In many instances, a taxpayer will have made estimated income tax payments that exceed the tax liability reported in the taxpayer's income tax return, resulting in a claimed overpayment in the tax return. The taxpayer may direct that the claimed overpayment be either refunded or applied as a payment of estimated tax for the next taxable year (or partly refunded and partly so-applied). A subsequent audit, however, may find that the tax liability was greater than that shown on the taxpayer's return (i.e., the claimed overpayment was erroneous), with the result that the refund received or the credit applied to the next taxable year created or increased a tax deficiency. The evolving rules for the computation of underpayment interest on the deficiency resulting from the erroneously claimed overpayment is the subject of this article.
The agonizing changing positions of the Internal Revenue Service ("IRS") as to the computation of underpayment interest in such situations have been reflected in a series of Revenue Rulings. The current-day position was developed largely in response to court decisions that were adverse to the IRS, but also in response to legislative directions in the Deficit Reduction Act of 1984. The most recently published pronouncement of the IRS position is Field Service Advice 200049001, Doc 2000-31661, 2000 TNT 238-57, dated November 15, 1999 and released December 14, 2000. The current IRS position applies a "use of money" principle originally enunciated in Manning v. Seeley Tube & Box Co., 338 U.S. 561 (1950), and applied by the Court of Federal Claims in May Department Stores (cited in Footnote 2). Thus, the current position of the IRS as to the computation of underpayment interest in the four situations described below is as follows:
Erroneous Overpayment Refunded Without Interest
Where a claimed (but erroneous) overpayment is refunded to the taxpayer without overpayment interest (because of the "45-day rule" of section 6611(e)), underpayment interest on the portion of a deficiency created by such refund starts on the date on which the IRS refunded the overpayment. See "Situation 3" and "Situation 4" in Rev. Rul. 99-40, supra. The ruling reasons that until the date of the refund the IRS had the use of the money without owing interest thereon and therefore the tax did not become "underpaid" until the date of the refund.
Erroneous Overpayment Refunded With Interest
Although Rev. Rul. 99-40 does not specifically address the situation where the claimed overpayment is refunded with overpayment interest (because it was not made within the 45 day period prescribed in section 6611(c)), presumably in that case underpayment interest would start on the unextended due date of the tax return on which the erroneous overpayment was claimed (i.e., the date from which the overpayment interest was due). However, interest on the portion of the underpayment created by the refund of the erroneously claimed overpayment should qualify for interest netting under section 6621(d) for the period for which overpayment interest was paid on the refund. That is, the underpayment interest on that part of the deficiency should be computed at the overpayment interest rate rather than the underpayment interest rate. See Rev. Proc. 99-43, 1999-47 I.R.B. 579.
Erroneous Overpayment Credited to Estimated Tax and Necessary to Avoid a Penalty
Where a claimed (but erroneous) overpayment is credited to the estimated tax for the succeeding taxable year, the underpayment interest on the portion of the deficiency created by the crediting of the claimed overpayment starts on the date the claimed overpayment is applied to the succeeding year's estimated tax, meaning when it is needed to avoid the liability for a penalty (an addition to tax under section 6654 or section 6655) for failure to pay estimated tax. See "Situation 1" and "Situation 2" in Rev. Rul. 99-40. As to when the credit is needed to avoid the penalty, Rev. Rul. 99-40 states that "the estimated tax rules in effect for the tax year for which the election to credit a return overpayment is effective are used to determine when the overpayment is applied to that year's estimated taxes, and, thus, for determining when interest begins to run on the subsequently determined deficiency." Form 2210 (in the case of the estimated tax owed by an individual, estate or a trust) or Form 2220 (in the case of the estimated tax owed by a corporation), as in effect for the year to which the credit is applied, can be used to make the computation of when an additional payment of estimated tax was needed to avoid a penalty and thus when interest on that part of the prior year deficiency should start.
Erroneous Overpayment Credited to Estimated Tax and Not Necessary to Avoid a Penalty
In an instance when no amount of the claimed overpayment is needed to avoid the penalty for underpayment of estimated tax (because no payment of estimated tax was required or because a sufficient amount of estimated tax was paid to avoid any penalty without resort to any credit of a claimed overpayment from the preceding year), underpayment interest on the prior-year deficiency created by the credit starts on the unextended due date of the tax return for the year to which the credit is made. See FSA 200049001, supra. The ruling reasons that, under section 6513(d), the amount credited is considered as a payment of tax for the succeeding taxable year on the unextended due date of the tax return for that year.
Taxpayer May Need to Calculate Underpayment Interest
We understand that the IRS does not (and perhaps cannot, without input from the taxpayer) sua sponte calculate underpayment interest as required by Rev. Rul 99-40. The IRS does not normally have the data needed to make the calculations required by Form 2210 or Form 2220 to determine the minimum amount of additional estimated tax payment to avoid the underpayment penalty. It would seem, therefore, that it is incumbent on a taxpayer faced with a deficiency created by such a credit of a claimed (but erroneous) overpayment to the estimated tax for the next tax year to make the calculation, using the appropriate form, of the amount of such credit needed on each installment date to avoid the underpayment penalty.
We suggest that such a taxpayer use Form 2210 or Form 2220, whichever is applicable, to determine whether a penalty would be due on any estimated tax installment date if there were no credit of the claimed overpayment from the prior taxable year. Any computational method that would reduce or eliminate the penalty if there were no credit, including the annualized income installment method should be used.
If there would be no penalty without regard to the credit, then interest on any deficiency for the prior year created by the credit would not start until the unextended due date for the return for the taxable year to which the credit was made.
On the other hand, if there would be a penalty in the absence of the credit, the amount of credit needed to reduce the penalty to zero (or to as small an amount as the credit would permit) for each installment date for the estimated tax, starting with the earliest installment date, should be determined. The amount so-determined for each installment due date would be the amount of the deficiency for the prior year that was created by the credit on which underpayment interest should start on that installment due date.
Notwithstanding the complications of making the computations as suggested above, the amounts involved in many cases are sufficiently large to warrant the additional effort.