The United States tax system is known as a “pay as you go” system which functionally means you may have to pay income taxes as you earn income or receive income (depending on your accounting method). Individual employees accomplish this by withholding payments every paycheck. Business owners accomplish this by making estimated tax payments. If you do not make enough tax payments throughout the year you will end up paying an additional tax underpayment penalty on your earned income. If you miss payments, you'll be subject to the estimated tax penalty rate.
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Let's first go over the basics of underpayment penalties. Business owners and self-employed individuals must pay taxes as they earn income. The penalty for underpayment kicks in once a taxpayer owes more than $1,000 in tax (after subtracting tax withholdings and refundable credits) or if they pay less than 90 percent of the tax liability for the current year, throughout the tax year. If there is a spike in the income, you can avoid an underpayment penalty by paying 100 percent of the tax shown on the prior year's return.
The IRS states the easiest way to avoid this situation is to make estimated tax payments. To avoid the penalty, you must make an estimated tax payment in four equal amounts. If you run a business with uneven income throughout the tax season you can vary the amounts of payments to avoid or lower the penalty by using an installment method. The installment method requires the use of IRS Form 2210 which is commonly referred to as the Underpayment of Estimated Tax by Individuals, Estates, and Trusts form. A quarterly tax underpayment penalty is slightly different than an IRS 1099 late filing penalty.
Similar to payroll tax payments, estimated tax payments are due on the 15th day of the month following the end of the calendar quarter. Quarterly tax deadlines are the same every year: April 15, June 15, September 15, and January 15 of the following year.
As with all federal payment due dates, if the 15th falls on a weekend or holiday the payment will be due on the next business day.
The Internal Revenue Service has defined 2 situations that allow for a waiver for penalties.
There are also special situations when the IRS may waive the penalty but these situations are out of the ordinary.
The requirement to pay estimated taxes covers an extremely broad group. It includes individuals (including sole proprietors, partners, and S corporation shareholders) if they expect to owe more than $1,000 in taxes when they file their tax return. Corporations have the same requirements but a threshold of $500 instead of $1,000.
Anyone who receives a salary or wages and uses Form W-4 to withhold taxes will avoid the requirement of paying additional estimated taxes. If you are employed and also have self-employment income, there is a special line on the W-4 where you can enter an additional amount you want your employer to withhold.
There are several situations when you technically meet the requirements to pay the estimated tax but the IRS states the penalty doesn't apply.
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To determine the penalty you can complete Form 2210. This is the "Underpayment of Estimated Tax by Individuals, Estates, and Trusts". At the very bottom of the form is the penalty formula. The total underpayment penalty depends on when the amount due is paid.
First, take the amount that was underpaid and multiply it by 0.01744. If you paid the penalty after 1/15/YYYY but before 4/15/YYYY, you can take the amount of the penalty and apply the following equation to reduce the amount owed:
The total figure for the Year x Number of days paid before 4/15/YYYY x 0.00008.
If you have already underpaid your income tax one of the options available is to let the IRS calculate the late penalty for you. If you meet the following criteria IRS will complete this calculation for you.
In most instances, it will not cost you more to have the IRS determine the penalty if you pay the amount due but the "pay date" identified on the IRS bill. While the IRS will typically complete this calculation for you, there are some situations where the IRS will still request you file a Form 2210
Interest is charged starting the due date of the amount you owe. This can get tricky because there may be multiple due dates. The first due date is the return date that the tax bill is due (even if you file an extension). The send due date is the penalty payment due date. This date will vary based on the penalty type and if there are multiple penalties.
Interest is due as it accrues which is why it is essential to pay an outstanding taxes as soon as possible. If you receive a note, then the interest will not be charged if you pay the entire amount by the "pay by" date.
The interest formula for underpayments falls into two categories: Standard and Large Corporate Underpayment.
The Standard formula applies to corporate and non-corporate underpayments. The interest rate used is the Federal short-term rate plus 3 percentage points. The current rate is published quarterly by the IRS. The Large Corporate Underpayment formula applies to underpayments of tax exceeding $100,000 by C-corporations. The interest rate is the Federal short-term rate plus 5 percentage points.
Even if you do not fall into any of the exception categories there is still an opportunity to reduce or eliminate the penalty in certain situations. While the situations vary, the one constant is you must file Form 2210.
There are 7 situations that may allow you to reduce or eliminate the penalty you owe when filing Form 2210.
The US Tax Code is applied equally to everyone but the penalty rules are particularly important for freelancers, self-employed individuals, and independent contractors because taxes are not often withheld from payments. At the end of the day, the key is to submit estimated tax payments by the appropriate due dates to avoid an underpayment penalty and interest. If you want to stay on top of your quarterly taxes and maximize your tax deductions, try our 1099 expense tracker software. We'll connect to your bank account and credit cards to organize all your write-offs.