Prepaying possible interest on a disputed tax liability

Nation's Business, Oct, 1989 by Gerald W. Padwe

Preparing Possible Interest On A Disputed Tax Liability Interest charges by the government resulting from an Internal Revenue Service audit can be quite high. The audit generally does not take place until a couple of years after the return is filed, and the interest charge on the disputed tax liability compounds daily until the audit is finished. An audit often takes several years to complete.

To avoid this unduly burdensome claim, many taxpayers offer to prepay some or all of the potential interest while continuing to fight the underlying tax liability. By doing so, they reduce ultimate interest liability and also may receive a current tax deduction.

However, the IRS traditionally has taken a very tough stance against an interest-only payment that results in a deduction. A 1984 IRS procedure holds that unless the taxpayer actually pays an amount of underlying tax that would support the calculation of the interest, the interest payment will not be deductible.

Note that paying the underlying tax does not concede any issues to the IRS. The "tax" payment is in the form of a cash bond and does not represented a voluntary self-assessment. The contest continues, and if the taxpayer is successful, the "tax" dollars will be returned.

One taxpayer, however, recently challenged this position in court--and won.

In 1983, the IRS issued a statutory notice of deficiency on the taxpayer's 1980 return. This included a calculation of $7,000 in interest charges from the filing date to the date of the notice.

The taxpayer sent the IRS a check for $7,000 and asked that the money be credited to the interest portion of the claim. He then filed a U.S. Tax Court petition to litigate the underlying tax. The IRS, however, credited the $7,000 to the tax liability, not the interest. When the taxpayer deducted that amount as interest on his 1983 return, the IRS disallowed the deduction.

When the "interest" was paid, said Uncle Sam, there was no formal debt from the taxpayer to the government, and thus there was no basis to calculate interest. The taxpayer was contesting the underlying tax and had not made any cash payment to support the $7,000 interest charge.

The Tax Court disagreed. Issuance of the statutory notice of deficiency is a claim by the government that the taxpayer owes the tax, thus creating a debt.

In regard to the IRS requirement that an amount equal to the underlying tax must be paid to support the interest deduction, the court pointed out that the Internal Revenue Code section on deductibility of interest has no requirement that a debt be paid before interest can be deducted. To the extent that an IRS procedure holds differently, that is an "unwarranted restriction" on the statute, the court said. The interest deduction was allowed.

This decision, however, does not open the door for any taxpayer, during an IRS audit, to send in a check for interest and receive a deduction. In this case, the audit reached the point where a statutory notice of deficiency had actually been issued. It was that notice that created the formal claim against the taxpayer. Without such formal assertion of liability, it is doubtful the court would have held as it did.

Gerald W. Padwe is national director-tax practice for Touche Ross & Co. Readers should see tax and legal advisers on specific cases.