Tax Pros, Leave Your Bad Habits In 2020. What Every Tax Controversy Pro Needs To Know, Part Two: 6603

Albert Einstein is reputed to have said “Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it.” Whether Albert Einstein really said that isn’t the point. Instead, consider that the point is well taken, and was never more well taken than when dealing with the Internal Revenue Service.

I started this week by talking about how while I’m not one for resolutions, this year I’m working to help Tax Professionals around the country resolve to kick bad habits. You can read part one of the series here.

The next bad habit I’d like Tax Professionals to “kick” isn’t something that they are doing wrong, it is something I see my colleagues not doing, and that’s advising clients on how to avoid paying IRS interest, which compounds daily. Interest is set by statute, I.R.C. § 6621, and the rate is 3 percent above prime unless the taxpayer is a large corporation, in which case it is even higher. In that case, “Hot” interest applies. Tax Nerds like myself get emails from the IRS that include the rates on a quarterly basis, like this:

Taxpayers who are audited have the following choices regarding how to proceed:

1. Agree to changes proposed by the IRS, pay the tax, and end the dispute.
2. Pay the tax in dispute under protest, file a claim for refund, and file a lawsuit if the IRS does not grant the claim for refund or six months has passed.
3. Do not pay the tax in dispute, and file a petition in United States Tax Court to contest the proposed adjustment. The IRS may only assess and attempt to collect the amount in dispute after the Tax Court renders a decision, and if the decision is in favor of the IRS. In other words, taxpayers don’t have to pay the tax unless and until the Tax Court says so, because the IRS can’t even assess it until the Court determines whether the IRS or the taxpayer is right.

Many clients I’ve had over the years have no interest in ever paying a penny to the IRS before a final court decision if tax is disputed. They think that in terms of negotiating, they’d be crazy to give the IRS money before they have to. They think it will look like they do owe the tax. They may not want to part with the money because parting with money is hard to do. Or, they may not have the money to pay. (By the way, this is wrong. The IRS doesn’t take any hints from the fact that taxpayers make a deposit or want to pay, and in fact, I’ve found IRS agents to be far more willing to negotiate when a taxpayer has paid or made a deposit than refused to pay.) There are lots of reasons why people don’t want to pay the IRS unless they have to, but there’s a good reason why tax pros should be advising their clients about the option to make a deposit even if they want to fight: interest.

The IRS has established a procedure by which taxpayers can make a “deposit” to suspend interest from accruing. Taxpayers who take advantage of this procedure will not be “paying” the IRS. Think of a Section 6603 deposit as a bond or a security deposit for an apartment. The funds belong to the taxpayer, not the IRS. If a taxpayer requests the funds be returned, unless the IRS thinks the taxpayer may flee the country and never pay, they have to be returned to the taxpayer upon request.

Imagine a taxpayer and his CPA receive a notice of exam from the IRS. The item in dispute is whether the taxpayer qualifies as a real estate professional. If the taxpayer wins, no additional tax will be due. If the taxpayer loses, then $1.5 million in tax will be due. The CPA should advise the taxpayer that he can deposit $1.5 million with the IRS using the procedures set forth in 6603 and Revenue Proclamation 2005-18. The taxpayer can fight and win and he won’t owe anything and will get his deposit back, plus the prime rate of interest. On the other hand, if the taxpayer fights and takes his battle all the way to tax court, and 5 years later a decision is entered against the taxpayer, he won’t owe $1.5 plus interest.

How does this work in practice?

At the current federal rate, assume a taxpayer had a $1.5 million dollar disputed item for the 2019 tax year. The tax is due in 2020. Likely the IRS won’t audit until 2022 at the earliest. If the IRS audits in 2022, and the audit lasts a year, the taxpayer goes to tax court and the trial lasts two years, then a decision comes out against the taxpayer in early 2026. Assuming no penalties apply (which is a big assumption), and the interest rate stays the same (another big assumption) the amount of interest due is now $384,055.45. Instead of owing the IRS $1.5 million, the taxpayer now owes the IRS almost $1.9 million.

Maybe the client won’t want to part with that much money, or want to make a deposit. There’s no reason why the client can’t make a deposit of $150,000 instead of $1.5 million. At least interest won’t accrue on that portion of a balance.

No matter what, taxpayers who have disputes with the IRS should be advised on their options to make a deposit. Whether they take it or not is up to them.