The Internal Revenue Service (IRS) method for calculating interest has changed over time. Currently, the method for calculating interest is described by the IRS as “daily compounding of interest (i.e., interest computed on interest).” Internal Revenue Service, Internal Revenue Manual, Part 18.104.22.168. In other words, each day interest accrues on the principal amount owed, and each day that principal amount increases based upon the inclusion of interest from prior days.
Generally speaking, interest is charged on any unpaid tax from the due date of the return until the date of payment. The interest rate is determined on a quarterly basis and is the federal short-term rate plus 3 percent Internal Revenue Service, Topic 653 – IRS Notices and Bills, Penalties and Interest Charges. Bear in mind that tax returns are checked for mathematical accuracy, and a failure to properly compute the amount of taxes owed could result in the accrual of interest on the unpaid portion from the date that amount was originally due. It is also important to note that interest on taxes is calculated separate and apart from any penalties that may accrue as a result of late filing, late payment, or any other action for which IRS penalties are typically assessed.
While it may seem that taxpayers unable to meet tax obligations are stuck between a rock and a hard place, there are a number of avenues by which taxpayers can prevent interest from accruing, and implement a payment plan or other situation that suits a taxpayer’s needs. Even if the IRS does not approve a request for a payment plan or an offer in compromise, the IRS has noted that “the funds necessary to pay your tax can be borrowed at a lower effective rate than the combined IRS interest and penalty rate.” Internal Revenue Service, Topic 653 – IRS Notices and Bills, Penalties and Interest Charges.
In short, IRS rules and procedures are such that it makes good financial sense to address your tax obligations directly rather than avoid them, whether it be through IRS-approved reconciliation procedures such as offer in compromise or periodic payment plans, or through other means such as borrowing to satisfy tax obligations. For answers to any additional questions relating to the accrual of interest on a taxpayer’s outstanding taxes, one should contact an experienced tax professional such as a licensed tax attorney.