Sec. 965 transition tax: Installment payments causing processing errors

Editor: Mary Van Leuven, J.D., LL.M.

The IRS has seemed to struggle from the outset of the Sec. 965 transition tax to develop workable administrative procedures to accurately process payments and maintain accounts when there has been a deferral election under Sec. 965(h). This election enabled a U.S. shareholder of a deferred foreign income corporation to pay its Sec. 965 transition tax in installments over an eight-year period.

The instructions to both IRS employees and taxpayers have been updated numerous times, as have the automated procedures within the computerized system. These continuing changes and the lack of a clear path forward at the beginning have caused myriad account servicing errors, including erroneous refunds, bills, and penalty and interest accruals. Additionally, in some cases, the IRS has inadvertently underassessed the deferred Sec. 965 transition tax that is due.

As discussed below, the processing of Sec. 965 transition tax deferrals is prone to errors because maintenance of the deferrals, accelerations, and transfers involves manual inputs, including those needed to suppress automatic systemic penalties and interest. While some aspects of the deferral maintenance have been automated, others still require manual inputs and corrections, which continue to lead to errors.

Background

In fairness to the IRS, the new regulation addressing these matters had to be put into place fairly swiftly — after the 2017 tax returns had already been published. Furthermore, there was no system infrastructure to administer the Sec. 965 transition tax deferrals, and the deferral and transfer architecture of the statute and regulation was, in many respects, incompatible with the IRS’s existing account management infrastructure. Accordingly, a system of manual maintenance or an update to the IRS’s IT account management system was necessary to implement the Sec. 965 transition tax deferral election and transfer-of-liability maintenance. Although the IRS may have requested more time to develop new procedures before the new law was implemented, that did not happen.

As background, on Dec. 22, 2017, Sec. 965 was amended pursuant to the law known as the Tax Cuts and Jobs Act, P.L. 115-97. As a result, for the last tax year that began before Jan. 1, 2018, certain taxpayers were required to include in income a Sec. 965(a) inclusion amount, based on the accumulated post-1986 deferred foreign income of certain foreign corporations the taxpayer owned either directly or indirectly through other entities. Sec. 965(h) allowed a U.S. shareholder of a deferred foreign income corporation to elect to pay its net tax liability of Sec. 965 transition tax in eight annual installments, without incurring interest or penalties.

These installments are:

• 8% in each of the first five years;
• 15% in the sixth year;
• 20% in the seventh year; and
• 25% in the eighth year.

Internal Revenue Manual procedures

To highlight the changing instructions that IRS personnel have been expected to follow involving these matters, and the potential for errors, below are some excerpts from the Internal Revenue Manual (IRM):

[C]omputer programming was not available for processing IRC 965 transition tax … until the beginning of July 2018. [The IRM instructs examiners to] ensure notices are delayed to prevent unnecessary collection activity. [IRM §21.5.13.2.1]

Programming froze 2017 overpayment tax modules, and the identified modules were reviewed and worked through a manual process for accounts processed through cycle 201852 [i.e., the 52nd week of 2018]. [IRM §21.5.13.2.2]

Beginning in cycle 201903 [i.e., the third week of 2019], this process was automated for tax returns with an IRC 965 inclusion and with payments in excess of the current IRC 965(h) installment. The only time an overpayment will be applied systemically is upon return settlement, not if an overpayment is created as a result of an adjustment. Those will need to be manually input. After midyear 2023, the systemic … posting will be obsolete. [IRM §21.5.13.2.2(3)]

From the passages above, it is clear that several aspects of automated processing must be monitored, and workarounds have been created by IRS employees tasked with maintaining accounts with deferrals of Sec. 965 transition tax. One common error involves accounts with Sec. 965 transition tax deferrals involving prepayments and/or amendments to Sec. 965 net tax liabilities. In most cases, the accounts are being monitored and adjusted “manually” for one reason or another. Thus, there is more opportunity for error because Sec. 965 accounts as a group are likely being inconsistently maintained by various individual IRS employees due to the manual nature of account adjustments.

The IRS has in some cases proactively identified these issues, whether involving incorrect installment amounts (e.g., Notices CP56, Section 965 Installment Payment is Due) or erroneous penalty and interest accruals. In these situations, the IRS generally issues a Letter 3064C, noting the systemic nature of the errors and that adjustments and monitoring of the account are in process.

Processing basics

To better understand the errors that can occur, it may be helpful to review the basics of the process. To record the payment deferral on a taxpayer’s account, the entire tax is assessed, including the Sec. 965 transition tax. Then a credit is posted for the deferred amount.

For example, if the total Sec. 965 transition tax is $1 million, then 8%, or $80,000, is due in year 1. The total $1 million tax is assessed, and a credit equal to the remaining 92%, or ($920,000), is also posted to the account. This results in a year 1 balance due of $80,000. Each subsequent year, a portion of the credit is reversed, thus creating a payable amount of the tax due for that year (this is reflected as transaction code (TC) 767 (Sec. 965 tax installment payment or payment acceleration) on the taxpayer’s account). This is a graduated deferral of when the tax payment is due; it is not a deferral of when the tax itself is due.

Source of errors

For a number of reasons, the Sec. 965 transition tax accounts for the 2017 calendar year or fiscal years beginning in 2017 can get messy. First, the method described above for tax assessments and credits is applied inconsistently by the IRS. While the tax is usually assessed correctly, the deferred tax credits are applied piecemeal and on different dates, as are the subsequent credit reversals.

Compounding these issues is the application of annual deferred payment amounts that are paid early and correlative acceleration of the deferred tax. In the case of prepayment, the IRS should reverse a like amount of credit. For example, if the remaining deferred tax balance is $920,000 and a taxpayer pays ($500,000), then a $500,000 credit reversal should post to the account. This is true even if payment is made prior to the due date of the next annual deferred installment payment and even if the payment amount exceeds the next required deferred installment payment amount. But this does not always happen.

Second, the deferred tax credit is posted as TC 766, the same transaction code that is used for many refundable tax credits, such as withholding and fuel tax credits, so it can be unclear which credit is posted to the account or why the credit was posted. For example, a TC 766 of ($920,000) deferred tax credit, and TC 766 of ($900,000) withholding tax could both post to the account during return processing. A future examiner may mistakenly treat both credits as deferred tax credits — or both as withholding tax credits. There are additional codes meant to differentiate one type of TC 766 from another, but they may not always be used correctly or consistently. Third, because the deferred tax credits post as “refundable,” refunds have occurred in error. This can happen especially when the IRS does not reverse the related credit soon after a payment is made. For example, if a taxpayer pays $500,000 instead of the $80,000 that is due under the current installment, and the IRS only reverses $80,000 of the deferred tax credit, then $420,000 may be automatically refunded in error.

Fourth, in some cases, interest and penalties are being assessed in error. This can happen when the net deferred tax credit is not posted with the correct dollar amount or when the credit reversal is posted in excess of the amount either due or prepaid. For example, if the deferred tax amount is ($920,000) but is posted as ($820,000) in error, then the tax owed is now $180,000 instead of $80,000. Because the taxpayer is unaware of the error, they pay ($80,000), per their Sec. 965 payment schedule. Then the IRS issues a bill for the $100,000 underpayment, plus penalties and interest. Another common issue is the failure to suppress automatically computed interest and penalties, given the disconnect between the tax due date associated with the liability account and the deferred installment due date under the statute and regulations.

Fifth, accounting for transfer agreements under Regs. Sec. 1.965-7 between parties to the transfer can result in account issues. Examples of when complications can arise include circumstances where the transferee was not in existence during the period in which the Sec. 965 transition tax arose or if the transfer involves multiple transferors to a single transferee. Processing of transfer agreements under Sec. 965(h)(3) requires careful processing and account management, which, like many of the account transactions discussed above, is a manual process.

Suggestions for practitioners

When looking at Sec. 965(h)-related IRS account transcripts, care must be taken to avoid the sea of confusing transaction codes, i.e., TC 766 (refundable credit) and TC 767 (reversed credit); a proper analysis requires a careful familiarity with the taxpayer’s return and the IRS’s transaction codes and account maintenance process vis-à-vis Sec. 965 transition tax deferrals. Such a careful analysis is necessary to determine whether all the transactions affecting a taxpayer’s Sec. 965 net tax liability have been correctly accounted for and to determine whether any intervening measures should be taken to correct the taxpayer’s account.

Thus far, the only intervening measures available are limited assistance and referral via the Sec. 965 hotline or written correspondence to the IRS with an explanation of errors and a request for account correction. In the authors’ subjective experience, the IRS has been slow to respond due to resource constraints and the limited number of technical experts in the area of Sec. 965 transition tax. Additional resources for account resolution and/or a systemic account solution would be welcome advances by the IRS.

The IRS has two phone numbers to call, depending on whether the Sec. 965 transition tax pertains to an individual or business account: (855) 223-4017, extension 729, for individual taxpayers and (800) 830-5215, extension 708, for business taxpayers. Helpful resources for general information regarding Sec. 965(h) deferred tax payments include:

• Regs. Sec. 1.965-7;
• General Section 965 Questions and Answers (Including Transfer and Consent Agreements) (last updated Jan. 13, 2023);
• The IRS’s 2017 FAQs; and
• IRM Section 21.5.13: IRC 965 Transition Tax Procedures — Accounts Management.

Editor notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C. Contributors are members of or associated with KPMG LLP. For additional information about these items, contact Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained in these articles is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the authors only, and do not necessarily represent the views or professional advice of KPMG LLP.