Allocating Advance Payments Between Tax and Interest

Editor: Annette B. Smith, CPA

Rev. Proc. 2005-18 supersedes Rev. Proc. 84-58, which for more than 20 years had specified the procedures for making remittances to suspend interest running on tax underpayments. The issuance of Rev. Proc. 2005-18 was welcome, as it provides guidance on making deposits under new Sec. 6603, withdrawing them and converting deposits made under Rev. Proc. 84-58 to Sec. 6603 deposits.

In one important respect, however, the lack of congruity between the scope of the new and old procedures has left a void. Specifically, while section 6 of Rev. Proc. 84-58 addressed in some detail the allocation of advance payments between tax and interest, Rev. Proc. 2005-18 does not address that issue. As a result, while it is tempting (and arguably, even reasonable) for taxpayers and tax advisers to continue to look to Rev. Proc. 84-58 for guidance on payment allocation questions, the fact that Rev. Proc. 84-58 has been superseded by Rev. Proc. 2005-18 would appear to compel taxpayers to identify—and evaluate the continuing applicability of—the statutory and regulatory provisions and case law that underpin section 6 of Rev. Proc. 84-58.

Full and Partial Payments

In the case of an advance payment in an amount greater than the tax due, Rev. Proc. 84-58 provided that the IRS would respect the taxpayer’s allocation of the excess amount to interest or penalties. This position is not controversial; support for it is found in Rev. Proc. 2002-26.

For partial payments, Rev. Proc. 84-58 stated that the Service would honor the taxpayer’s request to allocate all or part of the payment to interest if the taxpayer either (1) agrees to the assessment and collection of the liability by executing a waiver of restrictions (i.e., Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment; 870-AD, Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment; or 4549, Income Tax Examination Changes); or (2) pays the portion of the underlying tax that corresponds to the amount of the payment designated as interest. Otherwise, any purported partial payment of tax would be treated in its entirety as a deposit in the nature of a cash bond, unless (and until) the taxpayer cured the defect by redesignating the amount to be allocated to interest.

By honoring the taxpayer’s allocation of all or some of a payment to interest, the IRS was implicitly allowing the taxpayer to deduct that interest in the year of payment under Sec. 163(a). Although not explicitly mentioned in Rev. Proc. 84-58, the Regs. Sec. 1.461-1(a)(2) “all events” test appears to underlie the Service’s position. Taxpayers and advisers should look to that test for guidance on payment allocation issues.

In the first situation described above, if a taxpayer agrees to the liability and signs a waiver of the assessment restrictions, for accrual-method taxpayers the all-events test appears met; both the fact and the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred according to Regs. Sec. 1.461-4(e). For cash-method taxpayers, the interest has been paid; thus, it is deductible.

Resolution of the second situation—in which the taxpayer pays a portion of the tax and a corresponding amount of interest—depends on a number of factors, the existence of which cannot be determined from Rev. Proc. 84-58. For example, if the additional tax and interest have been assessed, or mutually agreed to but not yet assessed, Rev. Proc. 2002-26 may apply. It provides that if the Service accepts a partial payment, it will honor the taxpayer’s specific instructions regarding payment application; any part of the payment applied to interest will be deductible under Sec. 163(a) in the year of payment.

However, as noted above, under section 6.02 of Rev. Proc. 84-58, the IRS would honor a taxpayer’s allocation to interest only if a proportional amount of underlying tax has also been paid (but see Perkins, 92 TC 749 (1989); Preble, TC Memo 1989-208; and AODs 1990-022 and -015).

 Contested Liability

If the additional tax and interest have not been assessed or agreed to, Rev. Proc. 2002-26 would seem inapplicable. Instead, if the taxpayer is regarded as contesting the liability in spite of the partial payment, Sec. 461(f) seems to apply. An accrual-basis taxpayer can deduct a contested liability if the following conditions are met: (1) the taxpayer contests an asserted liability; (2) the taxpayer transfers money or other property to provide for the satisfaction of the asserted liability; (3) the contest continues after the time of the transfer; and (4) a deduction would be proper but for the contest of the liability. The deduction may be taken in the year in which the money (or other property) was transferred.

In a Rev. Proc. 84-58 partial-payment situation, the Sec. 461(f) “asserted liability” requirement is met. Section 6.02 of Rev. Proc. 84-58 states that the partial payment of tax is being made under section 4.03 of the procedure, which in turn provides that a remittance can constitute a tax payment only if made in response to a proposed liability. The taxpayer’s payment to the Service satisfies the “transfer of money (or other property)” requirement. Finally, as was noted, the existence of a contest has been assumed. 

In Rev. Rul. 89-6, an accrual-method corporate taxpayer remitted the total amount of unassessed tax proposed by the IRS (plus appropriate interest) in a 30-day letter, did not designate the remittance as a deposit and contested the proposed tax and interest both before and after making the remittance. The ruling held that the interest portion of the remittance was deductible under Sec. 461(f). Importantly, it specifically stated that it also applied to partial remittances that constitute payments of tax and interest under section 4.03 of Rev. Proc. 84-58.

Conclusion

While the issuance of Rev. Proc. 2005-18 is a complicating factor when dealing with payment allocation questions, Rev. Proc. 2002-26, Rev. Rul. 89-6 and the numerous other authorities that interpret and apply the all-events test should provide the guidance needed to resolve many such issues.

EditorsNotes

Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers, LLP.

If you would like additional information about these items, contact Ms. Smith at (202) 414–1048 or annette.smith@us.pwc.com.