All taxpayers, individuals and most companies, must file their tax returns by April 15 each year. However, the tax liability, or the amount owed for the year, must be paid in equal quarterly installments and due in full by April 15. The scheduled dates for these quarterly installments are June 15 and September 15 of the current year and January 15 and April 15 of the succeeding year. These dates apply to everyone.
All taxpayers are subject to an underpayment penalty if they do not pay enough in their quarterly payments or do not have enough withheld from their wages. There are two ways to avoid this penalty:
- pay 100% of last year’s tax liability, or
- pay at least 90% of the current year’s tax liability.
The focus of this blog is to explain how underpayment penalties are applied and how they can be avoided.
The Underpayment Penalty
The basic premise of tax law is for all taxpayers to make quarterly payments to the IRS as income is realized throughout the year. Employers make these quarterly payments and those not subject to withholding, like the self-employed and those with investment income.
The methods given above to avoid this penalty apply to taxpayers with an adjusted gross income (AGI) of $150,000 or less. Individuals and companies with an AGI of over $150,000 must pay the lesser of the following:
- 90% of the current year’s tax liability, or
- 110% of the prior year’s tax liability.
In either instance, the lower percentage applies to the current year when the income is estimated, and the higher percentage applies to the prior year when the amount of the tax liability is known.
The penalty will apply to those taxpayers who need more withheld from their paychecks and those who make uneven quarterly payments throughout the year. All quarterly payments must adequately correlate to the income for the period.
Taxpayers who estimate their tax liability must account for Social Security and Medicare taxes, in addition to the income taxes, in their quarterly payments. These taxpayers must pay their estimated taxes in four equal quarterly payments on or before January 15 and September 15 of the current year, and January 15 and April 15 of the following year.
It is the shortfall amount that is subject to the penalty. Of course, the IRS does not assess a static percentage or a flat fee. The interest and the penalty compound.
The Penalty
All underpayments over $1,000 are subject to a failure-to-pay penalty. This penalty is 0.5% of the shortfall amount owed for each month, or part of a month, during which a balance remains outstanding. This cumulative penalty cannot exceed 25% of the amount owed.
The Interest
Penalties are not interest; interest is assessed in addition to the penalty. The IRS determines the interest rate for each quarter; generally, the rate is the federal short-term rate plus 3%. For Q1 2023, the IRS set the interest rate at 7% for individuals and 9% for companies. These rates have increased by 1% from last quarter.
Penalty Calculation – An Example
So, let’s say a taxpayer owed the IRS $5,000 in tax liability for the year, but the taxpayer paid $2,000. The shortfall is $3,000. This shortfall is subject to the underpayment penalty, and the sum of these amounts will accrue interest.
The interest assessed to the shortfall in Q1 2023 is $210. However, the penalties are cumulative. So, 7% will be applied to the shortfall plus the accumulated interest outstanding for the past quarters. The interest will continue to accrue as long as an outstanding balance remains.
The $3,000, plus the interest, is also subject to the 0.5% per month failure-to-pay penalty. The 25% cap applies only to this penalty. There is no cap on the amount of interest that can accrue on unpaid taxes.
Special Considerations
The IRS will take special consideration to either reduce or waive an underpayment penalty. However, these considerations are narrow and specific and can include:
- a casualty event, natural disaster, or other reasonable cause,
- a retirement after the age of 62 where the taxpayer is no longer subject to withholding,
- a disability,
- a change in filing status that brings about a larger standard deduction, or
- situations where a significant amount of income is realized in a lump sum late in a calendar year.
The willful and intentional act of not paying does not warrant any special consideration.
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For further information or to schedule a consultation, please contact Anderson Bradshaw Tax Consultants at 877-550-3911 or visit www.AndersonBradshawTax.com to learn more.
