Sales Tax Slice: Interest on Deficient Tax Liabilities Illustrates States’ Varying Approaches to Tax Law

In a perfect world, all taxpayers would pay all tax liabilities in full and on time. However, we do not live in a perfect world, so it should not surprise you that states penalize late-paying taxpayers. Nor should it surprise you that states also add interest when taxpayers drag their feet. People tend to hustle more when they know that their deficiency accumulates every month, day, hour, and second they fail to act.

States vary regarding the time period at which they update their underpayment interest rates, but common periods are quarterly, six-month, or yearly cycles. October 1st marks the beginning of Q4 2015, so states that re-examine rates on a quarterly cycle will soon alert the public whether their interest rates are changing or holding steady for Q4.

It’s simple to calculate interest on an underpayment if the rate remains fixed across time. Consider a taxpayer that pays its $1,000 tax liability 100 days late in a state where the underpayment interest rate is 4 percent the entire time. The taxpayer would owe $10.96 in interest to the state:

        $1,000 * .04 * (100/365) = $10.96

Unfortunately, the calculation is not always that easy. Why? Because the interest rates change over time.

Consider Massachusetts, which operates on a quarterly cycle. Massachusetts is likely to issue a Q4 interest rate Technical Information Release any day now. (It released the Q2 and Q3 TIRs on March 19th and June 17th, respectively.) The Q4 TIR will inform us whether interest on underpaid Massachusetts tax liabilities will change for Q4 or will continue to accrue at a rate of 4 percent per year.

Revisiting our earlier example, let’s assume that the Massachusetts underpayment interest rate increases to 5 percent on October 1st, that October 1st happens to be the 101st day after the due date, and that another 40 days pass before the taxpayer finally pays the delinquent amount.  Here’s the revised calculation. As you can see, it’s now necessary to calculate the two periods separately:

        ($1,000 * .04 * (100/365)) + ($1,000 * .05 * (40/365)) = $16.44

This is a basic example, but other factors also are at play when considering a tax delinquency. For example, when does interest begin to accrue—does the clock start ticking on the first day after the due date, or does in begin at some later time?  How does the interest compound (e.g., continuously, daily, annually, or some other way)?  What tax type is in question? These factors and more are all important.

Further, one should understand that the interest concept is not a one-way street. Not only do states charge interest on tax underpayments, but also they calculate interest on overpayments (i.e., amounts beyond what a taxpayer was supposed to pay). Often, mere oversight or miscalculation causes a tax overpayment. However, one can envision a situation in which a state’s overpayment interest rate exceeds market interest rates offered by banks or other financial institutions. In that case, a crafty taxpayer might consider intentionally overpaying a tax liability in an attempt to earn above-market interest rates. Don’t try it. If the state catches you using it like a bank, you could encounter some big problems.

Lastly, sometimes all of this interest business is moot, as several states offer tax amnesty programs. Generally speaking, a tax amnesty program is a limited-time offer during which a taxpayer can pay past-due tax liabilities without also paying interest, among other things. For more information on tax amnesty, you can read on here.

Continue the discussion on LinkedIn: How should states address interest on tax under- and overpayments?

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