Tax prepayments--advance payments or deposits under Blom?

As the interest rate on Federal tax underpayments increases (8% for the calendar quarter beginning July 1,2006), taxpayers facing a tax liability dispute with the IRS are even more likely to consider making voluntary prepayments to obviate the effects of any interest and penalties. Taxpayers can make prepayments in one of two ways, as long as the IRS has not already assessed tax. They can designate them either as a deposit or an advance payment of tax. There is an important distinction between the two, which was highlighted in a recent court decision.

A deposit made under Sec. 6603 that is in accordance with Rev. Proc. 2005-18 will be returned if the taxpayer simply submits a written request to the ILLS. A prepayment made as an "advance payment of tax," however, will be returned only if the taxpayer follows the Service's procedures for claiming a refund. Consequently, a request for a return of an advance payment is subject to the strict statute of limitations (SOL) on refund claims. According to Sec. 6511, for the IRS to consider a refund claim, it must be filed within three years of filing the return or within two years of paying the tax, whichever is later. Taxpayers that do not file a return must file a refund claim within two years of paying the tax.

Facts

In Biota, ED PA, 5/31/06, the taxpayer prevailed in convincing a district court that a payment made by an estate was a "deposit in the nature of a cash bond." (Prior to the American Jobs Creation Act of 2004's enactment of Sec. 6603, a prepayment made as a deposit was referred to as a deposit in the nature of a cash bond.) While the taxpayer was successful, the case serves as a reminder that for a prepayment of a disputable tax to be considered a deposit, taxpayers must closely follow Rev. Proc. 2005-18's requirements.

In Blom, an executrix visited an IRS office to inquire about an extension to file the decedent's Federal estate tax return. The decedent had died on March 1, 1996. The executrix believed assets held in trust from the decedent's late husband's estate were supposed to be included in the decedent's taxable estate. The estate eventually became involved in litigation with the trustee.

As a result of her visit to the IRS, the executrix filed Form 4768, Application for Extension of Time To File a Return and/or pay U.S. Estate (and Generation-Skipping Transfer) Taxes, on Nov. 22, 1996. At the same time, she submitted two checks to the Service, totaling $140,000. Neither of the payments was designated as a deposit. One check included the reference "Federal Estate Tax" and the decedent's name, while the other carried no notation. The IRS accepted these payments and approved the extension request. However, the executrix failed to file the estate tax return by the extended due date, June 1, 1997. When the return was finally flied on Sept. 9, 2002, there was no tax liability noted.

The IRS had posted the payments as advance payments of tax. As a result, it treated the estate tax return as a refund claim, which it then proceeded to deny on the basis that the three-year SOL had expired. The executrix filed suit to recover the $140,000, contending that she intended the payments to be a deposit in the nature of a cash bond, not a payment.

Analysis

Both Rev. Proc. 2005-18 and its predecessor, Rev. Proc. 84-58 (applicable in Blom), state that a payment made before the IRS mails a deficiency notice cap, be considered a deposit only if the taxpayer designates it as such in writing. As previously noted, the executrix in Blom did not designate either check as a deposit. However, because the payments were made prior to the issuance of a deficiency notice (and, in fact, no taxes were due), the district court used the Third Circuit's "facts and circumstances" analysis to resolve the issue. It believed the facts supported the executrix's assertion that she intended the payments to be deposits. The executrix testified that she did not consult a tax professional to estimate the taxes and made the payments to avoid a penalty assessment against the estate for filing or paying late. According to the court, her intent was supported by correspondence she sent to the IRS before she filed the estate tax return. In that correspondence, she explained that the estate was involved in litigation and that she would not file the return until it was concluded.

Importantly, different courts treat a remittance that accompanies a request for a filing extension differently. Some courts have held, like Blom, that such payments are deposits, not advance payments of tax; see, e.g., Hill, 263 F2d 885 (3d Cir. 1959). Others have held the opposite; see, e.g., Deaton, 440 F3d 223 (5th Cir. 2006), aff'g TC Memo 2005-1, and Harrigill, 410 F3d 786 (5th Cir. 2005).

In footnote 4 of Blom, the court noted, "there is a body of law in other Circuits finding that an estimated payment filed with a Request for Extension is a 'payment' for purposes of tolling the statute of limitations." However, the court found such cases distinguishable. Of consequence is the fact that these cases predate Sec. 6603 and Rev. Proc. 2005-18. For that reason, taxpayers may not want to rely on previous decisions holding such payments to be deposits.

Conclusion

Taxpayers contemplating making a payment when there might be a potential tax dispute with the IRS should review and follow the requirements of Sec. 6603 and Rev. Proc. 2005-18. In particular, they should always closely monitor and adhere to the deadlines under Sec. 6511 for claiming refunds, in case they end up in a court that does not agree with Blom.

FROM DANNY SNOW, CPA,THOMPSON DUNAVANT PLC, MEMPHIS, TN