IRS Interest and C Corporations

By Nancy Faussett, CPA
Publication date: 01/22/2008

When a corporation underpays its tax liability, the IRS can assess both penalties and interest. Interest can be assessed on the tax that is owed but it can also be assessed on the penalty itself. The underlying principle for the assessment of interest is that the taxpayer had use of the money for a period of time during which it should have been in the possession of the government.

Interest is calculated on any underpayment amount at a prescribed rate. It doesn’t matter if the corporation paid less than what was owed or failed to file the tax return altogether. The reason for the underpayment is unimportant. Interest is assessed under the same set of rules. The calculation is dependent on:

  • Amount of the underpayment
  • Rate of interest
  • Period of time of the underpayment

Interest on the Underpayment of Tax

In general, interest begins to accrue on the due date of the tax return (without regard to any extension for filing the return) and ends on the date on which the IRS receives payment. If the IRS sends a letter of assessment, interest begins 30 days after it is sent. (If there is a deficiency notice, this is computed slightly differently.)

When an income tax liability is later reduced by the carryback of an NOL, a capital loss, or a business credit from a future year, the interest on that portion stops as of the first day after the due date of the return for the year in which the carryback was established, without regard to any extensions filed. The following illustrates this:

Example:
Short-on-Cash Corporation, a calendar-year-end business, underpays its income tax by $500 in the year 2002. In 2003, it has an NOL, which it carries back to 2002, reducing its 2002 tax liability by $200. IRS assesses interest on the $500 underpayment starting from March 15, 2003, the due date of the 2002 tax. However, beginning on March 16, 2004 (the day after the due date for the 2003 tax), interest accrues on only $300 ($500 underpayment less the NOL from 2003, which reduced its 2002 tax liability to $300).

Interest on Penalties

Interest is also assessed on penalties. The date on which interest begins to accrue depends on the type of penalty on which it is assessed.

  • For the failure-to-file penalty, accuracy-related penalty, and fraud penalty, interest begins on the due date of the tax return (including extensions) and ends on the date the IRS receives the payment.
  • For all other penalties, interest is payable from the date of the notice and demand for payment. However, if the amount due that is stated in the notice is paid within 21 days (10 days for amounts of $100,000 or more), no interest will be due.

Note: Interest on the penalty for the underpayment of estimated tax is charged at the federal rate, not the rate that the penalty is charged on the Form 2220. Interest does not start accruing until the IRS sends a notice for payment.

Rate of Interest Assessed

The prescribed rate of interest assessed on an underpayment amount is the federal short-term rate plus 3 percentage points. However, if you are a C corporation and the amount of your underpayment is more than $100,000, interest is assessed at the short-term rate plus 5 percentage points. The term for the latter is “hot interest.” 

The interest rates are adjusted quarterly for the calculation. Interest is compounded daily.

Other Issues

Consider the scenario when a C corporation owes the IRS tax and has been assessed both interest and penalties on the amount due. If the corporation sends in a partial payment without any instructions on how it should be applied, the IRS will apply the payment in the following order: tax, penalty, and then interest for the earliest period. If a corporation owes for more than one year and the partial payment covers more than the first year, the IRS will next apply it to the succeeding years in the same order: tax, penalty, and interest.

Interest is payable both to and by the IRS. Therefore, if a corporation overpays its tax, the IRS is required to pay interest to the corporation. The rate of interest that the IRS pays on overpayments by corporations is generally the federal short-term rate plus 2 percentage points. However, the interest rate for any portion of the overpayment that is more than $10,000 is the federal short-term rate plus one-half of one percentage point. Interest is required to be paid from the date of the overpayment to a date that is not more than 30 days before the date of the refund check.

However, the above works both ways: If the IRS makes a refund of any amount by error (whether of tax, interest, or assessed penalties), the corporation will have to both repay the amount of the refund as well as pay interest on it. Interest will start accruing from the date on which the refund check is cashed. However, unless the taxpayer has in any way caused the erroneous refund (or if the refund exceeds $50,000), the IRS must abate the interest until the date that the demand for repayment is made.

Summary

The IRS can assess interest on any underpayment of tax and on the penalties that it levies. The date on which interest starts to accrue depends on what it is being assessed, whether it is on an underpayment of tax or on a penalty. Furthermore, if interest is assessed on a penalty, the type of penalty also affects the start date for the assessment.

An extension of time to file the tax return is ignored when determining the date on which interest on an underpayment of tax starts to accrue. Interest on an underpayment of tax is always assessed starting with the original due date of the return. However, when interest is assessed on certain penalties, an extension to file the return is taken into account and interest does not start to accrue until the new filing deadline.

Interest generally stops accruing on the date the payment is received by the IRS, not the date the check is mailed.

The actual rate of interest increases if the amount owed is more than $100,000.

Remember that both the taxpayer and the IRS may at some point have to pay interest. Either may also be entitled to receive interest, depending if it was an underpayment or an overpayment and who made it.