Sunday afternoon rolls around, and the last thing on your mind was explaining the pros and cons of making partial payments of tax and deposits with the IRS to a relative who still sees “Charlie” lurking in his backyard from time to time.
Nonetheless, of all of your relatives, Cousin Elmer is, surprisingly, the least offensive to you. You may remember that Elmer is currently working with only seven and a half fingers and a score of little scars on remaining fingers, a reminder of an attack by a scurry of squirrels, which beset upon him after he tried, rather unsuccessfully, to eradicate their rather sizeable presence in his attic through the use of what can only be described as a Vietnam-era improvised explosive device.
Nonetheless, you know that Elmer has had as many run-ins with the IRS as he has with rodents. When he calls you on a chilly, fall afternoon, and explains the practical extent of his “difficulties” with past-due taxes, penalties, and interest, your estimation as “least offensive” suffers substantially. Elmer not only owes taxes on nine of his most recent ten returns, he also may or may not have been a “responsible person” for purposes of the Trust Fund Recovery Penalty (TFRP) asserted against him and his combat buddy, Jim Bob, arising out of employment taxes that their short-lived (and ultimately unsuccessful—in large part due to the raid of the Bureau of Alcohol, Tobacco, and Firearms) Army “surplus” store.
Elmer, like the devil who went down to Georgia was in a bind, he was way behind, and he was willing to make a deal. He tells you that he has come into $98,427. You tell him that you do not need—or more particularly want—to know how he arrived at such an oddly specific sum, but you have an uncomfortable sense that it may or may not correlate to the per-ounce cost of military-grade uranium.
Elmer wants to “discuss” the best way to pay off his liabilities, or at least as much as the radioactive check will cover. Apparently, Jim Bob told Elmer that he could use partial payments to the IRS to his benefit. It is not clear (a) where Jim Bob learned this, or (b) what precisely he meant by “to [Elmer’s] benefit,” but you are obliged to explain the different types of partial payments that Elmer can make to the IRS, and how best to ensure that these payments are applied to maximize his “benefit.”
An Introduction to Making Partial Payments of Tax and Deposits with the IRS
You begin with the low-hanging fruit.
The IRS, you tell Elmer, is all about receiving money from a taxpayer any way it can. A taxpayer can fork over a wad of one-dollar bills to an IRS agent, wire the funds, or roll a check into a little tube and attach it to a well-intentioned carrier pigeon named Hernando. At the end of the day, how the IRS receives its money is of little interest to the Fisc.
If, like Elmer, a taxpayer has a Federal tax liability, but is not able to fully pay it, it may send in a partial payment. When left to its own devices, the IRS will apply payments to liabilities as it sees fit to maximize its return, which generally means that the payments will be applied in the “effective date order.”
Thus, a partial payment generally will be first applied to the earliest taxable year for which there is a liability, typically to tax, penalties; and then interest.
The application rules become a bit more complex when the TFRP is in play. When the IRS receives a payment after proper notice been issued to the “responsible person,” the IRS will apply the payments in the following order, chronologically:
- The non-trust fund potion of the tax;
- The trust fund portion of the tax;
- Any assessed lien fees or collection costs;
- Assessed penalties, assessed interest, accrued penalties up to the date of payment; and then
- Accrued interest to the date of payment.
“Why does the IRS credit partial payments in this order?” Elmer asks.
As he might remember from this Taxing, Briefly article that you sent to some of your more distant relations, there is a statute of limitations on collection of a taxpayer’s liability. With more exceptions than squirrels left in Elmer’s attic, IRC § 6502(a)(1) provides that the IRS may generally only collect a liability ten years after it was assessed. Thus, the IRS wants to collect the earliest assessed tax first before it loses its ability to do so.
For taxpayers, like Elmer, on the other hand, the end goal is for the old liabilities to go away completely—whether by payment or, as is always the taxpayer’s dream, through the expiration of the statute of limitations on collection.
“If only there was a mechanism for a taxpayer to designate its payment to the most recent liability rather than paying off a liability that might expire soon,” Elmer muses to himself.
Making a “Designated Payment”
Well, Elmer, it just so happens that there is such a mechanism.
If a taxpayer makes a “designated payment”—and such designation was executed correctly by the taxpayer—the IRS must apply the payment as designated. Rev. Proc. 2002-26 provides the procedures by which a taxpayer may designate how voluntary partial payments are to be applied by the IRS against liabilities of tax, penalties, and interest.
Historically, taxpayers have also made payments to the IRS in order to stop the running of interest for a future liability. These payments are known as “deposits in the nature of a cash bond.” These deposits have unique characteristics, which bear a bit more discussion.
A Short History of Deposits in Partial Payment of Liability
From time immemorial (or at least circa-1964), taxpayers adopted the practice of making deposits with the IRS, generally with the intention of stopping the running of interest. This practice was initially conducted pursuant to a series of IRS revenue procedures, beginning with Rev. Proc. 64-13. Critical to these procedures was the distinction that was drawn between “payments made in satisfaction of a tax liability” and “deposits in the nature of a cash bond.”
The IRS took the position that a deposit in the nature of a cash bond had three operative characteristics (all of which, to no one’s surprise, were favorable to the IRS). First a deposit was not a payment of tax. Second, a deposit was subject to neither a claim for credit, nor a claim for refund. Third, and closest to the IRS’s heart, if the “deposit” were returned to the taxpayer, it would not bear any interest. Basically, a deposit in the nature of a cash bond was free money to the IRS.
It followed logically, that taxpayers were outraged that the IRS could hold their money (which, granted, the taxpayers voluntarily paid over to the IRS, without any obligation to do so, in order that interest would not accrue against the taxpayers) and not “allow” any interest to accrue on the deposit if they politely requested that the IRS fork it back over to them at a later date. To “clarify the law on this subject” (and to calm the uprising of taxpayer-qua-farmers with torches and pitchforks), Congress added IRC § 6603 to the Code in 2004.
The Great Deposit Compromise: IRC § 6603
Captioned “Deposits Made to Suspend Running of Interest on Potential Underpayments,” IRC § 6603 is a compromise between the IRS and the aforementioned angry horde. Under IRC § 6603(a), “Authority to Make Deposits Other Than as Payment of Tax,” a taxpayer may make a cash deposit with the IRS, which the IRS may use to pay any tax which has not been assessed at the time of the deposit.
Codified in IRC § 6603(b) is the prior procedural practice properly providing that, to the extent that the deposit is used by the IRS to pay tax, such tax will be treated as having been paid when the deposit is made for purposes of IRC § 6601 (relating to interest on underpayments of tax). Further, unless the IRS determines that “collection of tax is in jeopardy,” it must return any amount of the deposit to the taxpayer upon its request—to the extent that the IRS has not already used the deposit for the payment of tax—so long as the taxpayer makes such request in writing.
Not only are taxpayers permitted to make a deposit in the nature of a cash bond to prevent interest from accruing, pursuant to IRC § 6603(d), for purposes IRC § 6011, which sets out the rules on calculating interest on overpayments, a deposit in the nature of a cash bond that is returned to a taxpayer shall be treated as the payment of tax for any period “to the extent (and only to the extent) attributable to a disputable tax for such period.”
“But wait,” Elmer thoughtfully observes, “I thought you said that IRC § 6603 was a ‘compromise.’”
Not so fast, Skippy.
You see, Elmer, tucked in the middle of the first line, the largesse of overpayment interest is qualified by the statement “except as provided in paragraph (4),” referring to IRC § 6603(d)(4), which states that the rate of interest under IRC § 6603(d) is the Federal short-term rate determined under IRC § 6621(b), compounded daily.
“Why, that still sounds like a practical windfall for taxpayers,” Elmer says.
Slow your roll, nubby.
You must remember, Elmer, that under IRC § 6611(a) (through reference to IRC § 6621(a)), the general overpayment rate for individuals is the 3% plus the Federal short-term rate, which as of the writing of this article was sitting right at .22%. So, if you are keeping score at home, a taxpayer who makes a deposit and then claws it back from the clenched fingers of the IRS—the fisc’s fists, if you will—is entitled to only a pittance of interest. Nevertheless, this appeased the angry mob of depositors, and it placates Elmer for a moment.
Even still, a deposit bears such a middling amount of interest only if it is a payment “attributable to a disputable tax.” The term “disputable tax” means the amount of tax, specified at the time of the deposit, representing the taxpayer’s “reasonable estimate of the maximum amount of any tax attributable to disputable items.” In turn, a “disputable item” is an item of income, gain, loss, deduction, or credit…but only if (a) the taxpayer had a reasonable basis for the treatment of such item; and (b) the taxpayer reasonably believes that the IRS also has a reasonable basis for disallowing the taxpayer’s treatment of such item.”
The legislative history of IRC § 6603 confirms that Congress did not view a deposit as “a payment of tax prior to the time the deposited amount is used to pay a tax.” The most recent iteration of the revenue procedures to address deposits—Rev. Proc. 2005-18—likewise emphasizes the same point. Specifically, Rev. Proc. 2005-18, § 6.01 observes that a deposit made pursuant to IRC § 6603 is not subject to a claim for credit or refund as an overpayment “until the deposit is applied by the Service as payment of an assessed tax of the taxpayer.”
Furthermore, only if the deposit is “attributable to a disputable tax” will the itty bit of interest be included in the repayment. The question of what constituted a “disputable tax” and when a deposit was a deposit rather than a payment was discussed at length in the October 2021 Tax Court case of Hill v. Commissioner, which we’ll discuss in a moment.
Revenue Procedure 2005-18
To recap, historically, 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. However, in 2004, Congress added IRC § 6603 to the Code.
IRC § 6603(a) provides that a taxpayer may make a deposit with the IRS, which may be used to pay any taxes imposed on the taxpayer, and IRC § 6603(b) provides that, to the extent that a deposit is used to pay tax, the tax will be treated as paid on the date the deposit is made (for purposes of computing interest on underpayments under IRC § 6601.
Next, IRC § 6603(c) provides that the IRS will return any amount of a deposit requested by the taxpayer in writing, unless the amount was already used to pay tax (or the IRS determines that collection of tax is in jeopardy). IRC § 6603(d) authorizes the payment of interest on a deposit returned to the taxpayer to the extent (and only to the extent) that the deposit is attributable to a “disputable tax,” and IRC § 6603(d)(4) provides the rate of interest on such deposit.
Pursuant to IRC § 6603(d)(2), a “disputable tax” is the amount of tax the taxpayer reasonably estimates to be of the maximum amount of tax attributable to “disputable items,” which is defined in IRC § 6603(d)(3)(A) to be any taxable item, if the taxpayer has a reasonable basis for its treatment of such item and reasonably believes that the Service also has a reasonable basis for disallowing the taxpayer’s treatment of such item.
A remittance to the IRS must be accompanied by a written statement designating the remittance as a deposit and stating the type of tax, the tax year, and a statement described identifying the amount of and basis for the disputable tax, or it must be identified as a deposit under IRC § 6603. The statement must include the following:
- The taxpayer’s calculation of the amount of disputable tax;
- A description of the disputable item(s);
- The taxpayer’s basis for the treatment of such disputable item; and
- An explanation as to why the IRS also has a reasonable basis for disallowing the taxpayer’s treatment of such item.
This statement is critical, because if a taxpayer fails to identify the amount and nature of the disputable tax in writing at the time of the deposit, the payment of interest will not be allowed if the deposit is later withdrawn by the taxpayer. If the taxpayer makes a remittance that is not designated as a deposit (a so-called “undesignated remittance”), the IRS will it as a payment, which will be applied against any outstanding liability for taxes, penalties, or interest in the IRS’s preferred order.
It’s important to note that if, the taxpayer fails to initially provide a written statement identifying and describing the amount of the disputable tax, but it subsequently provides the IRS with a written statement, the IRS will only allow interest under IRC § 6603 from the date on which the taxpayer identifies the amount and nature of the disputable tax. Stated differently, the date that the IRS receives the written statement—not the actual deposit will be treated as the date of deposit for purposes of interest accrual under IRC § 6603(d).
Taxpayers who want the IRS to treat a deposit in the nature of a cash bond as a deposit eligible for interest under IRC § 6603(d) must submit a written statement requesting this identification to the IRS, which must include the following:
- The date(s) and amount(s) of the original deposit(s) in the nature of a cash bond;
- The type(s) of tax to which the deposit in the nature of a cash bond was applied;
- The tax year(s) to which the deposit in the nature of a cash bond was applied; and
- A statement identifying the amount of and basis for the disputable tax.
A deposit made pursuant to IRC § 6603 will not be subject to a claim for credit or refund as an overpayment until such time as the deposit is applied by the IRS as payment of an assessed tax of the taxpayer. Nonetheless, a taxpayer may request the return, in writing, of all or part of a deposit at any time before the Service has used the deposit for payment of a tax.
If the above requirements are met, the deposit will be returned to the taxpayer. To the extent the deposit is attributable to a disputable tax, interest will be included for the period from the date of deposit to a date not more than 30 days preceding the date of the check paying the return of the deposit.
The Hill Case – A Cautionary (though not Entirely Unforeseen) Tale
In late October 2021, the Tax Court decided the case of Hill v. Commissioner. The petitioner in Hill had been embroiled in familial litigation in Texas over, what else, oil—Texas tea, if you prefer. The parties to the crude litigation (not sorry) settled, and the petitioner was ordered to assign a $30,675,000 asset to trusts for the benefit of his children. Understanding that the assignment could (and did) generate a gift tax liability, the petitioner wrote a check for $10.3 million to the IRS in February 2012.
The letter accompanying the remittance designated it as a “deposit,” and further observed that the taxpayer intended “for this deposit to satisfy the requirements of IRC § 6603(a).” The use of the word “deposit” to apply to the remittance continued for years. Indeed, later letters demanding a return of the “deposit under IRC § 6603” stated that such remittance of the remittance was “authorized by IRC § 6603(a).” Finally, the petitioner’s attorneys stated that the refund request was made under the terms of Rev. Proc. 2005-18, § 6. If you’ve been following along, Rev. Proc. 2005-18, § 6 governs “request[s] for return of a deposit made pursuant to IRC § 6603.”
A notice of deficiency was issued…litigation ensued…and the parties ultimately stipulated to the determination of a gift tax deficiency of $6.8 million for 2011 (with no other deficiencies or penalties). In the stipulated decision the parties agreed that “the prepayment credit in the amount of [$10.3 million] will be reversed for petitioner’s tax year 2010 and applied to petitioner’s tax year 2011 gift tax liability.” In January 2020, the IRS issued the petitioner a check for $3.5 million, representing the difference between petitioner’s remittance ($10.3 million) and the deficiency the Tax Court determined ($6.8 million).
Critically, the check included zero interest.
The petitioner moved to redetermine interest in August 2020. In his motion, the petitioner contended that the IRS “erred in failing to refund the interest that accrued pursuant to IRC § 6603(d)(1).” The petitioner further alleged that the interest due on his excess deposit is $1.3 million, calculated using the interest rate payable on overpayments of tax (3% over the Federal short-term rate), rather than the “deposit” rate, which is simply the Federal short-term rate.
The IRS has jurisdiction to redetermine interest pursuant to IRC § 7481(c), though this jurisdiction is limited—especially when the motion to redetermine interest after a decision of the Tax Court is final. The Tax Court in Hill found that the petitioner had not made an overpayment; therefore, it lacked jurisdiction over his motion.
The Advantages (and Pitfalls) of Designating the Remittance as a Deposit
Designating this remittance as a “deposit” provided the petitioner in Hill with an important benefit. He could demand the immediate return of his deposit at any time. If, on the other hand, the petitioner had made an “advance payment,” he could have secured return of the funds only by pursuing the IRS’s formal refund process (which can—and generally is—long, difficult, and expensive).
The Hill petitioner’s initial and continued insistence on the remittance being a “deposit” had two adverse consequences for petitioner: (1) the Tax Court lacked jurisdiction to reopen the case and (2) interest on the excess deposit, while concededly due, must be computed at the Federal short-term rate, without the three-percentage-point “bump” applicable to interest on “overpayments.”
A Cautionary Tale
Let Hill serve as a warning to be careful what you wish (or repeatedly ask) for.
The petitioner and his representatives clearly intended the remittance to be a deposit. They used the word “deposit” throughout the process until, realizing the windfall if it weren’t considered a deposit, they reversed course in the “eleventh hour.”
Both payments and deposits accrue interest—with payments doing so at a substantially more favorable rate (3% more, accruing daily).
Nonetheless, there are significant drawbacks in making a “payment” versus a “deposit.” It’s critical to understand the end game before making designation, as the petitioner in Hill learned the hard way.
- IRM pt. 220.127.116.11.1(1). ↑
- Id. ↑
- Generally in the form of both a Letter 1153 (60-Day Notice of Proposed Assessment) and a Form 2751 (Proposed Assessment of Trust Fund Recovery Penalty). ↑
- Rev. Proc. 2002-26, § 3.02; see also IRM pt. 18.104.22.168.3.1(1); IRM pt. 22.214.171.124(1). ↑
- IRM pt. 126.96.36.199(8); see also IRM pt. 188.8.131.52 (Designated Payments). Note: IRM pt. 184.108.40.206(8) incorrectly refers to IRM pt. 220.127.116.11 rather than IRM pt. 18.104.22.168. Note, however, that if a taxpayer makes (i) a Federal tax deposit, whether timely or late; (ii) a partial payment on or before the due date; or (iii) full payment of tax on or before the date the return is filed, the IRS will apply the payment first to the non-trust fund portion of the tax and then to the trust fund portion of the tax. ↑
- Hill v. Commissioner, T.C. Memo. 2021-121, slip op. at *12. ↑
- See, e.g., Rev. Proc. 64-13, § 4. ↑
- Rev. Proc. 84-58, § 2.03. ↑
- See American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 842, 118 Stat. at 1598. ↑
- Alliteration is always acceptable, alright? ↑
- IRC § 6603(c). ↑
- IRC § 6603(d)(1). ↑
- See, e.g., Rev. Rul. 2021-21. ↑
- IRC § 6603(d)(2)(A). In the event that a taxpayer has received a notice of deficiency (a “30-day Letter”), the maximum amount of disputable tax may not be less than the amount of the proposed deficiency pursuant to IRC § 6603(d)(2)(B). ↑
- IRC § 6603(d)(3)(A)(i)-(ii). ↑
- See H.R. Rept. No. 108-755, at 649 (2004). ↑
- See Rev. Proc. 2005-18, § 6.03. ↑
- T.C. Memo. 2021-121 (Oct. 25, 2021). ↑
- Rev. Proc. 84-58. ↑
- A “taxable item,” as the term is used in this article is an “item of income, gain, loss, deduction or credit.” ↑
- Rev. Proc. 2005-18, § 4.01(1). ↑
- Rev. Proc. 2005-18, § 5.01. ↑
- Rev. Proc. 2005-18, § 7.02. ↑
- Rev. Proc. 2005-18, § 4.01(2). ↑
- Rev. Proc. 2005-18, § 7.04. ↑
- Rev. Proc. 2005-18, § 5.01. ↑
- Rev. Proc. 2005-18, § 5.02. ↑
- Such statement of disputable tax is described in Rev. Proc. 2005-18, § 7.02, as discussed previously. See supra n. 22. ↑
- Rev. Proc. 2005-18, § 6.01. ↑
- Rev. Proc. 2005-18, § 6.02. ↑
- Rev. Proc. 2005-18, § 6.01. ↑
- Rev. Proc. 2005-18, § 6.03. ↑
- Id. ↑
- Rev. Proc. 2005-18, § 6. ↑
- IRC § 6621(a)(1). ↑
- IRC § 6603(d)(4). ↑
- Tax Court may reopen the case solely to determine whether the taxpayer has made an overpayment of such interest or the Secretary has made an underpayment of such interest and the amount thereof. IRC § 7481(c)(1). This exception applies in two categories of cases: (1) where the IRS has made a tax assessment that includes interest; and (2) where the Tax Court finds that the taxpayer has made an overpayment under IRC § 6512(b). IRC § 7481(c)(2)(A)-(B); see also Estate of Smith v. Commissioner, 429 F.3d 533, 538 (5th Cir. 2005), vacating 123 T.C. 15 (2004). In order for IRC § 7481(c)(2) to apply, the Tax Court must have determined that there has, indeed, been an overpayment pursuant to IRC § 6512(b). Exxon Mobil Corp. & Affiliated Cos. v. Commissioner, 136 T.C. 99, 111 (2011), aff’d, 689 F.3d 191 (2d Cir. 2012). ↑
- See IRC § 6603(c). ↑
- See Ford Motor Co. v. United States, 768 F.3d 580, 588 (6th Cir. 2014) (noting that taxpayers before enactment of IRC § 6603 faced the dilemma of “immediate access without interest, or interest without immediate access”). ↑
- See IRC § 6621(a)(1). ↑
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