The clock is ticking on interest when taxpayers dispute how much they owe to the Internal Revenue Service. An outcome that is favorable to the taxpayer erases penalties and interest, but if the taxpayer is wrong and the IRS reclaims just a small amount, the result can be a highly inflated tax bill.
The power of the IRS allows the agency to penalize taxpayers for mistakes. Interest accumulates during tax disputes, reaching all the way back to the time of a tax return’s due date. Interest may compound for months and even years, if the tax return in question is not recent. When tax arguments favor the IRS, the fast-rising interest continues to add up until the date the taxes, penalties and interest are paid in full.
The IRS is not required to win an entire dispute to collect interest. In tax disagreements where the government wins only a partial concession, interest is still allowed to accumulate. The amount of interest paid is currently compounded daily at 3 percent above the short-term federal interest rate. The rate is reset by the IRS on a quarterly basis.
Taxpayers are frequently advised to halt the flow of hemorrhaging interest by making a retractable, sometimes refundable deposit to the U.S. Treasury. In order to stop the interest clock, a check for the entire amount of accrued interest to date, plus penalties, must be made.
If a taxpayer is confident the argument with the IRS will resolve in his favor, the advance deposit may be unnecessary. However, a tax advisor may recommend paying the interest-stopping deposit if the government has even a partial chance to prove victorious.
IRS rules apply to the process of stopping interest accumulation. A check must be labeled as a “deposit” and be accompanied by documentation outlining the tax dispute. When the check is officially named a “deposit,” the taxpayer gains the opportunity to withdraw the money by request if a financial emergency arises or if the taxpayer just wants it back. Taking back the check opens up a taxpayer to being charged interest again, all the way back to the tax return due date.
The government does not always hand the deposit back easily. If the IRS feels the withdrawal will jeopardize its chance to collect in a dispute, the agency can opt to hold onto the money.
Source: Forbes.com, “When Fighting IRS, Should You Pay To Stop Interest?” Robert W. Wood, Oct. 28, 2011