Escrowed Taxes Aren’t Payments

Interest on a tax deficiency (underpayment) generally runs from the due date of the return until the tax is paid. Interest is compounded (interest is charged on interest), so the longer the dispute goes on, the more dramatically the interest can grow. However, during the course of a tax dispute with the IRS, taxpayers may take action to stop the accrual of interest on a deficiency.

Deposit

As long as the IRS has not yet assessed an underpayment of income tax, you can make a deposit in the nature of a cash bond in order to suspend the running of interest on the potential underpayment.

• If you do owe the underpayment, you won't owe interest from the time you made the deposit.
• If you don't owe the underpayment, you'll recover your deposit, plus interest.

Alternative: Instead of making a deposit, you can stop the accrual of interest while contesting the amount the IRS says you owe by making a tax payment to cover the liability, plus any interest that has already accrued. If your position in correct, you can recoup your payment by making a refund claim.

Escrow

An escrow account is an arrangement where funds are held by a neutral third party pending the outcome of a dispute or the completion of contractual conditions. Is a payment in escrow the same as making a deposit so that interest stops accruing when funds are placed in escrow? A federal appellate court said no and the U.S. Supreme Court has now refused to hear the case, letting the appellate court's decision stand.

The reason for the difference: An escrow account does not transfer ownership of the money to the IRS. It only gives the IRS a security interest in the money. The terms of escrow specifically say that the arrangement does not constitute a tax payment.

Source: Larosa's International Fuel Company, Supreme Court, cert. denied, 6/2/08