What is Estimated Tax?
Paying taxes to the Internal Revenue Service (IRS) comes in all shapes and sizes. Most people pay taxes out of their paychecks every time their employer withholds income. But for some taxpayers, routine withholding does not make sense because they do not work in such a way that yields regular income. Rather than pay in small increments more frequently, individuals who do not receive their income in the form of a salary or wages may prefer to pay the IRS in lump sums four times a year.
Who Pays Estimated Tax?
Those best suited to choose the quarterly federal tax payment known as estimated tax are business owners and individuals with significant income from investments or estates and trusts. Taxpayers in this alternative program of payment are expected to cover their dues four times in a given tax year. If you opt to pay estimated taxes, you can mark your calendar to make payments to the IRS on April 15th, June 15th, September 15th, and January 15th.
Estimated Tax Requirements
Estimated taxes are the same as standard taxes in the sense that you must pay them. You do not get a free pass for choosing an alternative installment plan with the IRS. If you do not pay enough to the IRS in estimated taxes, you could potentially owe a penalty for underpayment of estimated tax.
What is Form 2210?
This is where IRS Form 2210 comes in. Form 2210 calculates penalties for underpayment of estimated taxes. To avoid a Form 2210 penalty, you must respect a number of requirements.
Pay on Time
IRS Form 2210 determines the amount you owe the IRS and this for every payment due. Each installment is considered independently, meaning you could amass multiple penalties if you are not careful. You could even find yourself penalized for an installment you actually paid, if you did so at a later date than agreed upon.
The deciding factor for the IRS is time. If you owed x on April 15th but only payed it off on June 15th, you risk a penalty. This is true across the board, even for payers who are technically due refunds from the IRS.
Pay in Full
Tardiness aside, the other situation that could lead to a penalty has to do with your total withholdings and estimated payments. Two factors decide whether you will pay estimated tax or not.
- If you anticipate owing at least $1,000 in tax after taking into account liabilities and withholdings, you will pay estimated tax for the current year.
- If these liabilities and withholdings are less than the smaller of either 90% of the amount due in taxes on your current return or 100% of the amount due in taxes on your previous return (110% for those with significant income that made over $150,000 in adjusted gross income filed jointly)
You can expect a penalty when the total of your withholdings and estimated payments does not equal at least the smaller of the amounts listed above.
Taxpayers with Significant Income
As mentioned above, taxpayers with an adjusted gross income (AGI) superior to $150,000 were expected to add 10% to the aforementioned percentages. At least this was the case for 2017. In other words, an individual with an AGI of $150,000 or more would have payed estimated tax if that year’s liabilities and withholdings amounted to less than the smaller of 110% of the taxes on the return of the prior year.
Farmers and Fishermen
Farmers and fishermen are exempt from regular estimated tax requirements. This is because the incomes of farmers and fishermen are tied to unpredictable factors such as natural disasters and draughts.
Farmers and fishermen benefit from alternative, reduced estimated tax requirements detailed in Form 2210-F. The IRS expects that farmers and fishermen pay either:
- 2/3 of the income tax of the previous year, or
- 90% of the current year income tax
The process of understanding and avoiding underpayment penalties for estimated taxes may seem daunting. Publication 505: Tax Withholding and Estimated Tax is a good resource to explore ways to lessen or cancel out penalties.
Form 2210 Instructions
The IRS uses Form 2210 for underpayment of estimated tax (Form 2210-F for farmers and fishermen) to track whether estimated taxes have been paid in full and on-time. If a taxpayer does not honor an IRS installment agreement, the IRS measures the tax deficiency by comparing each quarterly payment as it appears in Form 2210 and Form 2210-F. From this vantage point, the IRS can establish the appropriate penalty with confidence.
Keep in mind that penalties vary each year with the current IRS interest rate.
You can resort to abatement services if you seek to dispute a penalty. Generally speaking, you must convince the IRS that you had a good reason for not paying what was due. Taxpayers submit IRS Form 843 to claim an abatement.
The Internal Revenue Manual (IRM) Section 18.104.22.168.2 is helpful in preparing a request for a refund from the IRS. The IRM catalogues a number of successful defenses against penalties.
First-time Penalty Abatement
One of the more common success stories in appealing a penalty is playing the first-time penalty abatement card. The IRS is known to forgive taxpayers requesting a waiver for the first time who have a history of compliance.
The other option is what is known as reasonable-cause. The aforementioned IRM exposes instances of reasonable-cause that granted favorable results to the penalized. These include but are not limited to:
- Serious illness
- Bad advice
Underpayment Penalty Abatement
However, it is particularly challenging to argue reasonable-cause in the case of estimated tax underpayment penalties. Unless a taxpayer retired or became disabled over the course of the tax year, the best way to get out of paying estimated tax penalties is to:
- Prove that the IRS made an error in charging you with the penalty
- Prove that the penalty could be lessened or lifted if it were measured by another means.
With all this being said, preventing penalties is the best medicine. Paying your estimated taxes in full and on-time is preferable to spending time and money trying to annul penalties and interest.