TEFRA + LCU = Confusion, Part 3
In today’s post Bob Probasco concludes his three-part series on General Mills and the intersection of TEFRA and “hot interest.” Part One can be found here. Part Two, here. Christine
In Part 1, I described the decision by the Court of the Appeals for the Federal Circuit in General Mills, Inc. v. United States, 957 F.3d 1275 (Fed. Cir. 2020), aff’g 123 Fed. Cl. 576. (2015). The taxpayer’s refund suit sought recovery of $6 million of excessive underpayment interest, but the court dismissed the case based on a jurisdiction issue from a special TEFRA provision. I thought that the court made a crucial assumption, never clearly stated, as to the conceptual framework for adjustments resulting from a TEFRA proceeding. Part 2 explained why an alternative framework, which would have supported the taxpayer’s position instead of the government’s, is not only possible but perhaps the best way to think about these issues. Because the court dismissed the case for lack of jurisdiction, based on the TEFRA provision, we didn’t get a decision regarding the merits issue, concerning whether the IRS has assessed too much interest. It’s an issue that I had never dealt with before and I think the IRS’s position may be wrong. That’s what today’s post, Part 3, is about.
The case involved two sets of tax returns and audits: those for the General Mills (“GMI”) corporate tax returns and those for partnership tax returns for General Mills Cereals, LLC (“Cereals”). Various members of the GMI consolidated group were partners in Cereals, so the partnership tax returns – and any audit adjustments – for Cereals flowed through to GMI. The IRS audited the 2002-2003 tax returns (both corporate and partnership) and later the 2004-2006 tax returns (same). Although there are some slight differences between the audits for those two periods, for simplicity I will focus on the 2002-2003 tax returns.
Audits began for both GMI and Cereals in 2005 for these years. The IRS issued a 30-day letter for the GMI audit on June 15, 2007, asserting proposed deficiencies of more than $143 million for 2002 and almost $83 million for 2003. The partners in Cereals entered into settlement agreements in July 2010. On August 27, 2010, the IRS issued a document described as a “notice of computational adjustment” to GMI, identifying additional underpayments, resulting from the Cereals audit, of about $16 million for 2002 and more than $33 million for 2003.
The IRS assessed additional taxes, penalties, and interest resulting from the Cereals audit in September 2010. GMI paid all outstanding balances for these years, including interest, on April 11, 2011. The IRS sent GMI detailed interest computation schedules for these years, apparently for the first time, on April 18, 2011 and April 20, 2011. The schedules reflected that the IRS began charging a higher underpayment interest on July 15, 2007. GMI filed refund claims on March 28, 2013, arguing that the interest IRS accrued and assessed was almost $6 million too high. GMI then filed this refund suit on January 30, 2014.
The Basis for GMI’s Refund Claim – LCU Interest The interest rate for large corporate underpayments (LCU) is governed by section 6621(c), as supplemented by Treas. Reg. § 301.6621-3, which increases the normal underpayment interest rate by 2% for a corporate taxpayer’s underpayments that exceed $100,000. It was enacted in 1990, as part of the Omnibus Budget Reconciliation Act, and has typically been referred to by practitioners ever since as “hot interest.” There are two key concepts in determining whether, and when, to apply hot interest: the “threshold underpayment” and the “applicable date.”
Whether hot interest applies is not, oddly enough, determined by comparing the underpayment balance to $100,000. The regulation establishes a “threshold underpayment,” a term of art that appears only here. Hot interest applies if that amount, rather than the underpayment balance, exceeds the $100,000 statutory requirement. The threshold underpayment is defined as the correct amount of tax (excluding penalties and accumulated interest) less all payments made by the last date prescribed for payment. Thus, it appears to be a cumulative amount rather than the result of a particular transaction such as an audit. (But see below regarding “applicable date.”) Once hot interest is triggered, the higher interest rate would apply to the entire underpayment balance going forward, including interest and penalties and any amounts subsequently assessed. Under the IRS interpretation, hot interest would apply even if the actual underpayment balance declines below the $100,000 threshold as a result of payments.
The existence of a threshold underpayment is determined only when there is an assessment, not merely because of a proposed deficiency. (Contrast the determination of the “applicable date” discussed below.) If the taxpayer receives a 30-day letter or a notice of deficiency for $110,000 but the amount is reduced to $90,000 prior to assessment, the threshold underpayment is only $90,000 and hot interest does not apply. But even if an amount greater than $100,000 is originally assessed, the regulation states that hot interest will not apply if a subsequent judicial determination reduces the tax liability (and therefore the threshold underpayment) below $100,000.
The regulation doesn’t specifically address whether a subsequent administrative determination reducing the tax liability (e.g., an abatement resulting from a refund claim) would reduce the threshold underpayment, potentially below $100,000. Based on the definition of the threshold underpayment in the Code, it should – but I haven’t run across a ruling on this specific question. The IRS has challenged whether an abatement reduces the threshold underpayment but to my knowledge only in the specific context of an NOL carryback. The IRS lost, in Med James, Inc. v. Commissioner, 121 T.C. 147 (2003), but in that case the reduction from an NOL carryback was asserted as a counterclaim in a deficiency proceeding. If the abatement had been granted in an administrative determination, the taxpayer might have had to pay and file a refund claim/suit to address the hot interest issue.
Determining the amount of the threshold underpayment is complicated enough that the IRS can easily make mistakes. But if you look at the amounts above, it’s clear that GMI met the threshold underpayment requirement. That is only one part of the answer, though. To determine whether/when hot interest applies, the IRS also must determine the applicable date.
Interest on underpayments generally runs from “last date prescribed for payment,” typically the unextended return due date. The higher rate for hot interest only applies “for periods after the applicable date.” For assessments subject to deficiency proceedings, the applicable date is 30 days after the earlier of a “letter of proposed deficiency which allows the taxpayer an opportunity for administrative review in the Internal Revenue Service Office of Appeals” (i.e., a 30-day letter) or the notice of deficiency. That’s section 6621(c)(2)(A).
Section 6621(c)(2)(B)(i) is a special rule that applies to tax assessments not subject to the deficiency procedures; for such underpayments, the applicable date is 30 days after a letter or notice of the assessment or proposed assessment. This would apply to certain taxes other than income tax. This category also would include two common situations involving income tax: amounts shown on the original return but not paid on or before the last date prescribed for payment, and summary assessments for “mathematical or clerical errors.”
Although not explicitly addressed in the Code, the regulation includes within the scope of section 6621(c)(2)(B)(i) “underpayments attributable, in whole or in part, to a partnership item.” For those, the applicable date would be the 30th day after the first letter or notice that notifies the taxpayer of an assessment of the tax.
The Code also identifies three exceptions under which a letter or notice that otherwise qualifies would not establish an applicable date and start hot interest running:
- A 30-day letter or notice of deficiency that is withdrawn.
- A 30-day letter or notice of deficiency for which the taxpayer pays the amount in full within 30 days after the letter or notice is sent.
- Any letter or notice involving “small amounts,” that is, an amount that is not greater than $100,000 (as with threshold underpayment, excluding penalties and interest).
As with threshold underpayments, the proper determination of the applicable date may be complicated and subject to error. GMI believed that the IRS applied the law incorrectly and charged hot interest when it should not have.
IRS application and GMI’s argument
Interest at the normal underpayment interest rates generally (with some common caveats) begins as of the filing due date, without regard to extensions, rather than when the IRS made the assessments. But the increased interest rate for hot interest starts only on the applicable date. What does that mean when there are multiple assessments, including adjustments flowing through from TEFRA audits?
The IRS position apparently is that hot interest starts, for the entire underpayment balance, as of the first applicable date for any component of that underpayment balance. As noted above, GMI’s corporate audit resulted in a 30-day letter issued on June 15, 2007. So the IRS interest calculations increased the interest rate starting on July 15, 2007, one month later, for the entire underpayment balance, including that attributable to the computational adjustments from the TEFRA audit.
GMI, on the other hand, read sections 6621(c)(2)(A) and (B)(i) as bifurcating the underpayments for these tax periods. The portion of the underpayment attributable to the corporate audit and the portion of the underpayment attributable to the TEFRA audit would have separate applicable dates. Hot interest for the portion of the underpayment attributable to the corporate audit might start as of July 15, 2007. But the first letter or notice that notified GMI of an assessment of tax from the TEFRA audit was issued on August 27, 2010. So hot interest for that portion of the underpayment shouldn’t start until September 26, 2010, more than three years later than the applicable date the IRS used.
I think GMI’s position is certainly a reasonable interpretation. The Code is, as almost always, ambiguous and the drafters may not even have considered this situation. GMI’s particular situation, an assessment resulting from a corporate audit followed by an assessment resulting from a TEFRA audit, is not explicitly addressed anywhere in the 4-1/2 pages of regulations either. There are six examples in the regulations, but none involve this situation. Indeed, none of the examples even involve a partnership adjustment.
GMI pointed out that section 6621(c)(2)(A) already uses a “the earlier of” comparison between a 30-day letter and a notice of deficiency for which no 30-day letter was issued. If Congress didn’t want to bifurcate the underpayments in a situation like GMI’s, why not simply include the provision regarding non-deficiency proceedings as 6621(c)(2)(A)(iii) instead of 6621(c)(B)(i)?
I think it would be possible to carry the argument even further, arguing that hot interest applies only at the level of individual components of the underpayment balance, rather than the entire balance. Other interest provisions apparently work that way, e.g., the “restricted interest” provisions in sections 6601(c) and 6611(e). The references in section 6621(c) to letters or notices arising from specific adjustments, rather than to the entire underpayment balance, are very similar to the restricted interest provisions. That arguably suggests the same approach of applying the special rule to components rather than the entire balance.
That interpretation could also be inferred from the exception in section 6621(c)(B)(iii), under which a letter or notice for a deficiency or assessment less than $100,000 does not start hot interest running. Before that provision was added in 1997, hot interest would be triggered when the threshold underpayment from two or three separate transactions exceeded $100,000. That’s reflected in Treas. Reg. § 301.6621-3(d), Example 2, which has not been revised to be consistent with the Code provision as amended in 1997. What’s the purpose of section 6621(c)(B)(iii)? Maybe it reflects a determination that hot interest should be applied only to individual transactions over $100,000, rather than a cumulative balance. And maybe that implies that the applicable date should be determined separately for each of those transactions.
Further support is available from the exception in section 6621(c)(B)(ii), under which a letter or notice for which the taxpayer pays the amount in full within 30 days does not start hot interest running. That looks very much like an incentive for quick payment, doesn’t it? But if hot interest applies at the level of the entire underpayment balance rather than individual transactions, the incentive starts looking strange. There is an extra incentive to pay quickly for the first deficiency/assessment that triggers hot interest, but that extra incentive goes away for the second, third, etc. deficiency/assessment. Why would that be the case? I don’t recall ever seeing this issue before the Federal Circuit’s decision came out. The case was filed in the Court of Federal Claims in 2014, and that court ruled in 2015, but I missed those at the time. To my knowledge, this issue has not been addressed in any other cases. (If anyone has seen it elsewhere, please let me know!) So I was eager to see the court’s analysis. Alas, there was none. The case was dismissed for lack of jurisdiction, so we’re still waiting for the courts to rule on this issue.