What’s So Interesting About Interest Rates?

For those of us who regularly handle state audits, the focus is usually on the legal or factual arguments as to why no additional taxes are due. And it’s great when our clients can walk away with no additional taxes to pay. But in many cases, a “win” means negotiating a reasonable settlement of a difficult issue. In those cases, the final bill can come as a shock to taxpayers, once interest is included. Particularly with interest rates at historical lows, we expect those low rates to carry over to our tax bills. For the IRS and states that base their interest rate on the federal short-term rate or a similar metric, that’s true. The current IRS interest rate on individual underpayments and overpayments is 3%—not so bad.

But states are by no means required to follow the IRS on interest rates, although quite a few do. Some states may start with the IRS underpayment rate but then tack on a few percentage points (e.g. Virginia adds 2%). Other states, such as North Carolina (5%), Kansas (4%), Michigan (4.25%), and Oregon (4%), also keep their rates in line with overall interest rates.

But there are a handful of states that impose interest rates that deviate from any existing federal or commercial lending rate. New York is a shining example. The interest rate on almost all underpayments and late payments is 7.5% annually, compounded daily. If you underpaid your sales taxes, you may be subject to a so-called “penalty interest rate” of 14.5%! This can add up quickly. Say you undergo a lengthy personal income tax audit of your 2011 tax return, resulting in additional taxes due to New York of $100,000. Even if no penalties are imposed, you still will have to pay almost $30,000 in additional interest if it were due today. The situation is much worse if the penalty rate for sales taxes applies. There are many situations where old sales tax assessments against a business or its responsible officers (who are personally liable for the unpaid sales taxes) don’t get paid, and New York, if it cannot immediately collect, simply waits to get its money while interest accrues at 14.5%. Consequently, a $15,000 sales tax liability from 2000 would have accrued over $100,000 in interest by 2015! But keep in mind that if you are owed a refund, New York will only pay 2% interest to you.

New York is not alone in using interest rates to increase state revenue. The interest rates in Florida and Tennessee are 7% and 7.25%, respectively. Maryland imposes a whopping 13% interest rate, but at least that rate also applies to refunds. Connecticut and Georgia both use 1% of unpaid taxes per month, which doesn’t sound so bad until you realize that two years after that $100,000 should have been paid, you now owe an additional $24,000.

The long and short of it is that both taxpayers and practitioners should pay attention to interest rates, as they often have a big impact on the bottom line and are typically non-negotiable (and, unlike additional state taxes paid, non-deductible on a federal tax return). It might seem like a welcome respite when an auditor takes a few extra months to review documentation or doesn’t bug you about taking six months to respond to a document request, but the interest clock continues to tick regardless. If there is a tax bill at the end of that audit, you can be sure that it will also include interest.

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