Beware of hot interest.

Effective Jan. 1, 1991, Sec. 6621(c) authorized an additional 2% interest (known as "hot interest") for large corporate underpayments if certain triggering events occur. A "large corporate underpayment" is an underpayment exceeding $100,000 due in tax liability only for one tax period; i.e., several tax periods or accounts are not aggregated to reach the $100,000 threshold. Even though the $100,000 threshold only consists of tax due, if the higher rate is triggered, it applies to tax, penalties, interest and any additions to tax. Hot interest applies if the following criteria are met:

1. The company must be a C corporation for at least some part of the tax period. The tax period depends on the type of tax liability and the requirement for filing the returns. For example, income taxes are filed and paid on a yearly basis, while withholding taxes are feed and paid on a quarterly basis.

2. There must be an underpayment of tax exceeding $100,000 on any type of tax (e.g., income, excise or employment tax) but for one tax period only. In other words, it is possible to have hot interest on the Form 941, Employer's Quarterly Federal Tax Return, for the quarter ended Dec. 31, 1996, and not on the Form 1120, U.S. Corporation Income Tax Return, for the year ended Dec. 31, 1996.

3. There must be a notice or letter establishing the trigger date. A trigger date occurs when a notice or letter is issued by the IRS regarding an underpayment not paid in full within 30 days. The amount to be paid in full includes all tax, penalties and interest. If the amount is not paid within 30 days, any portion of the underpayment shown in the notice or letter is subject to the additional 2% interest rate. There can be one or more potential trigger notices or letters issued on a specific tax year, but there can be only one applicable trigger date. In such a case, the earliest notice or letter establishes the trigger date for the additional 2% interest rate.

Example: The Service issues a notice to X Corp. after an original Form 1120 is processed for the tax year ending Dec. 31, 1995. The notice is dated Nov. 15, 1996; X does not pay the amount shown on the notice within 30 days (as there is a question about the estimated tax credits). Ultimately, X agrees and pays the additional amount on the notice. If the IRS subsequently audits that return and issues a 30-day letter on this same tax period, the date of the earlier notice will be the applicable trigger date for purposes of the additional 2% interest.

The higher corporate rate applies on the thirtieth day after the earliest of:

* the date of a deficiency notice.

* the date a proposed deficiency with Appeal rights is sent (i.e., a 30-day letter).

* if deficiency procedures do not apply, the date the Service proposes assessment or notifies the client that the tax has been assessed.

The Taxpayer Relief Act of 1997 (TRA '97) contains a change to Sec. 6621(c)(2), providing that letters or notices are to be disregarded for purposes of triggering hot interest if the amount of the tax deficiency is not greater than $100,000. This change is effective for purposes of determining interest for periods after Dec. 31, 1997. (Informal conversations with personnel at the IRS National Office indicate that an interpretation of the change in order to maintain procedural conformity with the pre-existing requirements of the section is required and will be forthcoming.)

Hidden Dangers

Before the TRA '97, even small balance-due amounts remaining unpaid could trigger hot interest at a later date. For example, assume a client receives a balance-due notice from the Service for a $5,000 tax liability due to a math error on the return. The client pays more than 30 days after the initial notice. Subsequently, the client is audited and an additional deficiency of $96,000 is assessed. Because the underpayment exceeds $100,000 in taxes (the original $5,000 math error plus the $96,000 deficiency), and a notice was issued that was unpaid after 30 days, the thirtieth day after the original notice serves as the trigger date for hot interest.

Payment of the notice within 30 days would have prevented the trigger until the issuance of the 30-day letter or notice of deficiency. The important points to remember are:

1. The IRS applies the earliest trigger date possible.

2. There must be an underpayment of $100,000 in taxes at the due date of the return.

3. The $100,000 tax underpayment threshold may not be the total tax liability shown on the notice or letter. It may be the aggregate of tax liabilities shown on two separate notices or letters issued at different times with different requirement dates for timely payment. (See below for an exception.)

4. Examination is not necessary for hot interest to apply.

A few more issues should be considered:

* The IRS does not consider a cash bond payment as a payment of tax. This type of payment will not prevent an applicable trigger date.

* IRS transcripts cannot be relied on for the purpose of avoiding hot interest. Hot interest could still be applicable, even if there is a transcript showing no balance due.

* Any 90-day letter rescinded by the Service under Sec. 6212(d) and any assessment notice abated under Sec. 6404 are disregarded in determining the applicable trigger date.

* A 30-day letter can only be disregarded if it is issued to the wrong taxpayer or for the wrong tax period.

The following actions should be considered when trying to avoid problems with hot interest:

* Pay all balances due within 30 days unless they are definitely totally in error. Note, however, that the TRA '97 change to Sec. 6621(c)(2) provides that letters or notices are to be disregarded for purposes of triggering hot interest if the amount of the tax deficiency is not greater than $100,000. This change will apply for purposes of determining interest for periods after 1997.

* Try to resolve examination issues before a 30-day letter is issued.

* If there are underpayment years and overpayment years, try to close all years together to maximize interest savings and minimize the effects of hot interest.