Protecting your clients from estimated tax penalties

The U.S. income tax system is a pay-as-you-go tax system. What this means is that income taxes need to be paid throughout the year as your clients receive income. For W-2 employees, this is accomplished by federal income tax withholding throughout the year. For other taxpayers who have income sourced outside W-2 wages, it’s important to satisfy the pay-as-you-go system by making estimated tax payments.

The underpayment penalty, also known as the “estimated tax penalty,” is a penalty for not withholding or making estimated tax payments. The general rule is that most taxpayers will avoid the penalty if they satisfy one of the three conditions below:

1. The taxpayer will owe less than $1,000 in tax after subtracting withholding and refundable credits. This method to avoid underpayment penalties is difficult to estimate because refundable credits can vary from year to year, and other tax law changes could affect planning for your client to get under the $1,000 threshold. Most practitioners do not use this method to try to avoid the underpayment penalty.
2. The taxpayer had federal income tax withholdings and paid in estimated taxes of at least 90% of the tax for the current year. This method is recommended for clients who expect lower income in the following year compared to their current-year tax liability. For example, a client may have a large 2022 tax liability due to stock sales that will not occur in 2023. Therefore, a tax preparer would do a tax year 2023 projection based on 2022’s income without the 2022 stock sales. In addition, the tax preparer should go over the 2023 assumptions with the client to make sure that they are on the same page with regard to the estimate.
3. The taxpayer had paid 100% of the tax shown on the return for the prior year (or 110% for higher-income taxpayers). For most practitioners, the easiest way to protect their clients is defaulting to pay 100% (or 110% for higher­income taxpayers) of the prior-year tax liability because this amount is known when you finalize their tax return in the current year.

In general, taxpayers should make estimated tax payments in four equal installments to avoid a penalty. But if a taxpayer were to receive income unevenly during the year, they might be able to avoid the underpayment penalty by using the annualized installment method.

For example, in the fourth quarter, a taxpayer sold a building that triggered an additional $20,000 tax liability, but the taxpayer had not paid any first through third quarter estimated tax payments. The taxpayer would most likely pay a fourth quarter estimate to cover the taxes created with the sale of the property, and use the annualized installment method when preparing their tax return to avoid the penalty. 

However, there are times when a client needs to go on extension and the tax return will not be finalized before the first-, second-, or even third-quarter estimates are due. For example, a taxpayer normally files in October due to missing K-1 s that aren’t provided until September. In this scenario, the best practice is to prepare the 2022 return as much as possible before the extension is completed. At the time of the extension on April 18, 2023, the practitioner (along with the client) must estimate the income coming from the missing information and find a projected tax liability for tax year 2022. After those assumptions are agreed upon, with the client and you have an estimated 2022 tax liability, you would multiply the tax liability by 100% or 110% (depending on the taxpayer’s AGI) and make an extension payment to cover their 2022 tax liability along with the first- through third-quarter estimates.

When the 2022 return is finalized in October 2023, the tax preparer would apply the overpayment consecutively to each quarter and leave a fourth-quarter estimate for the taxpayer. This way, as you gather K-1s and other tax documents from April-September 2023, you can potentially recalculate the tax due and pay additional quarterly estimates (only if your estimated tax was underestimated). 

The IRS calculates the underpayment penalty based on the amount of underpayment, or the period when the underpayment was due and underpaid, and the interest rate for underpayments (the IRS publishes these rates quarterly). The IRS will also calculate interest on penalties. It is important to be proactive with your clients to educate them about the pay-as-you-go system, even if they are W-2 employees. To avoid the penalties, careful attention and planning need to be done today to mitigate any penalties in the future.

Editor’s note: Keep up with IRS News on the Intuit® Tax Pro Center.