Underpayment of Estimated
Tax Penalty
Added on 7/10/07
The
following is an example of a common occurrence across the country. A taxpayer
has completed and filed their tax return on time. The return showed an amount
due with the return that the taxpayer dutifully paid before the filing deadline.
Our fictional taxpayer believes they are done with the IRS until next year. Then
in early may they get a letter from the IRS. The letter is a bill for an
additional amount due for the past tax year. Our hero is very confused. They
paid the tax that was due on the return and they paid it on time. How could they
possibly owe more? I am afraid that our taxpayer has been introduced to an
Underpayment of Estimated Tax Penalty.
What is an Estimated Tax penalty? Let us first
explain what it is not. The penalty is not a late payment penalty, it can be
assessed even the tax due on a return is paid before the return’s filing date.
This penalty is in essence for not prepaying the tax.
The Internal Revenue Code requires that the tax for
a given year be paid in during that tax year. This is the reason that employers
withhold federal income tax from their employee’s wages. The code also allows
for a penalty to be assessed if sufficient tax is not paid prior to filing the
return. The tax can be paid with withholding tax or by estimated payments. That
is why it is called the Underpayment of Estimated Tax Penalty.
The main way to avoid this penalty is to pay in
sufficient tax. The payments can be done through withholding or estimated tax
payments. The amount of tax paid is also important in regards to the penalty. It
is possible to owe tax on the return and still not be subject to the penalty.
This is due to the safe harbor rules.
The taxpayer can avoid the estimated tax penalty by
paying in the smaller of 90% of the current year tax liability or 100% of the
previous years liability. The 100% rule is increased to 110% if the taxpayers
adjusted gross income is over $150,000 (75,000 for married filing separately).
The penalty also does not apply if the tax due is
under $1,000 or the taxpayer had no tax liability the previous year. Please
remember that getting a refund and having no tax liability is not the same
thing.
In a future article we will discuss the calculation
of the penalty. The information above is only for federal returns. Many states
have their own estimated tax penalty and the rules vary by state. If you have
questions about the underpayment of estimated tax penalty or making estimated
payments, please consultant your tax advisor.