Urgent: 2024 Estimated Tax Penalty Update

Urgent: 2024 Estimated Tax Penalty Update!

The United States has a “pay as you go” tax system in which payments for income tax (and, where applicable, Social Security and Medicare taxes) must be made to the IRS throughout the year as income is earned, whether through withholding, by making estimated tax payments, or both.

Individuals and corporations that underpay their taxes during the year are assessed estimated tax penalties by the IRS. The estimated tax penalty (also called the “underpayment penalty”) is calculated separately for each quarter based on the amount of unpaid tax for that quarter.

The penalty equals the federal short-term interest rate (in the first month of the quarter in which taxes were not paid) plus 3 percent.1

The federal short-term interest rate changes from time to time based on interest rates generally. Thus, the estimated tax penalty amount changes as well. For many years, while inflation and interest rates were low, the estimated tax penalty was also low.

As recently as 2022, it was only 3 percent.

But with the rapid rise in interest rates, the penalty has also risen. The estimated tax penalty is a whopping 8 percent from October 1, 2023, through March 31, 20242—the highest it has been since 2007.

As we explain later, the penalty is not deductible, so your effective penalty rate is much higher than the 8 percent.

With this high penalty rate, avoiding it by paying enough tax during the year makes sense. If you fail, you can look for a penalty waiver from the IRS, but it’s likely not available to you except in limited circumstances.

No such penalty relief is available for corporations.

Estimated Taxes for Individuals

To avoid an underpayment penalty, individual taxpayers must pay 25 percent of their “required annual payment” to the IRS by April 15, June 15, September 15, and January 15. The required annual payment is the smaller of3

o 90 percent of the total tax due for the current year, and

o 100 percent of the total tax paid the previous year, or 110 percent for higher-income taxpayers with adjusted gross incomes of more than $150,000 ($75,000 for married couples filing separately).

Individuals who receive most of their income in employee wages usually satisfy their required annual payment through the tax withheld by their employer from their paychecks.

But employees may need to pay estimated tax if they receive substantial income from which no tax is withheld, such as dividends, interest, capital gains, rents, and royalties. Alternatively, they can increase employee withholding to make the required annual payment.

Individuals who receive taxable retirement account distributions can have all or part of their tax withheld, pay estimated tax, or both.

No tax is ever withheld from the business income earned by the self-employed—sole proprietors, partners in partnerships, or members of limited liability companies. They must pay quarterly estimated taxes throughout the year.

LLC members and partners in partnerships must pay individual estimated tax on their share of the partnership or LLC income, whether or not the income is paid out to them. The partnership or LLC itself pays no tax.

But individual taxpayers don’t need to pay any estimated tax if they owe less than $1,000 in federal tax for the year—this includes income tax and self-employment (Social Security and Medicare) tax.

How Much to Pay

As mentioned above, the self-employed and other individuals who need to pay estimated taxes have two options for avoiding penalties:

1. Pay, depending on income, 100 or 110 percent of their prior year’s tax; or

2. Pay 90 percent of the tax due for the current year.

Most people make four equal, estimated tax payments due by the dates shown below.

Income received for the period:

Estimated tax due:

January 1 through March 31

April 15

April 1 through May 31

June 15

June 1 through August 31

September 15

September 1 through December 31

January 15 of the following year

Individuals have the option of using the “annualized income installment method.” This requires taxpayers to separately calculate their tax liability for the four income periods—prorating their deductions. They base their estimated tax payments on their actual tax liability for each quarter.4

The annualized method is a much more complicated way to calculate estimated taxes—it amounts to filing a miniature tax return each quarter to report that quarter’s income and deductions and to determine the income tax liability for that quarter. But this method can benefit individuals who receive their income unevenly throughout the year: They can pay less estimated tax for periods with less income.

Taxpayers don’t have to use the annualized income method throughout the year. They can use it for one or more quarterly payments and then switch to one of the other methods in the next quarter if it results in a lower payment. But when they switch, they must recapture (pay back) any savings from the prior quarters in which they used the annualized income method.5

Estimated Tax Penalty

The estimated tax penalties are automatically assessed if you don’t make the required payments. The penalties are not tax-deductible. They are in addition to tax.6

Key point. Because the penalties are not deductible, you pay the penalties with after-tax dollars. For example, say your combined income and self-employment tax rate is 40 percent. The 8 percent non-deductible penalty rate equals 13.3 percent interest (8 percent ÷ 0.6 percent after-tax rate).

The penalty is figured separately for each payment period. Thus, you can’t reduce the penalty for one period by increasing your estimated tax payments for a later period. This is true even if you’re due a refund when you file your tax return.

But you can avoid the estimated tax penalty for the fourth quarter if you file your tax return and pay all your tax due by January 31.7

You can calculate the penalty yourself by completing IRS Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, and pay it with your return. Or you can let the IRS calculate the penalty and bill you.

Estimated Tax Penalty Waivers

Unlike with most other IRS penalties, the IRS won’t waive the estimated tax penalty on grounds of reasonable cause.8 For example, it won’t waive the penalty because of a taxpayer’s serious illness or injury, a family member’s death, or a similar circumstance beyond the individual’s control. Nor can the penalty be waived through the first-time abatement penalty waiver.

The IRS can waive the estimated tax penalty only in the following limited circumstances.

Casualty or Disaster

The IRS can waive all or part of the penalty if imposing it is inequitable because the underpayment was due to a casualty, a disaster, or another unusual circumstance.9

Individuals living in a federally declared disaster area automatically receive extra time to pay their estimated taxes (to be eligible for this extra time, their home or office doesn’t need to be damaged). The IRS automatically identifies taxpayers located in a covered disaster area (by county or parish) and applies the appropriate penalty relief. Such individuals should not file Form 2210 to seek a waiver.10

Newly Retired or Disabled Individuals

The IRS will waive all or part of your underpayment penalty if11

· You retired after reaching age 62 during the tax year the estimated taxes were underpaid or the previous year, or

· You became disabled, and

· There was reasonable cause for not making a payment and not willful neglect.

For example, the IRS waived the penalty when a taxpayer failed to pay his estimated taxes because of a mental breakdown and complications due to AIDS.12 On the other hand, the IRS refused waivers where a taxpayer suffered from alcoholism13 and where another individual was caring for a spouse undergoing cancer treatment.14

Form 2210 must be completed and attached to the return to request a waiver. You must also include a statement explaining (1) why you could not meet the estimated tax requirements, and (2) the time period for which you are asking for a waiver.

If you’re requesting a waiver due to retirement or disability, you must attach documentation showing your retirement date (and your age on that date) or the date you became disabled.

If you’re requesting a waiver due to a casualty, a disaster (other than a federally declared disaster), or another unusual circumstance, you must attach documentation such as copies of police and insurance company reports.

Estimated tax penalty waivers are not automatic. The IRS will review the information you provide and decide whether to grant your request for a waiver.

Estimated Taxes for Corporations

C corporations must make quarterly estimated tax payments if they expect to owe tax of $500 or more when they file their return.15

S corporations ordinarily don’t pay estimated taxes. The only exceptions are if an S corporation owes $500 or more in taxes on built-in gains, excess net passive income, or investment credit recapture.

S corporation shareholders must pay individual estimated taxes based on their share of the corporation’s income. The tax code deems that S corporation income or loss passes through the corporation to its shareholders daily.16

C corporations use Form 1120-W, Estimated Tax for Corporations, to estimate quarterly tax payments. For calendar-year corporations, estimated taxes are due April 15, June 15, September 15, and December 15.

For corporations that use a fiscal year, installments are due on the 15th day of their fiscal year’s fourth, sixth, ninth, and 12th months. For example, a corporation with a June 30 year-end would have installment payments due on October 15, December 15, March 15, and June 15.

Like individuals, corporations must make estimated tax payments or suffer penalties. The penalties are not tax-deductible; they are in addition to tax.17 A corporation’s required annual payment is the lesser of18

100 percent of the tax shown on its return for the year, or

100 percent of the tax shown on its return for the preceding tax year.

But so-called large corporations can’t base their required annual payment on the preceding year’s tax. Large corporations are those with at least $1 million in taxable income for any of the three preceding tax years (or, if less, the number of years the corporation has existed).19

Corporations may use one of four methods to calculate estimated tax payments and avoid underpayment penalties: 20

Current-year method. The corporation makes four quarterly payments—each equal to 25 percent of the income tax it will show on its return for the year.

Preceding-year method. The corporation makes four quarterly payments equal to 25 percent of the tax shown on the return for the preceding tax year. This method can be used only if (1) the return the corporation filed the prior year was for a full 12 months, and (2) the prior year’s return showed a positive tax liability (not zero). A large corporation may use its prior year’s tax to determine only its first estimated tax payment for the year. It must recapture any resulting reduction in that first payment by increasing its next required payment.

Annualized income method. A corporation can use this method if it will result in lower estimated tax payments than the first two methods. This method allows corporations to pay estimated taxes based on their actual income earned during each quarter rather than using a simple straight-line projection.

Adjusted seasonal income method. If it results in lower estimated tax payments than the first two methods, corporations with recurring seasonal patterns of taxable income can annualize income by assuming income earned in the current year is earned in the same pattern as in preceding years. To qualify for this method, corporations must pass a mathematical test to establish that their income is earned seasonally.

If a corporation pays too little estimated tax, the estimated tax penalty is assessed on the underpayment. The penalty is figured separately for each installment due date. Therefore, the corporation may owe a penalty for an earlier due date, even if it paid enough tax later to make up the underpayment.

The penalty amount is the same as for individuals: the federal short-term rate plus three percentage points.21

But if a corporation has an underpayment that exceeds $100,000 for any taxable period, the penalty rate increases by two percentage points—that is, the penalty is increased to the short-term federal rate plus five percentage points. The interest begins to accrue at this higher rate on the entire amount of an underpayment (tax, penalty, and interest) 30 days after the date of a 30-day letter or a notice of deficiency.22

The penalty is calculated on Form 2220, Underpayment of Estimated Tax by Corporations. Corporations need not file this form; the IRS will compute the penalty and bill the corporation.

But Form 2220 must be completed and attached to the return of (1) a corporation that uses the annualized income or adjusted seasonal installment method, or (2) a large corporation that computed its first required installment based on the prior year’s tax.

There is no reasonable cause exception to the penalty for underpayment of estimated tax by a corporation.23 Moreover, unlike with individuals, the IRS does not grant waivers of the penalty to corporations for any reason.

Takeaways

Here are five takeaways from this article:

Individuals and corporations must make a “required annual payment” of their taxes to the IRS each year. Individuals may do so through withholding, estimated tax payments, or both. Corporations must make estimated tax payments.

An estimated tax penalty is assessed on all taxpayers who fail to make their required annual payment. This is an interest penalty based on the federal short-term interest rate plus three percentage points. The penalty is currently at 8 percent—the highest in 16 years, and it’s not tax-deductible. (For so-called large corporations, the penalty is at 10 percent.)

To avoid the estimated tax penalty, individuals must pay (a) 90 percent of the total tax due for the current year, or (b) 100 percent of the total tax paid the previous year, or 110 percent for taxpayers with adjusted gross incomes of more than $150,000 ($75,000 for married couples filing separately). Corporations must pay 100 percent of the tax shown on their return for the current year or preceding year (but large corporations can’t use the preceding year).

Individuals who have no or too little tax withheld, and all corporations, must make quarterly estimated tax payments to the IRS. Most taxpayers make equal estimated tax payments, but you can use an annualized income method if you receive income unevenly throughout the year.

The IRS can waive estimated tax penalties for individual taxpayers only if they fail to pay enough estimated tax due to retirement, disability, or a disaster or casualty event. No waivers are possible for corporations.