How to Avoid the Estimated Tax Penalties

Estimated Tax must be paid as you earn or receive income during the year, either through withholding or estimated tax payments using Form 1040-ES.

But you can avoid penalties and interest. if you meet the requirements for one of several safe-harbor rules. Check your status before the end of the year to avoid any unnecessary complications.

It is bad enough that you must pay a boatload of federal income tax each year. To add insult to injury, Uncle Sam wants his money up-front. Accordingly, if you do not pay income tax in a timely fashion during the year, you could be hit with an “estimated tax penalty” on top of the regular income tax you owe.

But you can skirt this tax trap if you meet the requirements for one of several safe-harbor rules. Check your status before the end of the year to avoid any unnecessary complications.

Who Must Estimate?

If you had a tax liability for last year, you may have to pay estimated tax for this year.

Basic premise: Generally, you are required to pay income tax during the year through withholding or quarterly installments, or a combination of the two. The quarterly due dates for the estimated tax payments—which are the same every year—are April 15, June 15, September 15, and January 15 of the following year (or the following business day if the due date falls on a weekend or holiday).

Thus, the next installment due date, for the fourth quarter of 2020, is Friday, January 15, 2021. Circle it on your calendar.

A failure to pay the required tax may result in an underpayment penalty based on the going IRS interest rates for underpayments. But you can avoid any tax problems by observing any one of the following three safe-harbor rules.

1. You pay at least 90% of the current year’s tax liability. Essentially, you’ll have to make a “guesstimate” of your current tax situation, which can be difficult to do.
2. You pay at least 100% of the prior year’s tax liability or 110% of your adjusted gross income (AGI) for the prior year exceeded $150,000. This is usually the easiest method to use because you know the exact amount of last year’s tax liability. Simply refer to your 2019 tax return.
3. You pay at least 90% of the current year’s “annualized income.” This method works well for certain individuals, such as independent contractors, who receive most of their income on a seasonal basis. It may apply if you only work during the winter holidays.

There are several ways for taxpayers to make quarterly estimated tax payments to the IRS. For instance, you can:

• Credit an overpayment from the prior year’s return to this year’s estimated tax liability.
• Mail-in the payment with a voucher, Form 1040-ES.
• Pay online, by phone, or another mobile device. (Refer to the Form 1040-ES instructions.)
• Pay via electronic funds withdrawal from the prior year’s e-filed return.

The IRS also helps taxpayers to figure out their estimated tax liability by including a worksheet in the Form 1040-ES instructions or you can rely on one of the online calculators readily available. But this can get a little tricky, so you may want to seek guidance from your professional tax advisor.

Sole proprietors, partners, and S corporation shareholders

You generally must make estimated payments if you expect to owe tax of $1,000 or more when you file your return. Use Form 1040-ES, for Individuals, to figure and pay your estimated tax. For additional information, refer to Publication 505, Tax Withholding, and Estimated Tax.

Corporations

You generally must make estimated tax payments for your corporation if you expect it to owe a tax of $500 or more when you file its return. Use Form 1120-W, Estimated Tax for Corporations (PDF), to figure the estimated tax. You must deposit the payments. For additional information, refer to Publication 542, Corporations.

Who Does Not Have to Pay Estimated Payments?

If you receive salaries and wages, you can avoid having to pay estimated payments by asking your employer to take more tax out of your earnings.  To do this, file a new Form W-4 with your employer. There is a special line on Form W-4 for you to enter the additional amount you want your employer to withhold.

Estimated Payments not required

You do not have to pay the estimated tax for 2020 if you meet all three of the following conditions.

1. You have no tax liability for last year
2. You were a US citizen or resident for the whole year
3. Your current year’s tax year covered a 12-month period

You had no tax liability for last year if your total tax was zero or you did not have to file an income tax return.  For additional information on how to figure your estimated tax, refer to Publication 505, Tax Withholding.

Estimated tax requirements are different for farmers and fishermen. Publication 505, Tax Withholding and Estimated Tax provide more information about these special estimated tax rules.

Finally, you may have one last ace up your sleeve. By deferring income at year-end, you can reduce the estimated tax you’ll owe. For instance, you might postpone to next year a sale of securities that would result in a big capital gain, assuming this otherwise makes financial sense. The gain will be taxable in 2021, so it would not increase your next quarterly estimated tax payment. Consider your options with your accountant