TREASURY INSPECTOR GENERAL
FOR TAX ADMINISTRATION
Tax Law Changes Are Needed to Improve Fairness in Paying Interest on Tax Refunds
Reference No. 2001-30-148
The Congress has taken significant steps to address the issues of when, why, and how much interest should be paid to taxpayers on six occasions since 1965. In taking these steps, the Congress has attempted to provide strong incentives for the Internal Revenue Service (IRS) to minimize interest payments by issuing fast refunds. At the same time, the Congress has sought to ensure all taxpayers are fairly compensated for IRS refund delays and that taxpayers are not rewarded with often-generous government interest for intentionally delaying the refund process.
In 1991, the IRS sought equal interest payments on both original and amended returns filed by taxpayers. The IRSí proposal followed the same theme as the new IRS mission that states a commitment to "top quality service" and "fairness to all." The proposal also had the potential to encourage the issuance of faster refunds to taxpayers, thereby significantly reducing interest payments.
In response, the Congress incorporated changes to interest laws into the Omnibus Budget Reconciliation Act of 1993 (OBRA 93). From Fiscal Year (FY) 1994 through FY 1999, the IRS paid $15.7 billion in interest based upon the revised interest laws.
Our audit objective was to evaluate the effect of changes made to the Internal Revenue Code (I.R.C.) by the OBRA 93 as they related to the IRSí payment of interest on tax refunds. We reviewed the IRSí records of interest payments for FYs 1994 through 1999 and performed detailed analyses of the $3.5 billion in interest payments made in FY 1999. Most ($2.2 billion) was paid to just 38 corporate taxpayers that received interest ranging from over $10 million to over $675 million.
Current interest laws limit the IRSí ability to carry out its mission to provide top quality service and fairness to all taxpayers. Interest payments are determined by the method used to identify an overpayment, the method of delivering an overpayment to the taxpayer, and the type of taxpayer receiving the overpayment. Basing the computation of interest on these factors treats taxpayers inequitably, leaves the tax system open to profit-motivated manipulation, penalizes taxpayers who wish to pay future taxes with their overpayments, and produces needless complexity in interest computations. In addition, the current interest laws create a government interest expense that averages $2.6 billion annually and prevent the IRS from eliminating that expense through improved responsiveness to taxpayers.
Simplifying Interest Laws Could Improve Fairness, Speed Refunds, and Reduce Annual Government Interest Costs by $2.6 Billion
The Congress has long sought to fairly compensate taxpayers for IRS refund delays while deterring taxpayers from abusing the tax system to receive interest from the IRS, which is sometimes greater than interest available on other investments in the public sector. To accomplish these goals, the Congress has targeted various types of refunds and groups of taxpayers with different interest computations and interest rates.
The OBRA 93 contained the last major revisions of the interest laws that determine whether interest will be paid and, if so, for what time period. However, the revisions did not change interest payment laws to achieve fairness for all taxpayers.
Basing interest on the method of identifying an overpayment prevents fairness and simplicity
Original returns, amended returns, and IRS examinations are all methods of arriving at the proper tax and identifying overpayments or underpayments. Although any of these three methods could be used to identify the same overpayment, determining the length of time for which interest is paid differs for each method. Depending upon the method used, the taxpayer may receive no interest or may receive many years of interest on any overpayment.
Current interest laws prohibit the IRS from paying interest on refunds issued within 45 days of an original return filing but require the IRS to pay up to 3 years of interest on refunds from amended returns. Significantly more than 3 years of interest may be required when the IRS examines a return.
Of the 38 corporations that received interest payments of more than $10 million in FY 1999, 36 received a total of $1.8 billion of interest as a result of IRS examinations. The IRS paid an average of 10.5 years of interest on the overpayments resulting from these examinations. The $1.8 billion paid to these 36 corporations represented 51 percent of the $3.5 billion of total interest paid to all taxpayers in FY 1999.
Basing interest on the method of delivering an overpayment to the taxpayer prevents fairness and simplicity
If the IRS delays the proper disposition of overpayments, taxpayers receiving refunds will be compensated with interest according to the OBRA 93. However, a pre-OBRA 93 I.R.C. provision can reduce or eliminate the interest based upon how the overpayment is used. The interaction of this interest law with the OBRA 93 interest laws produces 15 scenarios for any overpayment that must be considered to determine whether, and for what time period, interest applies. Such complexity in computing interest impairs fairness both in appearance and in practice.
For example, a taxpayer entitled to interest on a refund because of IRS delays will not receive the interest if the taxpayer elects to have the money used to pay taxes not yet due for the succeeding tax year. The taxpayer may also lose the interest if the money is used to pay the taxpayerís own current tax debts. However, the taxpayer will not lose the interest if the money is used to pay the tax debts of another taxpayer.
Basing interest rates on the type of taxpayer prevents fairness and simplicity
Interest rates paid to corporations are lower than both the rates they must pay on their tax debts and the rates the IRS pays to all other taxpayers. These lower rates were established to ensure that interest rates paid by the IRS did not encourage profit- motivated changes to taxpayer payment or filing behavior. Although corporations receive the majority of the interest paid by the IRS ($3.0 billion of the $3.5 billion paid in FY 1999), the extent of profit-motivated activity is unknown, and some leading corporate tax professionals believe the lower rates are an unwarranted penalty on corporations.
In addition, the separate rates for corporations further complicate interest computations. The separate rates, in conjunction with the methods of overpayment identification and delivery, create 30 different scenarios that the IRS must consider to determine whether and how much interest applies to any overpayment.
Basing interest payments on taxpayer and IRS responsibilities can ensure fairness and simplicity
Revisions to interest laws based upon the Congressional trend emphasizing taxpayer and IRS responsibilities could provide fairness for all taxpayers, eliminate the potential for profit-motivated abuse of the refund process, and simplify interest computations. This could be accomplished by basing interest payments upon both the timely fulfillment of the taxpayerís responsibility for notifying the IRS that an overpayment exists and the IRSí responsibility for responding timely to the taxpayerís instructions regarding the proper disposition of the overpayment.
If the IRS followed a taxpayerís instructions for returning an overpayment within 45 days, no interest would be paid. Otherwise, the IRS would compensate the taxpayer with interest for the time it takes to carry out the taxpayerís instructions. Under these conditions, interest computations would be simplified, taxpayers would be fairly compensated for IRS delays, and taxpayers would not be guaranteed interest if they intentionally delayed refund requests. Since interest payments would result only from IRS delays, the IRS could be held accountable for all interest paid. All interest payments could be eliminated if accountability for interest prompted the IRS to timely resolve all taxpayer claims.
Summary of Recommendations
We recommend that the IRS Commissioner propose new interest laws that are based upon the timely fulfillment of taxpayer and IRS responsibilities. The IRS should be responsible for paying interest on any overpayment not returned within 45 days in the manner requested by the taxpayer. Interest should be paid from the date of the taxpayer request to the date the money is returned to the taxpayer. Successful implementation of such simplified interest laws would provide the IRS with the opportunity to eliminate $2.6 billion in interest annually.
Since enactment of this legislation would deter profit-motivated refund delays, lower corporate interest rates will no longer be needed for this purpose. Therefore, we also recommend that the IRS Commissioner propose legislation that will require the same rate of interest be paid to all taxpayers. These two legislative proposals will provide the IRS the opportunity to carry out its mission to provide top quality service and fairness to all taxpayers in the payment of interest.
Managementís Response: The Deputy Commissioner of the IRS responded that he agreed with our concerns that the current interest rules are quite complex and that the interest of fairness is important. However, he stated that the IRS is unable to agree at this time with our recommendation because the responsibility to propose legislation is reserved to the Department of the Treasury. However, the Commissioner, Small Business/Self-Employed Division, will coordinate with the other IRS Operating Divisions, the Office of the Chief Counsel, and the Department of the Treasury to review the current interest rules. The final determination of the need for legislation stemming from that review is the responsibility of the Department of the Treasuryís Assistant Secretary for Tax Policy.
Managementís complete response to the draft report is included as Appendix V.