Penalty for Underpayment of Estimated Tax & How To Avoid It
If you earned money through self-employment but didn’t pay estimated taxes, you may find yourself looking at an IRS penalty for underpayment. Here’s what causes a tax underpayment penalty and what you can do to avoid penalties in the future.
What is the IRS Underpayment Penalty?
Although you file only one tax return each year, the federal income tax is technically a pay-as-you-go tax. You’re expected to pay tax on your income as you earn it throughout the year. Ordinarily, your employer does this for you through income tax withholding. If you work for yourself, however, you become responsible for making your own tax payments throughout the year.
The IRS may charge the underpayment penalty if you owe more than $1,000 in tax when you file your tax return. They may also apply the penalty if the payments you did make add up to less than 90 percent of the tax you owe. Let’s say, for example, that you owe $10,000 worth of tax on your 2020 tax return but you only made $8,000 in estimated tax payments. Because your tax payments only amounted to 80 percent of the tax due rather than 90 percent, the IRS could assess a penalty.
When the Penalty Doesn’t Apply
There are times when the underpayment penalty doesn’t apply. One such situation occurs if you paid 100 percent of your tax liability from last year. This is actually much simpler than it sounds. In our previous example, you owed $10,000 in tax for 2020 but only paid $8,000 over the course of the year. If your total tax from 2019 was $8,000, the tax underpayment penalty gets waived since you paid 100 percent of the previous year’s liability.
This rule changes a bit as your annual income increases. If your adjusted gross income for the current tax year exceeds $150,000,($75,000 if married filing separately), you need to pay 110 percent of your previous year’s tax liability. Let’s turn to our example again to see how this works.
Let’s say that in 2019, you paid $8,000 in tax. In 2020, you made more than $150,000 and owed $10,000 in tax. Because you made so much in 2020, you must make estimated tax payments of at least $8,800 ($8,000 x 110%) to avoid an underpayment penalty.
There are also a few other situations in which the penalty doesn’t apply. If you owe less than $1,000 in tax when you file your return, you need not worry about paying any fees or penalties. The same is true if you owed zero tax last year but were a United States citizen or resident alien for the entire year.
Ways to Lower or Eliminate the Penalty
If you fear that the IRS may charge you the penalty, you can plead your case and ask for a reduction or elimination of the penalty when you file your taxes. To do so, you will need to file IRS Form 2210.
You may be able to get a break on your penalty if you can prove that your income arrived in large, unpredictable chunks. You may, for example, have suddenly experienced an unexpected uptick in your workflow towards the end of the year. If so, the tax payments you sent to the IRS at the beginning of the year may now seem inadequate although the payment amounts were justifiable and reasonable at the time.
A similar situation could arise if you paid a large amount of tax at the beginning of the year. You may have, for example, overpaid on your taxes last year. If you applied that overpayment to this year’s taxes, your estimated tax payment amounts may vary substantially rather than being submitted in the desired equal installments.
The IRS also understands that certain life events can drastically alter your filing status and your tax picture. If your filing status changed from single to married filing jointly, you can generally combine last year’s income for you and your spouse, which can change your estimated payment amounts. The IRS can take this information into account when determining whether or not you made adequate tax payments. The full explanation of this tax situation is a bit too lengthy to detail here, however. If you would like more detailed information on this particular issue, see IRS Publication 505: Tax Withholding and Estimated Tax. You can also consult the instructions for Form 2210.
The IRS will also grant special clemency to farmers and fishermen under some situations. In 2020, you may be able to have your underpayment penalty waived or reduced if your total withholding and payments for the year amount to at least 66.67 percent of your total 2020 tax liability. As is true of many tax specifics, this percentage may change from one year to the next. Be sure to consult the current year’s tax guidelines when completing your Form 2210.
In some situations, you may successfully reduce or eliminate your penalty if the IRS gave you misinformation. If you called the IRS to ask a question and got bad advice from an IRS agent, you might succeed in avoiding an underpayment penalty. To have a chance at this one, make sure you always write down the date and time of your call to the IRS as well as the name of the person you spoke to. If you encounter an agent who is hesitant to give you a firm answer to your question try to be patient with them — many agents hesitate to give anything that may be construed as tax advice in case they misspeak or accidentally give you incorrect information.
Waiving the Penalty Altogether
There can be some discretion when it comes to whether the IRS waives or reduces your underpayment penalty, but the tax law clearly states two situations in which the penalty may be unquestionably waived. On is in the event of a disaster or other extreme circumstances. If you can prove that you were impacted by a natural disaster, death in your immediate family, a casualty event or some other major crisis, the IRS can waive your underpayment penalty completely. The law is designed to make sure you’re not charged a penalty when it would be unfair or inequitable to expect payment from you.
Under the law, the IRS may also wave your penalty if you are 62 years of age or older and opted to retire during the tax year. The penalty may also be waived if, during the current or preceding tax year, you became disabled. In this case, the IRS assumes that any nonpayment of estimated taxes is understandable and not the result of negligence or willfully ignoring the tax law.
Letting the IRS Calculate Your Penalty
While there are certainly circumstances in which it makes sense to try and avoid or at least reduce an underpayment penalty, there are other times where it’s simply best to accept that an oversight occurred and pay any penalty you owe. In some cases, you can file Form 2210 and calculate the amount of penalty you owe yourself.
Many taxpayers choose to have the IRS calculate the tax penalty for them. If you know you failed to make adequate estimated payments for whatever reason and aren’t asking for a penalty reduction, you need not do anything. You can simply file your taxes without a Form 2210. In this case, the IRS will calculate the tax penalty for you and send you a bill. In a handful of cases, your tax bill may come with a request for a Form 2210, but most of the time all you’ll need to do is make the payment.
Avoiding Future IRS Penalties
To avoid underpayment penalties in the future, the first step is making sure you know when you’re payments are due. Generally, the IRS expects tax payments quarterly with due dates of April 15, June 15, September 15 and January 15. If a due date hits a weekend or holiday, the payment is due the next business day.
If you work for yourself and have a regular job, you can help avoid underpayment penalties by adjusting your W-4 withholding at your day job. Doing so will offset your self-employment income tax by increasing the amount of tax your employer withholds for you. This can reduce or even eliminate the need for making estimated payments on your own.
If your business is seasonal, you can help avoid tax underpayment by annualizing your income. Let’s say, for example, that you own a landscaping business on the side. Your business makes about $30,000 a year, but all of that money comes in from May through October. When determining your estimated payments, take the $30,000 you expect to make and divide it by 12 months. This way you can spread the amount of your estimated tax payments evenly across the year and make sure you don’t run afoul of the IRS pay-as-you-go mantra.
Getting Help From A CPA
Of course, the best way to avoid underpayment penalties is to work with the tax professionals at Picnic Tax. If the IRS charged you a tax underpayment penalty, our CPAs are happy to help you figure out what went wrong and make sure it doesn’t happen again. Give us a call or click today and we’ll help you navigate the sometimes tricky world of estimated tax payment and penalties.