ESTATE THAT DEFERRED TAX AND THEN RECEIVED DEFICIENCY NOTICE MUST PAY INTEREST ON ANY UNDERPAYMENT AT PREVAILING RATE.

Rev. Rul. 89-32

ISSUE

If the time for payment of estate tax is extended under section 6166 of the Internal Revenue Code and a deficiency is assessed after the estate has timely made one or more annual interest payments, at what rate does interest accrued on unpaid interest that should have been paid on each past annual interest payment date?

LAW AND ANALYSIS

Section 6166(a)(1) of the Code provides generally that if the value of an interest in a closely held business is included in determining the gross estate of a decedent and exceeds 35 percent of the adjusted gross estate, the executor may elect to pay all or part of the estate tax in up to 10 equal installments.

Section 6166(a)(3) of the code provides generally that if the time for payment of estate tax is extended under section 6166, the first annual installment of tax must be paid on or before the date selected by the executor, which cannot be more than 5 years after the date prescribed by section 6151(a) for payment of estate tax.

Under section 6166(e) of the Code, if an election under section 6166(a) has been made and if a deficiency has been assessed, the deficiency shall (subject to the limitation provided by section 6166(a)(2)) be prorated to the installments payable under section 6166(a). Section 6166(e) does not apply if the deficiency is due to negligence, to intentional disregard of rules and regulations, or to fraud with intent to evade tax.

Section 6166(f) of the Code prescribes the time for payment of interest when the time for payment of tax has been extended pursuant to a section 6166(a) election. Under section 6166(f)(1), interest payable under section 6601 must be paid annually on any unpaid portion of the tax attributable to the first 5 years after the date prescribed by section 6151(a) for payment of the tax.

Section 6166(g)(3) of the Code provides generally that if any payment of principal or interest is not paid within 6 months of the date fixed for its payment under section 6166, the unpaid portion of the tax payable in installments must be paid upon notice and demand from the Secretary.

Section 6601(a) of the Code provides that generally that if any amount of tax is not paid on or before the last date prescribed for payment, interest on the unpaid amount must be paid at an annual rate established under section 6621 for the period from such last date to the date paid.

Under section 6601(e)(1) of the Code, any reference in the Code (except subchapter B of chapter 63, relating to deficiency procedures) to any tax imposed by the Code shall be deemed also to refer to interest imposed by section 6601 on such tax.

Section 6601(j)(1) of the Code provides generally that if the time for payment of an amount of estate tax, including any deficiency, is extended as provided in section 6166, interest on the 4-percent portion of the amount shall (in lieu of the annual rate provided by section 6601(a)) be paid at the rate of 4 percent.

Section 6601(j)(2) of the Code provides that the "4-percent portion" means the lesser of --

(A) $345,800 reduced by the amount of the credit allowable under section 2010(a); or

(B) the amount of the tax imposed by chapter 11 that is extended as provided in section 6166.

Through the statutory provisions described above, Congress has provided liquidity relief to an estate in which the decedent's interest in a closely held business is a significant part of the gross estate. If an election is made under section 6166 of the Code, the estate makes only annual interest payments during the initial five-year period on the tax attributable to the closely held business during which time payment of the tax deferred. Moreover, within the limits of section 6601(j)(2), interest accrues during the period of deferral under section 6601(j)(1) at the rate of 4 percent rather than under section 6601(a) at the prevailing rate.

If a deficiency is assessed during the five-year deferral period, and the deficiency is attributable to the decedent's interest in a closely held business and is within the limits of section 6601(j)(2) of the Code, the deficiency is prorated to the scheduled installments of tax, and interest is imposed at the rate of 4 percent. Sections 6166(e) and 6601(j).

The question presented is how interest is calculated if the deficiency is assessed after one or more annual interest payments have been made. In such case, the interest payments that were made before assessment of the deficiency will have been less than the payment that would have been made had the correct liability been shown on the return. If the 4-percent rate of interest were applied to the interest that should have been paid in past annual interest payments from the date such interest was due until the date of notice and demand for such interest, the estate would be in a better position than if the tax liability had been reported correctly on the return.

Under section 6166(f)(1) of the Code, interest on any unpaid deferred tax attributable to the first 5 years after the date prescribed by section 6151(a) for payment of tax must be paid annually. Because a deficiency represents a portion of the unpaid tax, interest attributable to a deficiency that qualifies for deferral must also be paid annually under section 6166(f)(1). When a deficiency is assessed after an annual interest payment date, the fact that the correct amount of interest was not paid within 6 months of the past annual interest payment date does not cause acceleration of the unpaid tax under section 6166(g)(3) if the additional interest is paid within 6 months of notice and demand. This does not mean, however, that the 4-percent rate of interest applies to the underpayment of interest until there is notice and demand.

The operation of what is now designated as section 6601(j) of the Code was explained by Congress in H.R. Rep. No. 2198, 85th Cong., 1st Sess. 20-21 (1958), 1959-2 C.B. 709, 723:

RATE OF INTEREST. -- . . . [T]he bill amends subsection (b) of section 6601 [presently subsection (j)] of the 1954 Code, relating to interest on extension of time to pay estate tax, to provide that interest shall be payable on any amount of estate tax, including a deficiency, which comes within the scope of section 6166, at the rate of 4 percent per annum instead of the normal rate . . . which is provided by subsection (a) of section 6601. However, if any amount of such tax is not paid on or before the expiration of the period of extension applicable thereto, the [normal] rate will apply from the date of such expiration to the date the tax is paid.

Under section 6166(f)(1) of the Code, an estate is obligated to pay the interest on the full amount of its unpaid tax annually, and the 4-percent rate of interest prescribed by section 6601(j) extends only to the date on which the interest should have been paid. Congress did not intend that an estate with a deficiency be entitled to the 4-percent rate of interest for any period beyond the date on which the annual interest payment on the full amount of unpaid tax was due. Because interest is considered part of the tax under section 6601(a), interest on any underpayment of interest accrues at the prevailing rate under section 6601(e) from the date the interest should have been paid under section 6166(f)(1) had the return shown the correct tax liability.

The above principles are illustrated with the following example:

D died on March 31, 1982, E, the executor timely filed D's estate tax return on December 31, 1982. The estate elected to pay $200,000 of the estate tax attributable to an interest in a closely held business in 10 equal installments under section 6166(a) of the Code. The first installment of tax is due December 31, 1987. The first interest payment of $8,161.66 as determined under Rev. Proc. 83-7, 1983-1 C.B. 583, which provides tables and procedures for computing interest using the daily compounding rules, was due December 31, 1983, and E made the payment timely,

      $200,000 x .040808298

The entire deferred deficiency accrues interest at 4 percent because the limits imposed under section 6601(j)(2) of the Code have not been reached, and the date has not passed for payment of any portion of the deficiency. However, the date for payment of the first annual interest payment was December 31, 1983, and interest attributable to the deficiency was not paid. This unpaid interest accrues interest under section 6601(a) at the prevailing rate from the date it was due (December 31, 1983) until paid. The total additional interest payable as of August 31, 1984, as reflected in the notice and demand, is:

      Interest on $40,000 for the period:

Interest for 1984 on the principal amount of the deficiency will be paid on December 31, 1984, as part of the annual interest payment due under section 6166(f).

HOLDING

If the time for payment of estate tax is extended under section 6166 of the Code and a deficiency is assessed after the estate has timely made one or more interest payments, the 4-percent rate prescribed by section 6601(j) is applied to determine the amount of interest that should have been paid in each annual payment. Interest on any underpayment of interest thus determined accrues at the prevailing rate under section 6601(a) from the date the interest should have been paid under section 6166(f)(1) had the return shown the correct tax liability.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 67-161, 1967-1 C.B. 342, concludes that the 4-percent rate provided in former section 6601(b) of the Code, now section 6601(j)(1), applies to a deficiency prorated under section 6166 to tax installments, both past and future. However, Rev. Rul. 67-161 does not address the period of time during which the 4-percent rate applies. The portion of a deficiency prorated to an installment accrues interest at 4 percent (if with the 4-percent limitations) from the date prescribed by section 6151(a) for payment of the tax until the date prescribed by section 6166(a)(3) for payment of the installment to which the portion of the deficiency is prorated. Thereafter, the portion of the deficiency accrues interest under section 6601(a). Rev. Rul. 67-161 is clarified and amplified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Mary Jane Kossar of the Office of the Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Ms. Kossar on (202) 566-3453 (not a toll-free call).