Restricted Interest and Common Errors Made by the IRS

Editor: Valrie Chambers, Ph.D., CPA

Procedure & Administration

The Internal Revenue Code allows the IRS to charge interest when a taxpayer does not pay all required taxes by the due date of the return. The Code also requires the IRS to pay interest on refunds in certain circumstances. While these broad general principles are not new, there are many nuances relating to the computation of interest that tax professionals should be familiar with.

In order to understand these complex issues, a review of the basic interest rules is necessary. The rate of interest is set by Sec. 6621. The rate is determined quarterly and can be found in a revenue ruling issued every quarter. Secs. 6601 (which deals with underpayment interest) and 6611 (which deals with overpayment interest) provide that, if applicable, interest starts on the return due date and ends on the date the taxes are paid or refunded. Within the Code and the Treasury regulations, there are many exceptions to the general rule. These exceptions are commonly referred to as the restricted interest rules.

One exception is when the tax adjustment is related to carrybacks. Tax adjustments involving net operating loss (NOL), capital loss, and credit carrybacks are deemed effective on the due date of the loss year (Secs. 6601(d) and 6611(f)). If a carryback reduces the amount of tax due, interest will stop accruing on the due date of the carryback year.

Example 1: Individual Q did not fully pay her 2008 income taxes. She files a Form 1045, Application for Tentative Refund, to carry back a 2009 NOL that fully pays the unpaid 2008 tax. Interest on the 2008 balance due is computed from April 15, 2009, to April 15, 2010. Additional deficiency interest is computed on the accrued interest from April 15, 2010, until the interest is paid.

Sec. 6611(e) provides that a refund relating to a carryback that is issued within 45 days of the date the carryback claim is filed will accrue no interest. If the IRS does not issue the refund within 45 days, interest will begin to accrue on the due date of the loss year.

Example 2: Z Corp. files a Form 1139, Corporation Application for Tentative Refund, to carry back a 2009 NOL to 2007. If the IRS does not issue a refund within 45 days, interest will accrue from March 15, 2010, until the refund is issued.

If the carryback adjustment is part of an IRS audit that has adjustments to the return and carrybacks from subsequent years’ returns, the IRS is required to complete a Form 2285, Computation of Increase (Decrease) in Tax, Concurrent Determinations of Deficiencies (Increases in Tax) and Overassessments (Decreases in Tax) in Cases Involving Restricted Interest Provisions of the Internal Revenue Code (commonly called a restricted interest worksheet). This form shows the amount of tax related to the tax year in question and then layers the tax effect of any carryback from subsequent years and, if completed correctly, provides the information needed to compute interest accurately.

There are many common errors or misconceptions related to these restricted interest computations. The first is an IRS agent’s failure to complete Form 2285 or to note in the exam report that restricted interest is involved. If the agent does not identify a restricted interest case, chances are that the interest computed by the IRS will be incorrect. Whether the interest error is in favor of the government or the taxpayer will depend on the underlying tax adjustments.

Example 3: Taxpayer G’s Forms 1120, U.S. Corporation Income Tax Return, for 2006 and 2008 are under examination. There is a 2008 NOL carryback to 2006 resulting in a tax decrease of $25,000, and the IRS issued a refund on March 15, 2009. The examination results in a tax decrease to the 2006 tax year of $100,000. The 2008 exam resulted in additional taxable income, which eliminates the loss carried back to 2006. As a result, the net adjustment to 2006 is a tax decrease of $75,000.

If the IRS does not complete Form 2285, it will compute refund interest on $75,000 from March 15, 2007, to the refund date. The correct interest computation would calculate interest on $100,000 from March 15, 2007, to March 15, 2009, and then compute interest from March 15, 2009, to the refund date on $75,000, plus the interest that accrued through March 15, 2009. In this case, if the IRS does not correctly compute the interest, the taxpayer will not receive enough overpayment interest.

A common error made by taxpayers and practitioners is failing to realize that interest is due on adjustments that are eliminated by NOL carrybacks. Interest will be due on any tax increase agreed to during the examination. The amount of interest can grow, especially if the taxpayer has taken advantage of a three-, four-, or five-year carryback under Sec. 172(b)(1)(H). Even with only a two-year carryback, the interest may be more than a taxpayer expects. For example, if an adjustment to the 2006 return results in a tax of $500,000 and the 2008 carryback NOL is large enough to fully eliminate the tax, the taxpayer may be surprised to receive a bill for almost $80,000 interest. In this situation, interest will run on the underpayment from March 15, 2007, through March 15, 2009, on $500,000, then interest will accrue on the interest from March 15, 2009, until the interest is paid.

An IRS error can occur if an NOL carryback releases a credit back to an earlier year. The credit carryback would have an effective date of the due date of the NOL year, not the year the taxpayer generated the credit. This would result in errors in the amount of interest. Again, the interest error may or may not be in the taxpayer’s favor.

More recently, the IRS has been incorrectly completing Form 2285 related to adjustments attributed to the addback of the domestic production activities deduction under Sec. 199. This section requires a recomputation of this deduction based on the revised taxable income. Accordingly, when the NOL reduces taxable income to zero, the domestic production activities deduction is eliminated. This adjustment is a result of the carryback, and the tax effect should be included in the tax adjustment related to that carryback. This is similar to the released credit adjustment discussed above. The IRS may not properly reflect the adjustment to the domestic production activities deduction as a carryback adjustment. By doing so, the IRS would be charging deficiency interest when it is not due.

The restricted interest rules, while complicated, do make sense when considered in light of the effective date of the event causing the tax to change. It is important for taxpayers and their representatives to request a copy of the Form 2285 if their exam adjustments involve any type of carryback.

EditorNotes

Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, TX. Susan Pick is with Grant Thornton LLP in Edison, NJ. They are both members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For more information about this column, contact Prof. Chambers at valrie.chambers@tamucc.edu.