The calculation of interest when an original overpayment is decreased on audit.

The IRS and the courts have taken opposite positions on the calculation of interest when an original overpayment, applied to the following year's estimated tax, is decreased on a subsequent audit. The Service's position is that the interest begins on the due date of the estimated tax payment to which the overpayment is applied, regardless of whether or not any actual underpayment exists. The courts have maintained that interest does not begin until the government is actually owed tax.

In Letter Ruling (TAM) 9646001, a taxpayer had an overpayment on its 1986 return, which it filed on Sept. 15, 1987. The taxpayer elected to apply the overpayment to its 1987 tax liability, but did not specify to which installment the overpayment was being applied. A similar situation arose when the taxpayer filed its 1988 return. During the period in dispute, the taxpayer had paid all taxes due. The Service assessed interest from April 15 for both 1986 and 1988. The taxpayer claimed that the interest should begin on September l15, the date the overpayment was applied to the following year, under the use-of-money principle.

The IRS determined that the interest on the deficiency began on the due date of the estimated tax to which the overpayment was applied. The Service relied on Rev. Rul. 88-98, which stated that when an overpayment from the year is applied against the following year's estimated tax, interest on a subsequent deficiency for the first year begins on the due date of the second year's installment, but only for the amount of the deficiency not exceeding the overpayment. Interest begins on the due date of the return for the amount of the deficiency that exceeds the overpayment.

The IRS brought up an interesting issue in its discussion of unrelated overpayments. The Service mentioned Avon Products, Inc., 588 F2d 342 (2d Cir. 1978), in which the court held that under Sec. 6601, interest begins when a tax becomes both due and unpaid and that interest is not a penalty, but only a means to compensate the government for the delay in the payment of tax. Because Avon Products dealt with underpayments instead of overpayments, the IRS rejected use of the decision for the overpayment years. The Service, however, made no mention of Avon Products in its discussion of interest for the underpayment years, and the TAM was not clear on whether the taxpayer offered Avon Products as support for its position in those years.

In opposition to the TAM is The May Department Stores Company, Ct. Fed. Cls., 11/4/96. The May Department Stores Company (May) estimated its fiscal-year 1984 tax liability at $111 million and timely paid this amount by Apr. 17, 1984. May filed its fiscal-year 1984 tax return on Oct. 15, 1984, and showed a tax liability of $103,090,774, resulting in an overpayment of $7,909,226. May elected to apply the overpayment to its fiscal-year 1985 tax liability, but did not specify the estimated tax installment to which the overpayment should be applied. The IRS applied the overpayment to the first installment, due May 15, 1985. The first two installments already had been paid in full.

Upon subsequent examination, the Service determined that May's actual fiscal-year 1984 tax liability was $108,018,931, a decrease in the amount of overpayment applied to fiscal-year 1985 of $4,928,157. The IRS assessed interest of $4,690,761, which it calculated from May 15, 1984 through the date of payment. May paid the tax and interest assessed, but filed Form 843, Claim for Refund and Request for Abatement, claiming a refund for the interest assessed for the period May 15, 1984 to Oct. 15, 1984. May also filed an amended return, electing to apply the overpayment to the third fiscal-year 1985 estimate due Oct. 15, 1984.

A similar situation occurred for the fiscal year ended Feb. 2, 1985. On Apr. 15, 1985, May extended its fiscal-year 1985 return and timely paid its estimated tax liability of $142 million. On Oct. 15, 1985, May filed its return showing a $136,161,486 liability, resulting in an overpayment of $5,838,514. May applied the overpayment to the following fiscal year, but did not indicate the installment to which it should be applied. The Service again credited the overpayment to the first installment, due May 15, 1985. The first two installments already had been paid in full.

The IRS determined that May's actual fiscal-year 1985 tax was $142,740,592, $740,592 more than its payments. The Service assessed interest of $4,810,716 for the period beginning May 15, 1985. May agreed to the tax and interest on the $740,592, but disputed the calculation of the interest on the amount applied to the estimated taxes. May stated that the interest should not begin on May 15, 1985, since the IRS continued to have the use of the overpayment until Oct. 15, 1895. May paid the tax and interest, but again filed Form 843 to recover the interest paid for the period May 15, 1985 through Oct. 15, 185. May also filed an amended return to apply the fiscal-year 1985 overpayment to the third estimate for fiscal year 1986.

May claimed that the Service can assess interest only when an underpayment exists. In each case, the underpayment was created when the overpayment was applied to the following year's tax. Therefore, the IRS could not assess interest until October 15 of each year, when May used the funds that rightfully belonged to the government by applying the overpayment to the following year's estimated tax. If interest were assessed before October 15, the Service would enjoy a double benefit: interest-free use of May's tax payments from May to October plus interest assessed on the increase in tax from May to October.

The IRS relied on Rev. Rul. 88-98 to begin accruing interest on the date of the following year's first estimated tax payment. The Service acknowledged that, had May designated on its return that the overpayment was to be applied to the following year's third estimated tax, the interest would have begun on the due date of the third estimate.

The Court of Federal Claims determined that the issue of whether there was a valid election to apply the overpayment to the third estimate was not relevant. Instead, it addressed the issue of the use of funds, citing Manning v. Seeley Tube & Box Co., 338 US 561 (1950). In Manning, the Supreme Court stated that a later occurring event could not retroactively change whether the government had previously enjoyed full use of all funds rightfully belonging to it. In this case, the IRS assessed tax that was later eliminated through a net operating loss (NOL) carryback from a subsequent year. The Court held that, although the taxpayer eliminated the deficiency, the taxpayer still had to pay interest because the government was without the use of the funds from the date of the deficiency to the date the NOL was carried back.

The Court of Federal Claims noted that May was the reverse of Manning. It stated that the fact that May used its overpayments to offset a subsequent liability did not indicate that the government was deprived of the use of the funds for the period during which the government undisputedly possessed those funds. Interest would be assessed only when the overpayment was credited to estimates that were underfunded or wholly unpaid. May's taxes were fully paid at all times between April 15 and October 15, even when the deficiency in the prior year's tax was considered. The court stated that the application of the overpayment to the first installment of estimated tax for the following year, which had already been paid, could not change the fact that the government had the use of the funds from April 15 to October 15, and thus suffered no underpayment. Therefore, May should not be treated as if it had not paid the full amount of its taxes during the period from May 15 to October 15.

The IRS has indicated that it will issue guidance on the interest accrual dispute during 1997. Until such guidance is issued, the May decision offers taxpayers support for avoiding undue interest charges.