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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The Basics of the Underpayment Penalty
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.
What Are Estimated Tax Payments?
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.
When Do You Have to Make Estimated Tax Payments?
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.
2 Situations Which Allow for a Penalty Waiver
The Internal Revenue Service has defined 2 situations that allow for a waiver for penalties.
- You didn't make the payments due to a casualty event, disaster, or other unusual circumstance and it would not be equitable to impose the penalty.
- You reached retirement age (after reaching age 62) or became disabled during the tax year (or preceding tax year) and the underpayment was due to reasonable cause and willful (intentional) neglect.
There are also special situations when the IRS may waive the penalty but these situations are out of the ordinary.
- The IRS will provide administrative relief, which is technically a waiver, if they make an error. For example, if you contact the IRS and an agent provides incorrect advice you may qualify for administrative relief because you were operating in good faith based on official advice from the IRS.
- In very specific situations you may qualify for a tax reform waiver. The most recent example is the Tax Cuts and Jobs Act of 2017. Due to confusion over how much tax was owed, the IRS waived the penalty for any taxpayer who paid at least 80 percent of their total 2018 federal tax obligation by January 15, 2019. Again, you typically have to paid at least 90% of your tax liability to avoid any underpayment penalties.
Who Is Required to Pay Estimated Tax?
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.
Who Is Not Required to Pay Estimated Taxes?
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.
Are There Situations When the Tax Penalty Will Not Be Applied?
There are several situations when you technically meet the requirements to pay the estimated tax but the IRS states the penalty doesn't apply.
- Your total withholdings for the year (including any estimated quarterly payments) was at least as much as your prior-year tax. It is important to note that if your adjusted gross income (AGI) is more than $150,000 you must pay 110% of last year's tax ($75,000 AGI if you are married and filing separately).
- In the previous tax year, you did not have any tax liabilities AND you were a U.S. citizen/resident alien for the entire tax year.
- The amount you owe this year is less than $1,000 more than last year.
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How is the Penalty For The Underpayment Of Estimated Tax Calculated?
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.
Should You Let the IRS Calculate Your Penalty?
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.
- You did not withhold enough tax by the end of the year
- You do not qualify for any exceptions
- You did not file a Form 2210
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
Is Interest Applied to the Penalty?
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.
What is the Interest Rate?
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.
How to Reduce or Eliminate a Penalty You Owe?
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.
- A large portion of your tax liability occurred later in the year. For example, if you sold a second home or significant investment in December which generated the gain creating the additional income tax.
- You made a significant portion of your estimated payments early in the year. A common reason this happens is when you receive a tax return in a prior tax year but instead of receiving the return, you can apply it to future year tax obligations.
- A casualty or disaster occurred which makes it unfair for the IRS to impose a penalty. This option applies to all types of IRS penalties, not just the penalty for underpayment.
- Your filing status changed during the tax year to or from married filing jointly. For example, if you married during this tax year and both you and your spouse filed as single in the prior year then you can combine last year's income tax from the prior returns instead of treating them as separate.
- Your estimated quarterly payments are adequate and timely for your situation. It may be a little surprising, but while you technically would not owe a penalty it is often recommended by tax professionals to file the Form 2210 with any underpayment to ensure no penalty is assessed.
- You are retired or disabled AND your underpayment is due to a reasonable cause instead of willful neglect. To show a reasonable cause, you will need to attach a statement to the your tax return explaining what caused the underpayment.
- You are a farmer or a fisherman and your withholding plus estimated tax payments are 66.67% or more.
Takeaways for Freelancers, Self-Employed Individuals, and Independent Contractors
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.