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By Joel B. Steinberg, CPA, Richard A. Eisner & Company, LLP

Practitioners who prepare tax returns for individuals subject to late filing or late payment penalties may help their clients minimize such penalties. An awareness of the details of how these penalties are computed, particularly the penalty period, is necessary to assure that clients do not overpay these penalties.

The penalty for late filing is 5% of the unpaid tax for each month or part of a month the return is late, up to a maximum of 25%. The failure-to-pay penalty is 0.5% of the unpaid tax for each month or part of a month that the tax shown on a return is unpaid, up to a maximum of 25%. If the taxpayer is subject to both penalties in any month, the failure-to-file penalty is reduced by the late payment penalty. That is, the total of the two penalties may not exceed five percent per month. Although the late filing penalty is limited to five months, the late payment penalty may run for an additional forty-five months beyond the first five months. The maximum total combined penalty is 47.5%, comprised of 22.5% for failure-to-file and 25% for failure-to-pay. These rules are contained in Section 6651 of the Internal Revenue Code, which contains an escape hatch where the failure is shown to be due to reasonable cause and not willful neglect.

It is important to note that these penalties run from the due date of the tax return to the date the IRS actually receives the return or payment. The "timely-mailed - timely filed" rule under IRC Section 7502 only applies if the return is filed on or before the due date. It does not apply to delinquent returns or delinquent payments. See Revenue Ruling 73-133, 1973-1 C.B. 605.

In counting the number of months for computing the penalty, any fraction of a month during which the failure to file or pay continues is regarded as a full month. If the original (or extended) due date is the last day of a calendar month, each calendar month or fraction there or constitutes a month. For any other due date, a month is the period that ends with the date numerically corresponding to such date in each of the following months. If a return is not timely filed or tax is not timely paid, then the fact that the due date falls on a Saturday, Sunday, or legal holiday has no bearing on determining the number of months in the penalty period. In Label-Matic Inc. v. U.S. (74-1USTC Par. 9380), a district court agreed with this position of the IRS. Conversely, the court held that if the last day for filing (or paying) to avoid an additional month's penalty falls on a Saturday, Sunday, or legal holiday, that additional penalty would not apply if the return was filed (or payment made) on the next business day.

On December 30, 1996, the IRS finalized regulations that make it easier for a taxpayer to obtain an extension of time to file. As long as the taxpayer properly estimated his tax liability on Form 4868 (Application for Automatic Extension of Time for Filing) and filed the form on time, an extension will be granted even if the amount of tax estimated to be due was not paid with the Form 4868. However, an extension of time to file a return does not extend the due date for payment of the tax. If the taxpayer files Form 4868 and is granted an automatic extension of time to file, he is still subject to the late payment penalty unless at least 90% of the tax shown on the return is paid by the due date (without regard to the extension) or he can establish reasonable cause. Thus, taxpayers should be encouraged to make tax payments in order to minimize interest and penalties.

For example, suppose a taxpayer properly estimated his tax liability of $100,000 at April 15, 1997, and therefore has a valid extension of time to file until August 15. However, the taxpayer made no previous payments and does not have an extension of time to pay. He remits $100,000 with his tax return which is mailed on August 15 and received by the IRS on August 18. The taxpayer is subject to a late payment penalty of $2,500 ($100,00 x .5% x 5 months). Had the taxpayer mailed his return with enough time for the IRS to receive it by August 15, he would have saved one month's penalty, or $500.

If the taxpayer in the example above did not have a valid extension of time to file, he would have incurred a late filing payment penalty of $2,500. Had the IRS received the tax return and payment by August 15, his combined penalty would have been reduced by $5,000 (late filing penalty of $4,500 and late payment penalty of $500).

Filing instructions prepared by practitioners generally advise clients to file returns by a certain due date, often the 15th day of a month. When penalties are applicable and material, clients should be advised to file by an earlier date so the returns and payments are received by the IRS in time to avoid an additional month's penalty. Alternatively, the taxpayer could hand deliver the filing and/or payment to the IRS on or before the 15th and request a delivery receipt. *


By James E. Brennan, CPA, Ernst & Young LLP, and Maria Engerman, Ernst & Young LLP

The Federal Claims Court ruled in The May Department Stores Co. v. U.S., No. 94-340T, 11/4/96 that the fundamental issue in assessing certain deficiency interest is governed by whether the government or the taxpayer had use of the money during the period in question. The IRS's arbitrary application of an overpayment to the next year's first and already fully paid estimated tax installment controlled the determination. It was concluded that the IRS had the use of the money for specific periods and therefore was precluded from assessing deficiency interest for those periods.

By way of background, The May Department Stores Co. ("May") filed Form 7004 in connection with its fiscal tax year ended January 28, 1984 ("1983 return"). At that time the liability was determined to be $111,000,000 and that amount was fully satisfied when the extension application was filed. Upon completing the Form 1120, it was discerned that the liability was $103,090,774. The overpayment of $7,909,226 was to be credited toward the succeeding year's tax liability, however, no statement was provided to indicate which installment of estimated tax should be credited.

Later, the IRS examined May's 1983 return and determined the actual liability to be $108,018,931. Hence, the overpayment was reduced to $2,981,069. Since the overpayment had been applied to the 1984 tax liability, a deficiency of $4,928,157 was created with respect to the 1983 tax year. The IRS accrued interest on the deficiency and calculated the interest from May 15, 1984. The IRS disallowed the claim.

The same fact pattern occurred for May in connection with its fiscal year ended February 2, 1985 ("1984 return"). The IRS assessed deficiency interest from May 15, 1985, and again, May's claim for refund of this portion of the interest payment was denied.

The matter before the court in the instant case is a dispute regarding the IRS's assessment of interest on the deficiencies from the date May paid its flex installment of estimated tax for the following tax year. The IRS had automatically applied the overpayment credit to the first installment of the 1984 and 1985 tax years. However, it needs to be strongly emphasized that May had timely remitted and fully satisfied its first two installments for those years before the filing of the returns which disclosed the overpayments. Therefore, May asserts that during the periods from May 15 through October 15 of 1984 and 1985 there were no deficiencies and hence there should be no deficiency interest assessed. The application of the overpayment to the first installments of the two years was unnecessary and only created excessive credits.

May asserts that the IRS can assess interest only when there is an underpayment and when a taxpayer has use of funds that rightfully belong to the government. This position relies on Avon Products, Inc. 588 F2d 342 (CA 2 1978) and May argues that the government cannot charge deficiency interest under Section 6601(c) until October 15 of each year. This is the date when May created the deficiencies by applying the overpayments against its subsequent years' taxes. Only at this moment did May use funds which rightfully belonged to the government. Interest should begin running when a tax becomes both due and unpaid and thus, October 15 should be the beginning date for purposes of assessing deficiency interest.

Conversely, the IRS believed that Rev. Ruls. 84-58 and 88-98 should control here. Rev. Rul. 84-58 holds that the IRS will apply an overpayment to the first installment due after the date the overpayment arose unless the taxpayer attaches a statement to the return specifying the installment to which the IRS should apply the overpayment. Rev. Rul 88-98 holds that if a taxpayer claims an overpayment on a return and the overpayment is applied in full to an installment of the subsequent year's estimated tax and a deficiency is determined for the earlier year, interest runs from the due date of that installment.

Thus, the IRS argued that Rev. Ruls 84-58 and 88-98 are applicable to determining when a tax becomes due and unpaid for purposes of computing interest on the subsequently determined deficiencies of May for the years 1983 and 1984. When the overpayment was credited to the next year's estimated tax liability, the previously paid tax in the amount of the credit became unpaid. Since there was no designation made by the taxpayer, Rev. Rul 84-58 was applied by the IRS. May 15 was the first estimated tax payment due date and also became the date on which the overpaid tax became unpaid in the eyes of the IRS for purposes of computing interest.

The court determined that the IRS was in error with this premise. Since the first and second installment payments were fully and timely paid, May's taxes were satisfied at all times from May 15 to October 15 of the years in question. In the instant case the overpayments were reduced; its taxes were never underpaid during this five month period in both 1984 and 1985. Since the first and second installments were fully paid, May's overpayments were reduced only after October 15, when it filed its returns and credited its overpayment to the following year's estimated taxes.

The court held that there were no banks for the IRS to assess deficiency interest from May 15 through October 15 and granted a judgment allowing refund of the debated interest. It was decided that consistent with the use of the money principle of Avon Products and Manning v. Seely Tube & Box Colk 338 U.S. 561 (1950), interest is appropriate and may be charged to compensate the government for funds which it did not possess but which it rightfully should have possessed. It was clear that before October 15 of each relevant tax year, May had paid the full sum of its taxes and there was no deficiency. The IRS's application of the overpayment to the first installment of estimated tax of the subsequent year has no bearing on the matter since this liability was already fully paid at that time. The government had the use of the funds from May 15 to October 15 and therefore is precluded from the assessment of deficiency interest.

This decision is clearly advantageous to certain taxpayers where the fact pattern contours. Taxpayers may be eligible for significant refund opportunities where deficiency interest has been assessed and paid in the same manner as by May. *

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editors:
Richard M. Barth, CPA

Robert L. Goldstein, CPA
Leipziger & Breskin

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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