds – $13,528,865
The amount above is $622,668 greater than the refund DEF will receive if the company fails to intervene to prevent the IRS from paying off the tax year 2000 deficiency by offset. However, our analysis is not complete without consideration of the opportunity cost to DEF of being deprived of the use of the funds remitted to pay the 2000 deficiency from April 15, 2005, the payment date, to June 15, 2005, the date on which the IRS issues the 1999 refund. We must also recognize the opportunity cost related to DEF waiting a full year, from June 15, 2005 to June 15, 2006 to receive its interest netting refund. On Table 3, we estimate those opportunity costs to be $136,613 and $63,659, respectively. The variables we applied in our present value analysis will differ among various taxpayers. Note that allowable interest accruing on the refunds mitigates the opportunity costs to some degree.
Table 3: DEF Corporation- Payment Strategy Opportunity Costs
Net refunds attributable to Payment Strategy – $13,528,865
Less net refund attributable to IRS offset method – ($12,906,198)
Benefit of Payment Strategy before consideration of opportunity costs $622,668
Less 7% opportunity cost related to April 15, 2005 payment remitted for 2000 that was not recovered until June 15, 2005, when the 1999 refund was issued – ($136,613)
Less 7% opportunity cost related to the interest netting refund not being issued until one year after the initial 1999 refund was issued on June 15, 2005 – ($63,659)
Net savings attributable to applying the Payment Strategy – $422,396
The strategy set forth herein is applicable only to taxpayers who are positioned to have certain tax deficiencies paid by offsets of overpayments that are available as of the due dates of the deficiency years. In such cases, tax executives need to determine whether the potential for savings exists with respect to applying the payment strategy, and, if so, whether the amount justifies the efforts required to implement the strategy. Tax executives attempting to make such a determination must have expertise with respect to interest computation matters, must be able to project the opportunity costs specific to their organization and must act proactively to remit payments before the IRS pays deficiencies via offsets. Once the IRS eliminates a deficiency by an offset, a taxpayer will rarely be successful in attempts to have IRS reverse the offset and accept a payment for a deficiency year. See Northern States Power Company.