A Partial End to Interest Rate Differentials on Tax Underpayments and Overpayments
Since the mid-1980s, the Internal Revenue Code has provided that when you owe money to the IRS, you pay the IRS 1% more in interest than the IRS would pay you if it owed you a refund. Currently, for most taxpayers this means that you pay the IRS 8% interest on tax underpayments, while the IRS pays you 7% interest on tax overpayments.
For corporations, the interest rate differentials can be worse. Currently, corporations that have large tax underpayments (i.e., over $100,000) must pay the IRS 10%. Currently, corporations that have tax overpayments exceeding $10,000 receive 5.5% from the IRS on the amount exceeding $10,000.
The Act makes two changes to the Code to eliminate some of the differentials. First, under Act §3302 (amending Code §6621(a)), effective for interest accruing after January 1, 1999, the interest paid to non-corporate taxpayers on overpayments will be raised to the same rate which is charged them on underpayments -- i.e., the "applicable federal rate" plus 3%, currently 8%.
Second, under Act §3301 (new Code §6621(d)), the interest rate differential is eliminated for all taxpayers (including corporations) where there are equivalent underpayments and overpayments by the same taxpayer and the periods of interest accrual overlap. For example, assume that as a result of an examination, an individual owes $10,000 of additional gift tax for 1995. The due date for the gift tax return (Form 709) was April 15, 1996. Interest on the $10,000 deficiency would be due from April 15, 1996 to the present. Assume that the individual also overpaid his 1997 income tax by $4,000, but has not yet been sent a refund check; interest is payable on the $4,000 from April 15, 1998 to the present. Under the new law, the net interest rate on the $4,000 overpayment and $4,000 of the $10,000 underpayment is zero for the period of interest accrual overlap -- i.e., from April 15, 1998 to the present.
There are some peculiarities about the drafting of this overlap-elimination statute which present questions. It has long been the rule that if, in the above example, the IRS had credited the $4,000 income tax overpayment against the gift tax deficiency, there would be no interest payable on the $4,000 overpayment and $4,000 of the gift tax underpayment would cease bearing interest as of April 15, 1998. Code §§6601(f) and 6611(b)(1). This rule has two effects: it not only eliminates the interest rate differential, but ensures that no interest is paid to the taxpayer -- an important fact for individuals today because, literally, the Code expects individuals to pay tax on interest income but, in most cases, allows no tax deduction for interest paid on tax deficiencies. This rule applies only when the IRS applies the overpayment as a credit against the underpayment -- something the IRS is not required to do by law. Thus, the rule does not apply if the IRS refunds the overpayment to the taxpayer in a check.
The new law, which does not repeal the existing law, applies where the IRS does not apply the overpayment as a credit, but mails out a refund check. In providing for a "net" interest rate of zero, however, the new law leaves unclear whether the gross interest payable on the overpayment is now 0%, 7% (the refund rate), or 8% (the deficiency rate). Hopefully, the law will be interpreted to impose a gross interest rate on both overpayments and underpayments of 0%. Otherwise, individual taxpayers may still face the problem of having to pay tax on interest income without a corresponding interest deduction.
The new law is effective for interest accruing after October 1, 1998, regardless of the taxable year involved. The new law is also effective for interest accrual periods beginning before July 22, 1998, but only if the taxpayer (1) contacts the IRS not later than December 31, 1999, (2) requests that the new law apply, and (3) "reasonably identifies and establishes periods of such tax overpayments and underpayments for which the zero rate applies." Thus, a taxpayer who recently received a refund check including interest and recently paid a tax bill charging interest should look into whether there was an overlapping interest accrual period. If one exists, Form 843 (a refund claim for overpaid interest) should be filed with respect to the interest charged on the underpayment. Presumably, the statute of limitations for refund claims (usually, two years from the date of payment or three years from the date the return was filed) will apply to preclude taxpayers from making claims for overcharges occurring many years ago.
Some taxpayers may currently be in the midst of income tax examinations in which they expect eventually to have overpayments and underpayments in different years, but the exact amounts are not known. If the overpayment and underpayment amounts are still not fixed by December 31, 1999 (because of continued audit, Appeals Office, or court proceedings), consider making a protective request under the new statute by that date so that pre-October 1, 1998 interest which is eventually charged gets the benefit of the new statute.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.