New guidance on computing underpayment interest.

In Rev. Rul. 99-40, the IRS explains the computation of underpayment interest for a year in which the taxpayer originally reported an income tax overpayment. The ruling modifies the Service's position on the subject and promises to alleviate future disagreements between taxpayers and the IRS over interest charges. Nonetheless, issues remain unresolved.

Background

In the 1970s, the Service argued that underpayment interest runs from the statutory due date for payment of the tax. The Second Circuit rejected that view in Avon Products, Inc., 588 F2d 342 (1978), holding that underpayment interest starts only when tax is both due and unpaid. In other words, the taxpayer owes interest only when and while it has the use of money rightfully belonging to the government.

In 1983, the IRS announced that it would follow Avon; see Rev. Rul. 83-112, modified and superseded by Rev. Rul. 88-98. Rev. Rul. 88-98 analyzed the use-of-money principle under various scenarios. In one of these, a calendar-year corporation elected to credit a year 1 overpayment to its year 2 estimated tax liability but did not specify the installment to be credited. The Service later determined a year 1 deficiency. The issue was the start date of underpayment interest. The ruling held that interest on the deficiency, to the extent of the overpayment, began to run as of the due date of the first installment. In reaching this conclusion, the ruling assumed that the overpayment would be applied as of that date (thus, the year 1 tax would no longer be unpaid), in accordance with Rev. Rul. 84-58. Rev. Rul. 84-58 provided that when a taxpayer makes an election, under Sec. 6402(b), to credit an overpayment to the next year's estimated taxes, the overpayment will be applied to the first installment for that year unless the taxpayer designates a different installment on its return.

The reasoning of Rev. Rul. 88-98 came under attack in May Dept. Stores Co., 36 Fed. Cl. 680 (1996), acq.; accord, Kimberley-Clark Tissue Co., DC Pa 1997; and Sequa Corporation, DC NY 1998. In May (as in the ruling), the taxpayer elected to credit a year 1 overpayment to year 2 estimated taxes without designating which installment to credit. Although the taxpayer had already paid its first and second installments at the time of the election, the IRS applied the overpayment to the first installment under Rev. Rul. 84-58; subsequently, it determined a year 1 deficiency.

Consistent with Rev. Rul. 88-98, the Service asserted that underpayment interest on the deficiency, to the extent of the overpayment, ran from the due date of the first installment. On the other hand, the taxpayer asserted that under a proper application of the use-of-money principle, underpayment interest begins to run only when a year 1 overpayment is used to satisfy an unpaid year 2 installment. (For the taxpayer, this was the third installment.) Until then, the IRS retains the use of the taxpayer's funds.

The Court of Federal Claims in May agreed with the taxpayer. It distinguished Rev. Rul. 88-98 as resting on the implicit assumption that the year 2 installment against which the year 1 overpayment is credited is either unpaid or underpaid. The court reasoned that the Service had the use of the taxpayer's funds until such time as they were applied to another outstanding liability. It made no difference from the court's point of view that the IRS credited the overpayment to the first installment of year 2, because that liability was then overpaid.

In 1997, the Service announced its acquiescence in the May decision.

Rev. Rul. 99-40

Rev. Rul. 99-40 reconsiders Rev. Ruls. 88-98 and 84-58 in light of May. The ruling provides that, if a taxpayer makes a Sec. 6402(b) election for year 1, the IRS will apply the overpayment to unpaid year 2 estimated tax installments due on or after the date the overpayment arose in the order in which they must be paid to avoid the penalty. Underpayment interest on any subsequently determined year 1 deficiency, to the extent of the overpayment, will be computed from the dates of such application. Interest on the balance of the deficiency, if any, will be computed from the original due date of the year 1 tax. The Service will no longer automatically credit a year 1 overpayment to the first year 2 installment absent a contrary designation by the taxpayer. It will honor such designations made before Oct. 4, 1999, but will not accept a designation made on or after that date.

The ruling offers four illustrations. In Situation 1, a corporation elects to credit a year 1 overpayment to year 2 estimated taxes. The corporation pays the required installments for the first two quarters, and a year 1 deficiency smaller than the amount of the overpayment is later determined. In Situation 2, the facts are the same, except the corporation underpays the first two installments by an amount exceeding the amount of the overpayment. In Situation 3, the IRS refunds, without interest, an overpayment shown on an individual's income tax return. A deficiency less than the amount of the overpayment is later determined for the same year. In Situation 4, the facts are the same, except that the deficiency is larger than the overpayment.

The ruling concludes that, in Situation 1, the overpayment will be applied to the third installment. Underpayment interest on the deficiency will run from the date of such application. In Situation 2, the overpayment will be applied to the first installment as necessary to avoid the estimated tax penalty, with the balance being applied to the second installment. Underpayment interest on the deficiency, which in the example is less than the portion of the overpayment credited to the second installment, will run from the due date of the second installment. In Situation 3, underpayment interest will run on the deficiency only from the date of the IRS refund check. In Situation 4, the result is the same, except that interest on the portion of the deficiency exceeding the refund will run from the payment's original due date.

Critique

Rev. Rul. 99-40 reflects a commendable change in the IRS'S position. That change was not unexpected. In addition to the Service's acquiescence, views similar to those in the ruling have appeared in a series of recent field service advice (FSA) memoranda; see FSAs 1999-11001 (discussing May; concluding that a year 1 overpayment may be split between installments), 1999-10014,1999-20010,1999-30007 and 1999-30008.

Rev. Rul. 99-40 should help obviate future disputes between taxpayers and IRS field personnel in situations substantially like May. On the subject of retroactivity, the ruling provides that, under Sec. 7805'(b), it will not be applied adversely to a taxpayer that designated an overpayment to apply to an installment of estimated tax in accordance with Rev. Rul. 84-58 prior to Oct. 4, 1999. In addition, taxpayers that did not make such designations and that may benefit from the ruling's application may be able to invoke it to resolve existing disputes.

In any event, however, it seems unlikely that Rev. Rul. 99-40 will end all controversy in this area of the law. Consider, for instance, the taxpayer that has, without regard to a year 1 overpayment, fully paid all year 2 estimated tax installments. To the extent that a year 1 deficiency does not exceed the overpayment, when does year 1 underpayment interest run? According to the IRS, the overpayment must be applied to year 2 no later than the original due date of the year 2 return, even if no tax remains unpaid for year 2; see FSAs 1999-30031 and 1999-32010. Thus, year 1 underpayment interest runs from that date. This view relies primarily on Sec. 6513(d), which treats, as a payment of year 2 tax, a year 1 overpayment claimed as a credit against year 2 estimated taxes under Sec. 6402 and prohibits the taxpayer from seeking a refund for year i of the overpayment so credited.

The Service's reliance on Sec. 6513(d), however, may be misplaced. First, the statute assumes the typical case (unlike the example) when the taxpayer actually used the year 1 overpayment as a credit against year 2 estimated taxes. It specifically refers to Sec. 6402(b), which by its own terms speaks to the "crediting against the estimated tax ... of the amount determined ... to be an overpayment of the income tax for a preceding taxable year" (Emphasis added.) Second, the statute does not purport to invoke or rest upon the use-of-money principle. Rather, its primary purpose is to fix the payment year to make refunds, determine the statute of limitations and compute overpayment interest; see Owens-Corning Fiberglass Corp. (Ct. Cl. 1972) (discussing legislative history of Sec. 6513(d)) and Regs. Sec. 301.6611-1 (h) (vii) (providing that year 1 overpayment interest is not allowed on portion of overpayment applied to year 2 estimated taxes). In short, one may plausibly argue that, if all year 2 installments have been paid and no year 2 tax remains unpaid, there is no basis for applying the year I overpayment to year 2.

Consider another situation: An individual files a year i return late, after the original due date of the year 2 return. The year 1 return reports an overpayment that the taxpayer elects to apply to year 2. His first year 2 installment (which he does not pay) equals the amount of the overpayment. The taxpayer pays all other amounts due for year 2 on or before April 15, in year 3. Does he owe underpayment interest for year 2? One might assume that the IRS would apply the year 1 overpayment to the first installment; see Rev. Rul. 99-48. The overpayment would be treated as a payment of tax as of the original due date of the year 2 return.. Sec. 6513(a) provides that prepayments of tax are deemed paid as of the return's original due date. Thus, the taxpayer would not be underpaid. Yet, the Service has taken the contrary view in such circumstances. In Schafer, DC Ohio, 1997, it successfully argued that the year 1 overpayment need not be credited to year 2 until the year 1 return is actually filed. Thus, in this example, the IRS would treat the taxpayer as underpaid, in the amount of the year 1 overpayment, at the time the year 2 tax was due. The Service would charge the taxpayer interest on the amount of the "underpayment" from the original due date of the year 2 return until the date it received the year 1 return. (Parenthetically, the IRS would also charge estimated tax and late payment penalties and, if the year 2 return were late, a delinquency penalty, as well.) That result, however, clashes with the use-of-money doctrine, since the Service has the use of the taxpayer's funds no later than April 15 in year 2.

As these examples illustrate, future disputes between taxpayers and the IRS over the applicability of the use-of-money principle are foreseeable. In fact, the precise contours of that doctrine have yet to be fully explicated. Still, Rev. Rul. 99-40 is arguably a step in the right direction.

RONALD A. STEIN, LL.M., CPA, ARTHUR ANDERSEN LLP, CHICAGO, IL