Underpayment of Estimated Tax Penalty

Added 01/22/08

In an earlier article we discussed the Underpayment of Estimated Tax Penalty. The article looked at when the penalty was assessed and ways to avoid the penalty. This article will look at the calculation of the penalty if it is assessed.

The first thing to remember is that a taxpayer does not have to calculate the penalty on their tax return. The IRS will determine if the penalty is due and will figure the penalty and send a bill to the taxpayer. In some cases where the tax underpayment, and the penalty, is small this will be the easiest way to deal with the penalty. However the IRS will calculate the penalty using the method that produces the highest amount.

The method that the IRS uses to calculate the penalty is based on the taxpayer receiving their income equally over the year. The penalty is based on the underpaid tax derived in equal amounts over four quarters. If a taxpayer’s income is earned equally over the year this is the only available method to calculate the tax.

However if a taxpayer receives income in unequal amounts over the year there is another method to determine the penalty. This is called the Annualized Installment Method. This method calculates the penalty based on the actual income the taxpayer received in each quarter of the year. This method can produce a much lower penalty especially if most of the taxpayer’s income is received later in the year. In order to use this method you must be able to determine your actual income for each quarter.

The penalty is calculated on Form 2210 Underpayment of Estimated Tax Penalty. The taxpayer uses the Annualized Method worksheet to calculate the penalty. The worksheet is fairly involved and can take a good bit of time. We recommend that you review your particular situation with your tax adviser.