A tax liability begins the second the IRS assesses the tax. Usually assessment occurs when the taxpayer files a return or when the IRS files a return on behalf of the taxpayer (called “substitute for return”). Once the liability is created, and it is not paid, interest begins to accrue.
The interest on taxes is not easy to compute. First, the interest rate is set by a formula rather than a simple rate. The formula is based on the short-term federal interest rate. Second, the interest rate fluctuates quarterly. Third, it compounds daily. Fourth, the interest accrues on both the tax and penalties owed.
Because the interest on taxes compounds daily and accrues on both tax and penalties, it is not unusual for the interest to eventually exceed the tax owed. Tax collection is one area where procrastination definitely does not pay.
Penalties can be reduced by the IRS, which is called abatement. Interest generally cannot be abated. The few cases where it can be abated are as follows: (1) Cases where the IRS erroneously computed the interest. (2) Interest accrued during an improper IRS delay. (3) Where the IRS improperly sent a refund, only to later seek to get it back with interest. (4) The IRS failed to properly notify the taxpayer that tax was owed within 18 months after the return due date or the date the return was filed. (5) The interest accrued on a return filed late while the taxpayer was living in a federally declared disaster area.
Where the taxpayer overpays taxes, the taxpayer is entitled to interest from the IRS from the date of the overpayment. The interest rate is again formula driven, and it varies depending on the nature of the taxpayer. Individuals get a higher interest rate than corporations. The interest compounds daily. The interest does not accrue, however, during any period during which the return was filed late.