Interest Netting: One of the Easily Overlooked Differneces Between the Federal and State Tax Codes

Minnesota laws do not always provide for the same tax treatment that is provided under federal law. Some of these differences are obvious and easy to plan for, however, many times it is the subtle differences between the state and federal laws that prove most problematic. Taxpayers or practitioners who are not aware of these subtle differences and their consequences, will be subjecting themselves or their clients to unintended tax liabilities at either the state or federal level.

One difference between state and federal law is their treatment of interest in the audit process. When either the IRS, or, the state, and a taxpayer, as part of resolving an audit, agree to move income from one year to another, interest will be owed by one or both parties. Moving income to an earlier year creates interest owing from the taxpayer to the agency and corresponding interest owing from the agency to the taxpayer. At the federal level, the two amounts offset each other so either the taxpayer, or the IRS, owes only the interest on the difference between the two amounts. The offsetting of these two amounts is called “interest netting.”

The problem at the state level is that the state treats all of the interest as taxable income to the taxpayer. The state issues the taxpayer a Form 1099 INT for this interest, forcing the taxpayer to report this amount as income. This would not be a problem if the taxpayer could deduct the interest that he or she “paid”, but the state does not allow such a deduction. The result is that the taxpayer pays tax on multiple years of accumulated interest instead of the actual one year difference. This result is unfair to the taxpayer.

The following table illustrates the consequences at the state level:

Interest netting demonstrates the importance of understanding the differences, no matter how subtle, between state and federal tax laws. Congress saw the problem of interest netting many years ago and corrected it by adopting Section 6621(d) of the Internal Revenue Code. The state has yet to adopt such a law, and thus, practitioners must be aware of the consequences, when representing a taxpayer in an audit, of agreeing to move income from one year to another year.