Penalty for Underpayment of Estimated Tax
Workers who are employees have Federal taxes withheld from their wages. Their employers are required to make these withholdings and remit the funds to the Internal Revenue Service.
The idea is that the taxes that are withheld will be sufficient to pre-pay the worker’s taxes. So when the worker fills out his or her Form 1040 the following year, they will not owe any additional taxes. That is the goal that our tax law tries to accomplish (if the goal is not met, the IRS may issue a lock-in letter).
You can see that this reduces the risk for the IRS that the worker will not have unpaid tax due.
Those who have other sources of income have to make their own payments. This is where estimated taxes come in and helps explain why there is a penalty for failure to make estimated tax payments.
Note: if you are trying to figure out how to get estimated tax penalties removed, please scroll to the end of this article.
About Estimated Taxes
What are estimated tax payments?
Estimated tax payments are pre-payments of Federal taxes. Estimated tax is prepaid tax.
These prepayments have to be made for any tax that is reported or computed on an income tax return. This usually just includes Federal income taxes, alternative minimum taxes, and self-employment taxes (self-employment tax is computed and paid with an individual’s form 1040).
Who has to pay estimated taxes?
You have to pay estimated taxes if you do not have enough tax withheld from your wages. You also do not need to pay estimated taxes if your withholdings are large enough so that you only owe up to $1,000 of taxes when you complete your income tax return. This gives you a little wiggle room before penalties apply, as explained below.
This is why it is important to talk to your employer and figure out whether your withholding is sufficient. You can also review the instructions for Form W-4, as they explain how to estimate your tax liability. You then provide your employer with the completed Form W-4 to tell them how much to withhold from your pay. You can provide an updated Form W-4 to your employer at any time to adjust your withholdings.
You also have to pay estimated taxes if you have other income that is subject to tax. This can include rental income; pension or retirement account income, income from the sale of assets, investments, or businesses (including capital gains); and even taxable prizes, such as lottery winnings and lawsuit settlement awards.
You have to make estimated payments regardless of whether you are an individual taxpayer or a corporation for tax purposes. Individual taxpayers generally report sole proprietor (which includes most independent contractors), partnership, and S corporation income on their personal tax returns, so the owners pay estimated taxes for these businesses based on the income reported on their personal income tax returns from these businesses.
As noted below, there are slightly different rules for individuals and corporations.
How to calculate estimated taxes?
Estimated taxes are just that. They are an “estimate.” You have to make an estimate of what your tax will be for the year so you can satisfy your tax requirements.
You do this by trying to determine what income you will receive and what deductions and tax credits you may be entitled to.
For individual taxpayers, your prior-tax return provides a good starting point for making this estimate. You can take your prior-year numbers and round them up or down to estimate your total tax due. The easiest way to do this is to use your prior-year tax return to fill out Form 1040-ES. The Form 1040-ES walks you through the calculation for making the estimate.
Once you have the estimate, you generally divide it by four and that is the amount of each quarterly installment you need to remit to the IRS.
When are quarterly taxes due?
The question asked gives the answer. They are due quarterly.
The quarters run from January 1 to March 31, April 1 to May 31, June 1 to August 31, and September 1 to December 31. January 1 to March 31st is referred to as the “first quarter.” The next period is the “second quarter,” etc.
Quarterly taxes are due by the 15th day after the end of the quarter. So the first quarter estimated taxes are due on April 15th. These are the estimated tax due dates.
The same rules that apply for extending income tax deadlines due to weekends and legal holidays apply to estimated tax payments. Thus, the due date may not be on the 15th in any given year. It may be on the 16th or 17th.
How to file quarterly taxes?
There is no tax form that has to be filed to report your estimated tax payments. You can complete Form 1040-ES to help estimate the amount of your payments, but the form is not filed with the IRS.
Your tax preparer (or tax software) may provide you with estimated payment vouchers. These vouchers can be used to mail payments to the IRS. However, you do not need a voucher to submit payment to the IRS. These vouchers are just there for your convenience as they have the amount of your estimated payment, the due date, and the IRS mailing address already printed on them.
How to pay quarterly taxes?
The IRS makes it easy to take your money. You can pay estimated taxes by mail (check or money order), phone (bank transfer, credit card, or debit card), or even online (bank transfer, credit card, or debit card).
Many taxpayers simply send the IRS a check each quarter. If you are interested in other options, you can read about those at irs.gov/payments.
What are the rules for farmers and fishermen?
Congress provided special rules for farmers and fishermen. Famers and fisherman
These individuals are only required to remit one annual installment payment. This payment is due on January 15th of the following tax year. The 90 percent safe harbor (described below) is reduced to 66 2/3 percent.
What happens if I miss an estimated tax payment?
The short answer is usually “not much.” The IRS will not start collections or take any other action in the short term. Missed payments can be remedied by remitting the payment to the IRS.
If it is late, the IRS will impose an underpayment penalty–as described below. The IRS will send you a notice and tax bill saying that the penalty was imposed and the notice will solicit payment.
The Estimated Tax Penalty
What is an underpayment penalty?
The underpayment penalty is just what it sounds like. It is a penalty that applies if you fail to timely remit your estimated tax payments. This penalty is often referred to as the “IRS underpayment penalty.”
The underpayment rate is set out in Section 6621. For individual taxpayers, it is the applicable Federal short-term rate plus three percentage points. For corporate taxpayers, the rate is the same but it increased to an additional five percent, not three percent, if the amount of the underpayment exceeds $100,000.
The Federal short-term rate changes periodically. You can find the rates online. The rate you use is the rate for the first month of the prior quarter.
How is estimated tax penalty calculated?
The penalty is calculated for each installment date. You calculate the penalty based on the tax due (per your tax return) and the safe harbor amount.
The safe harbor amount is either 100 percent or 110 percent of the tax on your tax return for the prior year. The 110 percentage is used if you are a high-income individual, i.e., your adjusted gross income for the prior tax year is more than $150,000 (if you file married filing jointly, and $75,000 for others).
You calculate the estimated tax penalty by subtracting your current year tax from the amount paid, less 25 percent of this safe harbor amount. The result is multiplied by the underpayment rate noted above. The number of days that each installment remains unpaid is used.
How to avoid estimated tax penalties?
There are several instances when no penalty applies.
For example, no penalty applies if you do not have an income tax liability for the current year. Similarly, no penalty applies if you did not have a tax liability for the prior year and you were a U.S. citizen or resident for the entire year. Note that this will usually not be the case if you received a tax refund in the prior year. The refund will often mean that you owed tax, but you overpaid your taxes.
No penalty applies if you meet the 90 percent safe harbor. This test says that you annualize the taxable income for the current year up to the month of the installment. Then if your payments equal or exceed 90 percent of the tax computed on your annualized income up to this month period, no penalty is to apply.
No penalty applies under the 100 percent (or 110 percent) safe harbor noted above. Most taxpayers rely on these safe harbors to avoid estimated tax penalties as it is usually the safest option.
There are other strategies that may also help, such as making certain tax elections, changing the tax filing status of business entities, or changing accounting methods. These strategies are just examples that might be considered to meet your tax obligations.
Is there a reasonable cause defense to estimated tax penalties?
Generally, no. The reasonable cause defense that applies to most other common IRS penalties does not apply to the estimated tax penalty.
There is a limited exception for certain retired and disabled individuals. The IRS can remove the penalty if the taxpayer is retired (62 years or older) or disabled and the taxpayer can establish reasonable cause for the underpayment.
There is another defense that may also apply. The IRS is authorized to remove this penalty if the understatement is due to “casualty, disaster, or other unusual circumstances the imposition of such addition to tax would be against equity and good conscience.”
Help With Your Estimated Tax Penalty
We are tax attorneys in Houston, Texas and we help get penalties removed. This includes estimated tax penalties.
If the IRS has imposed an underpayment penalty and you want to see if we can help remove it, please call us. We can be reached at (713) 909-4906.
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