Deducting Deficiency Interest Expense in the Proper Tax Year

Taxpayers under IRS examination often face many challenges, including responding to information document requests under tight time constraints, dealing with technical issues, locating and obtaining documentation from various company locations, managing limited resources, and negotiating proposed adjustments. Indeed, taxpayers may become so focused on closing the audit that they often overlook a potentially significant deduction.

Example: X is a calendar-year taxpayer under federal income tax examination for years 2005–2007. On December 15, 2009, X receives Form 5701, Notice of Proposed Adjustment, for certain changes to its federal taxable income for the years under examination. X reports on the accrual method of accounting for federal income tax purposes. On December 31, 2009, X indicates that it is in agreement with the proposed changes and signs Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment. As of May 15, 2010, the IRS has yet to sign Form 870, and X has not yet paid the IRS the amount of tax deficiency and related deficiency interest.

Is the liability for deficiency interest fixed for federal income tax purposes as of December 31, 2009, thereby allowing the taxpayer to deduct the interest assessed?

The Law

Under Sec. 461(a), a deduction is allowed in the proper tax year under the method of accounting used in computing a taxpayer’s income. Regs. Sec. 1.461-1(a)(2)(i) provides that under the all-events test of the accrual method of accounting:

• A liability for an expense accrues in the year in which all the events have occurred that establish the fact of liability for the expense;
• The amount of the liability can be determined with reasonable accuracy; and
• Economic performance has occurred with respect to the liability.

The Tax Court explained in Hallmark Cards, Inc., 90 T.C. 26 (1988), that “[t]he all-events test is based on the existence or nonexistence of legal rights or obligations at the close of a particular accounting period, not on the probability—or even absolute certainty—that such right or obligation will arise at some point in the future.” The Supreme Court, in Dixie Pine Products Co., 320 U.S. 516 (1944), stated that all events are not fixed “where the liability is contingent and is contested by the taxpayer.”

Regs. Sec. 1.461-2(b)(2) defines a contested liability as a liability subject to any contest that would prevent its accrual under Sec. 461(a). A contest arises when there is a bona fide dispute as to the proper evaluation of the law or the facts necessary to determine the existence or correctness of the amount of an asserted liability.

Regs. Sec. 1.461-4(e) provides that in the case of interest, economic performance occurs as the interest cost economically accrues, in accordance with the principles of relevant provisions of the Code.

In Rev. Rul. 70-560, during the 1968 tax year, the IRS asserted a federal income tax deficiency for the tax year 1966 against an accrual-method corporation. The taxpayer contested the deficiency in Tax Court, and in 1970 the court determined the tax was due. The taxpayer did not appeal the decision and paid both the income tax deficiency and interest thereon.

The IRS ruled that interest on a federal tax deficiency asserted against an accrual-basis taxpayer accrues in the year the liability for the deficiency is finally determined and is an allowable deduction in that year. The IRS also noted that the liability would have accrued in 1968 if the taxpayer had not contested the liability and instead had agreed to it.

Some cases have examined certain facts that resulted in the liability’s not being fixed for purposes of deducting the deficiency interest. In Exxon Corp., T.C. Memo. 1999-247, the Tax Court denied the taxpayer a deduction for interest related to allegedly uncontested tax deficiencies based on the taxpayer’s failure to indicate on Form 5701 whether it agreed, agreed in part, or disagreed with each proposed adjustment. The court noted that the adjustments were not fixed and definite because the taxpayer provided “insufficient specific communication” to the IRS reflecting agreement to the proposed adjustments. The court further explained that a taxpayer’s liability is fixed when agreements regarding the tax adjustments are entered into in a clear and formal manner.

In Phillips Petroleum Co., T.C. Memo. 1991-257, the Tax Court denied a deduction for deficiency interest relating to uncontested tax deficiencies. In facts similar to Exxon, the taxpayer did not expressly agree to the proposed changes by indicating agreement on Form 5701. The court held that the taxpayer’s adjustments were not sufficiently settled to allow the taxpayer to accrue deductions for related interest prior to the point at which the taxpayer signed Form 870-AD, Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment, or Form 866, Agreement as to Final Determination of Tax Liability, both of which gave the IRS permission to assess the tax deficiency. The court observed that prior to signing these forms, the taxpayer neither explicitly agreed to the proposed adjustments nor explicitly contested them.

Most recently, in Chief Counsel Advice 200521026, the IRS ruled that deficiency interest cannot be deducted in the year in which a taxpayer under the Coordinated Examination Program gave the IRS a written statement that met the definition of a qualified amended return (QAR). The ruling stated that providing the QAR failed to meet the fixed and determinable prongs of the all-events test. Rather, amounts were fixed when agreements between the taxpayer and the IRS regarding the underlying tax adjustments were entered into in a clear and formal manner. In addition, the amount of interest on the tax adjustments was not reasonably determinable until all the adjustments were agreed to and calculated. The ruling, in analyzing the Tax Court cases above, suggests that entering into a partial Form 870 waiver agreement would have fixed the liability.

Analysis

In the example, the taxpayer’s liability for the federal income tax deficiency interest is fixed and determinable as of December 31, 2009. During December 2009, the taxpayer agreed with the IRS regarding certain federal changes to its taxable income. The taxpayer entered into a clear and formal agreement with the IRS through the completion of two actions. First, the taxpayer indicated on the Form 5701 that it was in agreement with the proposed audit adjustments to its taxable income for its 2005–2007 tax years by signing the form and checking the box “agreed to changes.” Thus, in signing the Form 5701 prior to year end, the taxpayer agreed to the changes to its federal taxable income, whereby such action demonstrated that the federal tax deficiencies were uncontested as of December 31, 2009.

Second, the taxpayer signed Form 870 for the 2005–2007 audit cycle prior to year end, thereby granting the IRS permission to assess the tax deficiency. Through these documented actions, the taxpayer further demonstrated that the federal adjustments to its taxable income were uncontested as of December 31, 2009. Thus, in the example, the company’s liability for federal income tax deficiency interest is “fixed” as of December 31, 2009, for federal income tax purposes. Accordingly, the taxpayer should take a deduction for that interest in 2009 because that is the year in which the liability is fixed, the amount can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

Conclusion

Deficiency interest is often overlooked after the audit cycle closes. Taxpayers can effectively plan the timing of deducting deficiency interest simply by being aware of when proposed audit adjustments are agreed upon.

Editor: Kevin D. Anderson, CPA, J.D.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO Seidman, LLP, in Bethesda, MD.

For additional information about these items, contact Mr. Anderson at (301) 634-0222 or kdanderson@bdo.com.

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