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Interest on overpayments by S corporations.

Garwood Irrigation Co., a Texas company, acquired very valuable water rights in 1900. Garwood had operated for a time as a C corporation, then elected S status before selling its rights in January 1999. The sale triggered recognition of a built-in gains tax, which the company reported and paid on its 1999 tax return. On audit, the IRS disagreed with the value assigned to the water rights on the date of the company's conversion to S status and, therefore, the amount of built-in gains reported.

Garwood and the service litigated the issue of the value of the water rights and the resulting tax paid by the company, and the Tax Court determined that Garwood had overpaid its tax liability for that year by more than $10,000.

The IRS calculated interest on the refund at the federal short-term rate plus 0.5 percentage points (the rate prescribed for large corporate overpayments). Garwood argued that the appropriate rate was the short-term rate plus 3 percentage points, the rate prescribed for noncorporate taxpayers. The two sides returned to court to litigate the interest rate question.

Result. The conclusion was a draw--more or less. The court determined the appropriate rate was the federal short-term rate plus 2 percentage points, the rate prescribed for corporate taxpayers.

IRC section 6621 sets the rate of interest to be paid on overpayments of tax at the federal short-term rate plus 3 percentage points (+3 rate) for noncorporate taxpayers and plus 2 percentage points (+2 rate) for corporate taxpayers. Another provision limits the rate for a corporate overpayment that exceeds $10,000 to the federal short-term rate plus 0.5 percentage points (+0.5 rate). This would appear to have limited Garwood's interest to the +0.5 rate, except that this part of the tax code contains a confusing cross-reference to section 6621(c)(3).

The section defines large corporate underpayments, with instructions to substitute "overpayment" for "underpayment." It then specifies that an underpayment by a C corporation that exceeds $100,000 is a large corporate underpayment. It also defines taxable period for purposes of this large corporate underpayment. Garwood argued that the +0.5 rate did not apply to its overpayment because the cross-reference indicates that only C corporations are included in the definition of corporation for purposes of interest on overpayments.

The IRS argued that the cross-reference is intended to refer only to the definition of "taxable period" and that, since the large corporate underpayment had set up a different threshold ($100,000 vs. $10,000), it was not meant to be the same definition.

The court found some basis in a congressional committee report for concluding that the cross-reference refers to the large corporate underpayment definition. As Garwood was an S corporation, it was not subject to that definition, and the +0.5 rate did not apply. The court disappointed Garwood, however, by finding that the +3 noncorporate rate didn't apply either.

The statute does not specifically exempt S corporations from the definition of a corporation for purposes of interest on the overpayment. In addition, Garwood operated as a C corporation for a time and the overpayment in question related to built-in gains tax that had resulted from its operation as such. The court concluded that the appropriate interest rate was +2.

Tax preparers need to keep in mind that, although an S corporation generally is taxed according to subchapter S of the Internal Revenue Code, it is taxed as a C corporation when an issue is not addressed in that subchapter. For interest on overpayments, S corporations are treated as corporations, but are not subject to the lower rate for large corporate overpayments.

* Garwood Irrigation Company v. Commissioner, 126 TC no. 12.

Prepared by Cheryl T. Metrejean, CPA, PhD, assistant professor of accounting, Georgia Southern University, School of Accountancy, Statesboro.
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Title Annotation:Garwood Irrigation Co. v. Commissioner
Author:Metrejean, Cheryl T.
Publication:Journal of Accountancy
Date:Nov 1, 2006
Previous Article:When payments to an S corporation don't create basis.
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