Interest on Deposits May Prevent Taxpayers From Obtaining Costs and Fees from Service.

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Today’s post deals with the intersection of the deposit procedures for suspending the running of overpayment interest and seeking administrative costs and fees.  Although not quite as sexy as Rihanna settling her tax case, it highlights a strange and potentially unfair requirement for obtaining interest on deposits, and shows the impact of the rule that may not have been considered by the drafters.  As discussed below, taxpayers seeking interest on their deposits in the event of their ultimate success must “endorse” the position of the IRS as reasonable at the same time they are attacking the position as incorrect.

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For years, taxpayers have been allowed to make advanced remittances in the nature of cash bonds to post against potential tax debts.  These remittances stop the running of underpayment interest on the potential debt and allow taxpayers still to seek prepayment review in the tax court, but historically also did not allow the taxpayer to receive overpayment interest on the amount remitted unless the taxpayer pays it after filing a Tax Court petition.  If the taxpayer elected to treat the advanced remittance as a payment, the taxpayer would be entitled to overpayment interest, but there are various reasons why a taxpayer would potentially not want the remittance treated as a payment (tax court review, refund procedures, statute of limitations).   As a side note, Les and I are currently finishing up the rewrite dealing with Chapter 6, in IRS Practice and Procedure by Saltzman and Book, which deals with interest.  Advanced remittances is an area that received a substantial rewrite.  The new version should be available by the fall!

In 2004, Congress amended Section 6603 to codify portions of the advanced remittance treatment that was in largely in place, but also added a provision under Section 6603(d) that offered taxpayers the ability to receive interest on some advanced remittances treated as bonds when there was a “disputable tax”.  Under the statute, interest will be paid on the advanced remittance if the disputable tax is identified at the time the remittance is made.  To identify the disputable tax the taxpayer must specify “at the time of the deposit…the taxpayer’s reasonable estimate of the maximum amount of any tax attributable to disputable items.”  The key issue is the definition of “disputable items”, which is “any item of income, gain, loss, deduction, or credit if the taxpayer has a reasonable basis for its treatment of such item and reasonably believes that the Secretary also has a reasonable basis for disallowing the taxpayer’s treatment of such item.”

This is a strange requirement, and I’m not sure its equivalent is found in any other provision of the Code.  I obviously take no issue with the taxpayer stating it has a reasonable basis for its position, but am perplexed by the requirement that the taxpayer reasonably believe the IRS had a reasonable basis for disallowing the treatment.   I believe the policy behind this provision was to ensure there were actual controversies, and taxpayers didn’t simply park their funds with the Service to generate interest on unnecessary deposits.  But, the statute frames this requirement in a manner requiring the taxpayer to opine on the reasonableness of the Service’s position.

With this requirement, the statute on its face prohibits interest from being paid if the IRS position lacks a reasonable basis (unless the Service is unreasonable, but the taxpayer reasonably believes the IRS is being reasonable).  It is unclear how this advances the tax system, or encourages taxpayers to make deposits.  In fact, by forcing the taxpayer to state the Service is being reasonable, the statute could thwart the overall intention of the statute in increasing deposits and providing interest on those deposits, as it limits the number of controversies covered and, as explained below, taxpayers may not be willing to state the Service has been reasonable.

It is also unclear, save an exception to be discussed below, how a taxpayer would know in all situations if the Service has a reasonable position, and to what extent the taxpayer must investigate this to actually show the taxpayer reasonably believes the Service was reasonable.  It would be entertaining if this caused the Service to make the perverse argument that it was unreasonable in an attempt to deny interest, but I assume any disagreement in this area would be based on whether or not the Service was taking the position claimed by the taxpayer.  Presumably, if the Service declined the taxpayer’s position for interest, there would be some type of appeal allowed.  Revenue Procedure 2005-18 does not specify the appeal procedure, and the statute does not specify what should occur during a disagreement.

As I mentioned above, there is an exception for the taxpayer having to determine what the Service’s position is for a disputable item, and if it is reasonable.  Section 6603(d)(2)(B) states that in the case of a taxpayer who has been issued a 30-day letter, the maximum amount of the disputable tax shall not be less than the amount of the proposed deficiency specified in the 30-day letter.  Taxpayers can, in fact, submit the 30-day letter in lieu of the other disputable tax notification pursuant to Rev. Proc. 2005-18.  Submitting the 30-day letter is an easy way to show the disputable tax, but the statute does not state submitting the 30-day letter will cause the underlying tax attributes to not be “disputable items”.  In submitting the 30-day letter, the taxpayer may still be treated as taking the position the Service was reasonable, although not required to state as much in its submission.  I would certainly argue otherwise, but there was no guidance on the matter.  This is an important point for the fees and costs discussion below.

Not allowing interest when the Service is acting unreasonable seems like a sufficient reason to revisit this statute, but taking the position that something is a “disputable tax” has at least one other presumably unintended consequence.  If a taxpayer subsequently desires to seek administrative or litigation costs and attorneys’ fees, acknowledging the Service position was reasonable would prevent the taxpayer for obtaining the costs under Section 7430.  Under Section 7430, the “prevailing party” is entitled to costs and fees in certain circumstances.  The statute, however, has an exception to treating a taxpayer as the prevailing party if the service is “substantially justified.”  This is shown, under the regulations, by the Service showing it had a reasonable basis in both fact and law.  If the taxpayer has already stated the Service had a reasonable basis for its position when the taxpayer was seeking interest on the deposit, the Service would seemingly have little trouble showing it was substantially justified for that particular tax item.

We’ve discussed before on Procedurally Taxing some of the potential benefits of qualified offers in attempting to receive fees and costs, and this is another potential benefit.  If a qualified offer is made, the Service is precluded from showing it was justified in its position, making the taxpayer’s statement regarding the Service’s position unimportant.  That does provide some relief, but taxpayers rarely use the qualified offer option.

Overall, requiring the taxpayer to endorse the Service’s position as reasonable, allowing no interest when the Service’s position is unreasonable does not advance tax administration and creates a policy for obtaining interest that could disallow fees and costs even if the Service unjustifiably protracts a matter.  There are certainly other ways for the Code to determine if there has been an actual controversy without requiring the taxpayer to state the Service is being reasonable.  For instance, the taxpayer could notify the Service he or she is taking the position that there is a disputable item, and the Service could have a set time period to respond or state it is not taking the alleged position.    There are probably even more efficient and clever ways of handling this that would benefit the Service by encouraging more deposits, and benefit taxpayers by providing interest on those deposits.

Stephen Olsen About Stephen Olsen

Stephen J. Olsen’s practice includes tax planning and controversy matters for individuals, businesses and exempt entities for the law firm Gawthrop Greenwood, PC.

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Comments

  1. Mandi Matlock says

    Should taxpayers just make an advanced remittance of the amount of tax, interest, and penalty they believe will ultimately result from the audit? What do you tell taxpayers who are concerned that submitting an advanced remittance signals to the IRS the amount they believe should be the result of the audit? I know IRS shouldn’t draw any inferences from the advanced remittance amount, but is there some authority/thought on this?

  2. Mandi Matlock says

    Also, since a taxpayer can designate how payments are allocated between tax, interest and penalty, may a taxpayer who previously has made a general deposit designate in writing how the deposit funds must be applied when the liability is finally determined and the taxpayer is ready to permit IRS to use the deposit? Or does a designation between tax, interest, and penalty have to be made at the time the deposit is made?

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