Reduce interest due IRS: favorable new rules for interest-reducing deposits

California CPA, June, 2005 by Stuart R. Josephs

Interest continues to accrue while a tax liability is disputed, but the taxpayer has only a few choices to limit underpayment interest. The taxpayer can continue the dispute, but if the taxpayer ultimately loses, interest will accrue from the return's original due date until the payment date.

To avoid this accrual, the taxpayer can pay the disputed tax and file a refund claim, preventing interest from accruing if the taxpayer loses. The taxpayer earns interest on the overpayment if successful. However, this denies Tax Court access.

Rev. Proc. 84-58 allowed a deposit in the nature of a cash bond. Such a deposit permitted Tax Court access and stopped interest accruing on the underpayment, equal to the deposit, if the taxpayer lost. But no interest was earned on the deposit if the taxpayer prevailed.

Recent Tax Law Change

Under new IRC Sec. 6603, a taxpayer can deposit cash with the IRS that may be used to pay an underpayment of income, gift, estate, generation-skipping, or certain excise taxes. No interest will accrue on the portion of the underpayment for the period that it was on deposit.

Generally, deposited amounts that have not been used to pay a tax may be withdrawn upon the taxpayer's written request. Withdrawn amounts will earn interest at the Federal short-term rate, compounded daily, to the extent attributable to a "disputable tax." Under Rev. Rul. 2005-15, this rate is 3 percent for the quarter beginning April 2005.

Note: The interest rate on tax overpayments is the above rate plus 3 percentage points for noncorporate taxpayers or 2 percentage points for corporations (0.5 percentage point if the overpayment exceeds $10,000).

For tax underpayments, the interest rate is the above rate, plus 3 percentage points or 5 percentage points for C corporation underpayments exceeding $100,000.

Disputable Tax: This is the amount of tax specified at the time of the deposit as the taxpayer's reasonable estimate of the maximum amount of any tax attributable to "disputable items."

A disputable item is any item of income, gain, loss, deduction or credit if the taxpayer:

1. Has a reasonable basis for the item's treatment on the return; and

2. Believes the IRS has a reasonable basis for disallowing that treatment.

However, under a safe harbor, all items included in a 30-day letter are deemed disputable. Thus, the disputable tax cannot be less than the proposed deficiency. A 30-day letter is the first letter of proposed deficiency allowing review in the IRS' Appeals Office.

Note: A 30-day letter determines a disputable tax regardless of whether there are disputable items. Without this safe harbor, the requirement that a disputable item be an item of income, etc. would limit payment of interest on returned deposits to income taxes because most gift, estate, generation-skipping and excise tax issues would not constitute disputable items.

Implementing Rules

Rev. Proc. 2005-18 (IRB 2005-13, March 28, 2005) provides procedures for taxpayers to make, withdraw or identify deposits. Rev. Proc. 84-58 is superseded for remittances made after March 27, 2005.

A taxpayer may make a deposit under Sec. 6603 by remitting a check to the IRS service center where the taxpayer's return must be filed or the office examining the return, with a statement designating the remittance as a deposit and including the type(s) of tax, the tax year(s) and a statement identifying the disputable tax's amount and basis.

Generally, an undesignated remittance will be treated as a payment and applied to the earliest year for which there is a liability--first to tax, then penalties and finally to interest.

Other detailed procedures apply to the treatment of:

* Deposits made during an examination upon its completion.

* An undesignated remittance in the full amount of a proposed liability.

* Remittances made during an examination, but before the IRS proposes a liability.

* Post-statutory notice remittances.

* A deposit made under Rev. Proc. 84-58 as a Sec. 6603. deposit.

* A request for return of a deposit pursuant to Sec. 6603.

Determining Underpayment

Interest: Interest on an assessed tax satisfied by applying a remittance, whether initially treated as a tax payment or a deposit, will be suspended on the date the IRS received the remittance--regardless of when the tax is assessed or the remittance is applied against the taxpayer's account.

If a deposit is returned, with or without interest, and a deficiency is later assessed for that period and type of tax, interest will not be suspended during the period that the IRS held the deposit.

Effective Date: Rev. Proc. 2005-18 is effective March 28, 2005 and applies to deposits made after Oct. 22, 2004. A deposit made after Oct. 22, 2004 and before March 28, 2005 will be treated as made on the date remitted (for Sec. 6603(d) purposes) if the taxpayer provided the written deposit designation (described above) before May 27, 2005.

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A deposit under Rev. Proc. 84-58, held on Oct. 22, 2004, will be treated as made Oct. 23, 2004 (for Sec. 6603(d) purposes) if the taxpayer provided a written statement identifying the amount as a Sec. 6603 deposit before May 27, 2005.