Analyzing the difference between tax payments and deposits
Editor: Alexander J. Brosseau, CPA
Taxpayers contesting a tax liability should consider taking action to stop interest from accruing. Interest on the tax liability and penalties can add up quickly and, in some instances, can even exceed the underlying tax. This item summarizes the deposit and payment procedures taxpayers can use to stop interest from accruing on the underlying tax and penalties while they dispute the tax lability with the IRS or in court. Additionally, this item discusses recent cases in this area and what they mean for taxpayers.
Overview
If the IRS determines that a taxpayer owes more tax than reported on its tax return, the taxpayer must pay interest on the underlying tax liability and, if any, penalties. Under Sec. 6601(a), the taxpayer owes interest from the payment due date (generally, the unextended date the tax return was due) until the IRS receives the payment covering the entire tax, penalties, and interest as of the date the payment is received. The underpayment interest rate is the federal short-term rate plus 3 percentage points (Sec. 6621(a)(2)). The rate for large corporate underpayments (exceeding $100,000), once triggered, is the federal short-term rate plus 5 percentage points (referred to as “hot interest”) (Sec. 6621(c)).
There are two primary methods taxpayers can use to stop interest from accruing when contesting a tax liability: deposits or advance payments.
Deposits
Since 2004, the Internal Revenue Code has expressly allowed taxpayers to make deposits. Before 2004, the concept of a deposit was found in case law. In Rosenman, the Supreme Court considered whether the three-year refund statute began to run from the date of a remittance by the taxpayer. The Court concluded the statute had not begun to run because the remittance was merely a deposit to suspend interest from accruing and not a payment of the tax liability (Rosenman, 323 U.S. 658, 660 (1945)). Since Rosenman, courts have developed and applied a “facts and circumstance” test to determine whether a remittance was a deposit or a payment. The IRS issued Rev. Proc. 84-58, which provided procedures for taxpayers to make remittances, or “deposits in the nature of a cash bond,” to suspend the accrual of interest on deficiencies. Under Rev. Proc. 84-58, a deposit in the nature of a cash bond was not a payment of tax, was not subject to a claim for credit or refund, and, if returned to the taxpayer, did not bear interest.
In 2004, as part of the American Jobs Creation Act of 2004, P.L. 108-357, Congress codified a taxpayer’s ability to make a deposit in Sec. 6603. Sec. 6603(a) allows taxpayers to make a deposit for any income tax, estate and gift taxes, and certain excise taxes that have not been assessed at the time of the deposit. In certain instances, a taxpayer will be paid interest on a deposit that is returned to the taxpayer to the extent that the deposit is attributable to a disputable tax (Sec. 6603(d)).
The next year, the IRS released Rev. Proc. 2005-18, which provides detailed instructions to taxpayers on how to make deposits. Rev. Proc. 2005-18, Section 4.02(2), governs how the IRS will treat the deposit. Once the IRS assesses the tax liability (e.g., after the IRS issues a notice of deficiency and the taxpayer does not petition the Tax Court), the IRS will convert the deposit to a payment against the tax. If the taxpayer petitions the Tax Court, the IRS will convert the deposit into a payment unless the taxpayer requests the deposit continue to be treated as a deposit during the Tax Court proceeding. This request must be made in writing before the deadline to petition the Tax Court expires.
If the deposit is converted into a payment, Sec. 6603(b) provides that the taxpayer is treated as having paid the tax on the date the deposit was made. Thus, a taxpayer who made a deposit would owe interest only for the period from the due date of the tax payment to the date of the deposit. For example, a taxpayer’s 2007 taxes were due April 15, 2008. In 2010, the IRS begins an audit of a deduction that, if disallowed, will increase the taxpayer’s tax by $1 million. On July 15, 2010, the taxpayer deposits $1 million with the IRS for its 2007 tax liability. After a lengthy audit, IRS Appeals, a Tax Court trial, and an appeal to the U.S. Court of Appeals, the taxpayer loses the issue on Oct. 2, 2021, and is deemed to have paid the tax and interest on Nov. 10, 2021. Because the taxpayer made the deposit, it owes interest on the $1 million only from April 15, 2008, to July 15, 2010. If the taxpayer had not made a deposit and first made payment on Nov. 10, 2021, it would owe interest from April 15, 2008, until Nov. 10, 2021.
To make a deposit, the taxpayer must follow the procedures detailed in Rev. Proc. 2005-18, Section 4.01(1). Generally, a taxpayer must send the deposit and a written statement to the IRS Service Center where it files its returns or the office where the taxpayer’s return is under examination. The written statement must explicitly designate the remittance as a deposit and include: (1) the type of the tax; (2) the tax year(s); and (3) a statement identifying the amount of and basis for the “disputable tax.”
Interest on a deposit under Sec. 6603(d) will be allowed only to the extent that the deposit is attributable to a disputable tax. Sec. 6603(d) defines a “disputable tax” as the amount of tax specified at the time of the deposit as the taxpayer’s reasonable estimate of the maximum amount of any tax attributable to an 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 IRS also has a reasonable basis for disallowing the taxpayer’s treatment of such item.
If the IRS receives a remittance without the written statement designating it as a deposit, the IRS will treat the remittance as a payment and apply it to any outstanding liabilities for taxes, penalties, or interest (Rev. Proc. 2005-18, §4.01(2)). The IRS will apply the undesignated remittances treated as payments to the earliest tax year for which there is a liability, and the remittance will be applied first to tax, then penalties, and finally to interest (Rev. Proc. 2005-18, §4.01(2)).
Advance payments
An advance payment is simply the payment of the proposed tax liability before the IRS assesses the tax. It operates the same as any other time a taxpayer pays a tax. The payment is credited to the taxpayer’s account, and if the ultimate liability is less than the amount of the advance payment, the IRS will credit the excess against the taxpayer’s other tax liabilities (if any) and refund the excess (IRS Notice 1016, How to Stop Interest on Your Account (February 2006)).
A taxpayer must identify the tax and tax period to which it is making the advance payment. Just as with undesignated deposits, if the taxpayer does not designate the payment for a specific tax and period, the IRS will apply the payment against outstanding taxes in the order of priority the IRS determines will serve its best interest (Rev. Proc. 2002-26, §3.02). If the amount of the payment is less than the total liability for the tax period, the IRS will apply the amount first to tax, then penalties, and then interest.
Critical differences
Although both deposits and advance payments will stop interest from accruing, there are critical differences.
First, a taxpayer can get a deposit back from the IRS much easier than a refund. To request the return of a deposit, the taxpayer must follow the procedures in Rev. Proc. 2005-18, Section 6. Under Sec. 6603(c), the IRS must return the deposit (to the extent not already used as a payment of tax). In exceptional circumstances, the IRS does not have to return the check if the collection of the tax is in jeopardy (Sec. 6603(c)). With respect to advance payments, a taxpayer cannot simply ask for them back. Sec. 6511 requires a taxpayer to file an administrative refund claim (which the IRS could deny), and it must file the refund claim within the statute of limitation for filing refund claims (which is generally the later of three years from the date the return was filed or two years from the date the tax is paid).
Second, although taxpayers are generally entitled to interest when the IRS returns deposits or refunds advance payments, there are differences. When the IRS returns a deposit, the taxpayer is entitled to interest from the IRS only to the extent the deposit relates to a “disputable tax” (Sec. 6603(d)(1)). If the IRS owes interest, the interest rate is the federal short-term rate (Sec. 6603(d)(4)). When the IRS refunds an advance payment, the taxpayer is entitled to interest regardless of whether it relates to a “disputable tax” (Sec. 6611). Under Sec. 6621(a)(1), the interest rate is the federal short-term rate plus 3 percentage points (2 percentage points if the taxpayer is a corporation or 0.5 percentage point if the taxpayer is a corporation and the overpayment is in excess of $10,000). Thus, taxpayers receive more interest from the IRS on the refund of advance payments than on the return of deposits.
Third, if a taxpayer makes an advance payment before the issuance of a statutory notice of deficiency, it cannot petition the U.S. Tax Court for a redetermination; the U.S. Tax Court is a prepayment jurisdiction. If a taxpayer pays a deficiency in full before a notice of deficiency is issued, the Tax Court lacks jurisdiction (Bendheim, 214 F.2d 26 (2d Cir. 1954)). However, if a taxpayer makes a payment after the notice of deficiency is mailed, the Tax Court retains jurisdiction (Sec. 6213(b)(4)). A “deposit,” regardless of when made, does not count as a payment, and the taxpayer can still go to the Tax Court (Baral, 528 U.S. 431, 439 n.2 (2000)).
The chart, “Distinctions Between Deposits and Advance Payments,” below, summarizes some of the key distinctions between deposits and advance payments.
Recent developments
Although Sec. 6603 and Rev. Proc. 2005-18 have reduced the amount of litigation on what constitutes a deposit or advance payment, the issue still occasionally arises. Last year, the Fifth Circuit considered whether a credit-elect overpayment constituted an advance payment and the Tax Court considered in two separate instances whether a payment the taxpayer labeled as a deposit was in fact a deposit. These cases are discussed below.
Goldring
In 2021, the Fifth Circuit held that underpayment interest did not accrue because the IRS possessed sufficient credit-elect overpayment funds from the taxpayer to satisfy a later-determined tax deficiency (Goldring, No. 20-30723 (5th Cir. 10/4/21)).
Background: Jane Goldring owned shares in a corporation. As part of a merger, the corporation canceled Goldring’s shares and converted them to a right to $45.83 per share. In December 1997, Goldring sued the corporation for unfair dealings and breach of fiduciary duty. In 2010, the Delaware Court of Chancery ruled for Goldring and ordered the corporation to pay her $114.04 per share. In addition to the fair market value of the shares (approximately $13 million), the court also ordered the corporation to pay Goldring interest on the shares from the date of the merger (approximately $26 million) plus various litigation costs.
On their tax return for 2010, Goldring and her husband treated the approximately $40 million they received from the corporation as income from the disposition of a capital asset. This meant that the $40 million was taxed at the long-term capital gain rate instead of the higher ordinary income tax rate. The Goldrings recognized that the IRS might treat the $26 million interest payment as ordinary income. If the $26 million was ordinary income instead of long-term capital gain, the Goldrings would owe an additional $5 million in tax. To avoid owing underpayment interest in the event the IRS assessed a tax deficiency, the Goldrings overpaid their reported 2010 tax liability by approximately $5 million.
Rather than send the IRS a $5 million remittance either as a deposit or an advance payment, the Goldrings overpaid their 2010 tax liability by $5 million and they completed line 75 of the Form 1040, U.S. Individual Income Tax Return. On the 2010 Form 1040, line 75 asked the taxpayer what amount of their overpayment they wanted applied to their 2011 estimated tax. This is referred to as a “credit-elect overpayment.” On their 2010 tax return, the Goldrings elected to credit the approximately $5 million overpayment to their estimated 2011 tax liability (i.e., credit-elect overpayment). On their tax returns for tax years 2011 through 2016, the Goldrings never used the $5 million overpayment to pay their current-year tax liability, and they always continued to make credit-elect overpayments.
As the Goldrings predicted, the IRS audited their 2010 tax return and determined the $26 million interest payment was ordinary income. The IRS assessed approximately a $5 million deficiency and $600,000 of underpayment interest. The Goldrings paid the tax and filed for a refund.
The IRS did not act on the Goldrings’ refund request, and six months after filing their refund request, the Goldrings filed suit in a Louisiana district court. The court considered two issues: (1) whether the $26 million interest payment was long-term capital gain or ordinary income; and (2) if $26 million was ordinary income, did the Goldrings’ overpayment reflected on their 2010 tax return stop the interest from accruing on the tax deficiency. The district court held for the IRS on both issues, finding that because the Goldrings elected to credit the overpayment to their 2011 estimated tax, the overpayment was no longer available to suspend the interest on their 2010 underpayment. The Goldrings appealed to the Fifth Circuit.
Assessment of underpayment interest: The Fifth Circuit upheld the lower court’s ruling that the $26 million was ordinary income, rejecting the taxpayers’ argument that the lower capital gains rate applied because the $26 million was related to the disposition of a capital asset (the corporate shares).
The real issue, as the Fifth Circuit saw it, was whether the Goldrings’ $5 million overpayment suspended the running of underpayment interest. The IRS argued that when the Goldings elected to credit that overpayment to their 2011 estimated tax liabilities, the funds were no longer available to cover the 2010 deficiency.
The IRS relied on FleetBoston Fin. Corp., 483 F.3d 1345 (Fed. Cir. 2007). In that case, the majority of the Federal Circuit held that the funds could not be credited to any later-determined deficiency for the year of the overpayment because the taxpayer elected to credit the payments to its next year’s account. The court stated that a “credit elect overpayment will be deemed to reside in the tax account for the succeeding year, even if it is not needed to pay estimated tax in that year.”
The Fifth Circuit rejected the Federal Circuit’s reasoning and instead relied on the Second Circuit case Avon Products, Inc., 588 F.2d 342 (2d Cir. 1978). In that case, the Second Circuit held that the IRS could not assess underpayment interest for the period between when the taxpayer made an overpayment and when it used that overpayment to pay its next year’s tax liability. The Second Circuit held that underpayment interest may not run during any period the IRS possessed enough credit-elect overpayment funds to satisfy a later-determined tax deficiency.
The Fifth Circuit, citing Avon and the “use-of-money” principle of Manning v. Seeley Tube & Box Co., 338 U.S. 561 (1950), held for the Goldings. Under the use-of-money principle, a taxpayer is liable for interest only when the government does not have the use of money it is lawfully due. The court found that the IRS had continuous possession of the Goldrings’ credit-elect overpayment funds sufficient to satisfy the 2010 deficiency; accordingly, the Goldings did not owe any underpayment interest. The Fifth Circuit said its decision was consistent with the Second Circuit decision that had found “that a tax is not considered ‘unpaid’ and § 6601(a) underpayment interest may not run during any period the IRS possesses enough credit-elect overpayment funds to satisfy a later-determined tax deficiency” (Goldring, slip op. at 13 (citing Avon)).
Taxpayers in jurisdictions other than the Fifth Circuit should be prepared for the IRS to take the position that credit-elect overpayments are not available to stop underpayment interest from accruing.
Hill
In another recent decision, Hill, T.C. Memo. 2021-121, the Tax Court rejected a taxpayer’s attempt to recharacterize a deposit as an overpayment.
Background: In 2012, Albert G. Hill remitted a check for approximately $10 million to the IRS. The taxpayer designated the remittance as a deposit to be applied toward his anticipated gift tax liability for 2011. On July 19, 2019, the Tax Court entered a stipulated decision determining a 2011 gift liability of approximately $6.7 million and no overpayment for any year. Afterward, the IRS sent Hill a check for approximately $3.3 million — the amount of his excess deposit, but without any interest.
Hill filed a motion with the Tax Court for a redetermination of interest. Hill asserted that he was entitled to interest at the advance payment rate, which is the federal short-term rate plus 3 percentage points. The IRS conceded that it owed Hill interest on the $3.3 million, but only at the deposit rate, which is just the federal short-term rate. Thus, the issue before the Tax Court was whether the $10 million remittance was a deposit or an overpayment.
Tax Court decision: The Tax Court concluded the $10 million remittance was a deposit, based on Hill’s repeated labeling of the payment as a deposit. When Hill sent the $10 million check to the IRS, he designated it a deposit and stated that he intended for “this deposit to satisfy the requirements of section 6603(a).” In correspondence with the IRS, Hill repeatedly called the $10 million remittance a deposit. In his protest to the IRS’s 30-day letter, Hill again stated that the $10 million was a deposit submitted pursuant to Rev. Proc. 2005-18 for the purpose of making a deposit under Sec. 6603.
Hill argued that the IRS unilaterally converted his $10 million deposit into a “payment” of tax. The Tax Court summarily rejected the taxpayer’s argument because (1) it was aware of no authority that permits the IRS to unilaterally overrule a taxpayer’s designation of a remittance as a deposit and (2) there was no evidence that the IRS actually overruled the taxpayer’s designation.
The Hill case is a good reminder to taxpayers to make informed decisions when deciding whether to make a deposit or advance payment because, as seen in Hill, the Tax Court will not allow taxpayers to recharacterize deposits as payments based on hindsight.
Ahmed
In December 2021, the Tax Court held that a taxpayer’s remittance was a payment even though the taxpayer labeled the remittance as a deposit and stated he was submitting it pursuant to Rev. Proc. 2005-18 (Ahmed, T.C. Memo. 2021-142).
Background: In 2018, Faisal Ahmed petitioned the Tax Court to challenge the IRS’s collection activities (i.e., federal tax liens) with respect to his income tax liabilities for several years and trust fund recovery penalties (TFRPs) for several quarters. The Tax Court eventually dismissed the income tax liabilities because they were paid in full so the only remaining issue was the TFRP liabilities. The Tax Court remanded the case to the IRS’s Appeals Office for a supplemental hearing, which was held in May 2020.
Around June 9, 2020, Ahmed sent the IRS a check for $625,000. In the accompanying letter, Ahmed’s attorney stated that the check was a “cash bond deposit” being submitted under Sec. 6603 and Rev. Proc. 2005-18. The letter explicitly stated that the remittance was not a payment. The letter said the IRS should not post the remittance as final payment until the Tax Court entered a decision. Despite the “deposit” label, on June 29, 2020, the IRS posted the $625,000 as payment toward Ahmed’s outstanding TFRP liabilities. The IRS subsequently released the federal tax liens with respect to those liabilities.
The IRS then moved to dismiss the Tax Court case as moot. The IRS argued the case was moot because Ahmed had paid in full his tax liability and there was no collection activity for the Tax Court to review. Ahmed objected and asserted that the tax liability was not paid in full because the $625,000 was merely a deposit, not a payment.
Tax Court decision: The Tax Court has limited jurisdiction and can hear only the cases that Congress has explicitly identified as falling within its jurisdiction. Congress has given the Tax Court limited review of IRS collection activities. Before the IRS can make a levy and after it files a notice of lien, the IRS must give the taxpayer a right to a Collection Due Process hearing before an IRS Appeals Officer (Sec. 6330). The Appeals officer will review the file and determine whether the collection activity should be upheld. If the Appeals officer upholds the IRS’s actions, the taxpayer can petition for review in the Tax Court. Sec. 6330(d)(1) grants the Tax Court jurisdiction over those cases, but the Tax Court can only consider whether the proposed collection activity is appropriate. The Tax Court does not have the jurisdiction to determine whether there is an overpayment; likewise, it cannot order a refund or credit of taxes in a proceeding brought under Sec. 6330. Once the IRS concedes there is no tax liability on which to collect, the case becomes moot and the Tax Court loses its jurisdiction (Greene-Thapedi, 126 T.C. 1 (2006)).
Ahmed argued the case was not moot because the $625,000 was merely a deposit and not a payment of the tax. Although Ahmed labeled the $625,000 a deposit submitted pursuant to Sec. 6603 and Rev. Proc. 2005-18, he conceded that it was not a valid deposit under those rules. To be a deposit under Sec. 6603, the remittance must be made before the IRS assesses the tax. Here, Ahmed remitted the $625,000 after the IRS assessed the tax. However, Ahmed argued the $625,000 was still a deposit under cases that predated Sec. 6603 (e.g., Rosenman, 323 U.S. 658 (1945)). The Tax Court summarily rejected that argument; the court stated that those cases were “readily distinguishable” because in each case the taxpayer made the remittance before the IRS assessed the tax. The court stated that even if the $625,000 was initially a deposit, it became a payment when the IRS applied it to his outstanding tax liabilities.
The Tax Court, therefore, concluded the case was moot because “[p]etitioner has received all the relief that section 6330 authorizes the Tax Court to provide.” Because the $625,000 was deemed a payment instead of a deposit, Ahmed would have to file an administrative claim (and possibly file a refund suit in court) to attempt to receive a refund.
Analyze the facts and circumstances
When taxpayers are facing protracted tax disputes with the IRS, they should consider making a remittance to stop interest and penalties from continuing to accrue. Whether the taxpayer should make a deposit or an advance payment will depend on the specific facts and circumstances. Although both deposits and advance payments will stop interest from accruing, they have key differences that taxpayers should consider before deciding which one to use.
EditorNotes
Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.
For additional information about these items, contact Mr. Brosseau at 202-661-4532 or abrosseau@deloitte.com.
Contributors are associated with Deloitte Tax LLP unless otherwise noted.
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