The Estimated Tax Penalty Hits Its Highest Mark in 16 Years

In the United States, taxes are paid on a “pay as you go” basis, meaning that as individuals earn income throughout the year, they must make payments for income tax, and if applicable, for Social Security and Medicare taxes to the IRS either through withholdings or by making estimated tax payments.

If individuals or corporations don’t pay enough taxes during the year, the IRS imposes an estimated tax penalty, also known as the underpayment penalty. This penalty is calculated for each quarter based on the unpaid tax amount for that quarter.

The penalty rate is the federal short-term interest rate for the first month of the quarter in which the taxes were unpaid, plus an additional 3 percent.

This federal short-term interest rate fluctuates according to general interest rate movements, affecting the estimated tax penalty amount. When inflation and interest rates were low, the estimated tax penalty remained minimal. For example, in 2022, the penalty was just 3 percent.

However, due to a significant increase in interest rates, the penalty has surged. From October 1, 2023, to March 31, 2024, the penalty rate has reached 8 percent, the highest since 2007.

It’s important to note that this penalty is not tax-deductible, meaning the actual cost of the penalty is effectively higher than 8 percent.

Given this steep penalty rate, it is advisable to ensure sufficient tax payments are made throughout the year to avoid it. Although individuals may seek a waiver for this penalty from the IRS under specific circumstances, such relief is generally not available, and no penalty relief is offered to corporations.

Personal Estimated Tax Contributions

To prevent incurring the estimated tax penalty, individual taxpayers are required to make quarterly payments to the IRS. These payments should equal at least 25 percent of their required annual payment by the due dates of April 15, June 15, September 15, and January 15. The required annual payment is calculated as the lesser of two amounts:

• either 90 percent of the total tax for the current year or
• 100 percent of the tax paid in the previous year.
• For taxpayers with higher incomes, exceeding $150,000 for singles or $75,000 for married filing separately, this amount increases to 110 percent of the previous year’s total tax.

Most individuals earning wages have their required annual payments met through employer withholdings. However, for income not subject to withholding, such as dividends, interest, capital gains, rents, and royalties, taxpayers may need to pay estimated taxes. They could alternatively adjust their withholding to meet these obligations.

Taxable distributions from retirement accounts offer the flexibility of withholding part or the entire tax, paying estimated taxes, or combining both methods.

For self-employed individuals, including sole proprietors, partners, and LLC members, there’s no automatic tax withholding on business income. They are obligated to make quarterly estimated tax payments. While LLC members and partnership partners must pay estimated tax on their income share, the businesses themselves are not taxed.

However, there’s an exemption from the estimated tax penalty for taxpayers who owe less than $1,000 in federal taxes for the year, encompassing both income tax and self-employment tax. This provision helps minimize the administrative burden on individuals with smaller tax liabilities.

Payment Amount Calculation

As highlighted earlier, individuals required to pay estimated taxes, including the self-employed, can steer clear of penalties through two primary strategies:

1. Pay either 100 or 110 percent of the tax from the previous year, depending on their income level.
2. Pay 90 percent of the tax owed for the current year.

Typically, these taxpayers opt to make four equal payments of estimated tax, adhering to the due dates specified earlier.

To mitigate the estimated tax penalty, individuals can employ the “annualized income installment method.” This approach involves calculating tax liability for each of the four income periods separately, adjusting deductions accordingly. Taxpayers make their estimated tax payments based on the actual tax liability for each quarter.

The annualized method is notably more complex, essentially requiring the taxpayer to prepare a mini tax return each quarter to detail that period’s income and deductions, thereby determining the quarter’s tax liability. However, this method is particularly advantageous for individuals who earn their income unevenly over the year, allowing them to lower their estimated tax payments during leaner income periods.

Taxpayers are not obligated to stick with the annualized income method for the entire year. They have the flexibility to apply it for one or several quarters and then switch to a simpler method if it promises a reduced payment. However, upon switching, they must compensate for any previous savings achieved through the annualized method by recalculating and paying any underpaid amounts from earlier quarters.

Estimated Tax Penalty

Estimated tax penalties are imposed automatically if the necessary payments aren’t made, and these penalties are not deductible from taxes. They are additional charges beyond the owed taxes.

It’s important to note that because these penalties are non-deductible, they must be paid with after-tax dollars. For instance, if your combined rate for income and self-employment tax is 40 percent, an 8 percent non-deductible penalty effectively becomes equivalent to paying 13.3 percent interest (calculated as 8 percent divided by the remaining 60 percent after-tax rate).

Penalties are calculated for each payment period individually, meaning that you cannot offset a penalty for one period by overpaying in another. This holds true even if you end up receiving a refund when filing your annual tax return.

However, there is an opportunity to avoid the estimated tax penalty for the fourth quarter by filing your tax return and settling any outstanding taxes by January 31.

To determine the amount of the penalty, you can fill out IRS Form 2210, titled “Underpayment of Estimated Tax by Individuals, Estates, and Trusts,” and include it with your tax return. Alternatively, you can opt for the IRS to calculate the penalty and send you a bill.

Waivers for Estimated Tax Penalties

In contrast to many other IRS penalties, the estimated tax penalty is not subject to waiver for reasons of reasonable cause. This means that the IRS will not dismiss the penalty due to circumstances like severe illness or injury of the taxpayer, the death of a family member, or other similar situations that are beyond the taxpayer’s control. Additionally, this penalty cannot be waived under the first-time abatement penalty waiver.

However, the IRS does allow for the waiver of the estimated tax penalty under very specific conditions:

• Casualty or Disaster: The IRS may waive all or part of the penalty if it would be unfair to impose it because the underpayment resulted from a casualty, a disaster, or another unusual circumstance.
• Federally Declared Disaster Areas: Individuals residing in areas that have been officially declared disaster zones are given additional time to pay their estimated taxes without penalty. To qualify for this extension, it is not necessary for their home or office to have suffered damage. The IRS automatically identifies taxpayers in the affected disaster areas (by county or parish) and grants penalty relief accordingly. Those in designated disaster areas should not submit Form 2210 to request a waiver.

For individuals who have recently retired or become disabled, the IRS offers leniency regarding the estimated tax penalty under certain conditions:

• The waiver applies if you retired upon reaching age 62 or older in the tax year in which the estimated taxes were underpaid, or the year before.
• It also applies if you became disabled during these periods.
• Additionally, there must be a reasonable cause for the failure to make the payment, and it must not be due to willful neglect.

In these scenarios, the IRS may waive all or part of the underpayment penalty, provided these specific criteria are met.

The IRS has shown flexibility in waiving the estimated tax penalty in specific cases. For instance, a waiver was granted to a taxpayer who didn’t pay their estimated taxes due to a mental breakdown and complications from AIDS. However, waivers were denied in situations where a taxpayer was dealing with alcoholism or another was caring for a spouse with cancer.

To request a waiver, you must fill out Form 2210 and attach it to your tax return, along with a written statement detailing why you were unable to comply with the estimated tax requirements and for which period you are seeking a waiver.

If the waiver is being requested on the grounds of retirement or disability, supporting documentation must be provided that verifies the retirement date and age at retirement, or the date of becoming disabled.

For waivers requested due to casualties, disasters (excluding federally declared disasters), or other unusual circumstances, relevant documentation such as police and insurance reports must be attached.

It’s important to understand that estimated tax penalty waivers are not granted automatically. The IRS evaluates each request based on the provided information before making a decision on whether to approve the waiver.

Corporate Estimated Tax Payments

C corporations are required to make quarterly estimated tax payments if they anticipate owing $500 or more in taxes at the time of filing their return.

Conversely, S corporations generally do not have to pay estimated taxes. However, there are exceptions, such as when an S corporation is liable for $500 or more in taxes due to built-in gains, excess net passive income, or the recapture of investment credit.

Shareholders of S corporations are responsible for paying individual estimated taxes on their proportion of the corporation’s income. This is because the tax code treats income or losses from S corporations as passing directly to the shareholders daily.

To calculate and pay estimated quarterly taxes, C corporations use Form 1120-W, Estimated Tax for Corporations. The due dates for these payments for corporations on a calendar year are April 15, June 15, September 15, and December 15.

For corporations operating on a fiscal year basis, the estimated tax payments are due on the 15th day of the fourth, sixth, ninth, and twelfth months of their fiscal year. For instance, a corporation with a fiscal year ending on June 30 would have its installment payments due on October 15, December 15, March 15, and June 15.

Similar to individuals, corporations are obligated to make estimated tax payments to avoid penalties. These penalties are not deductible from taxes and are charged in addition to the owed taxes. The amount a corporation must pay annually as estimated tax is determined by the lesser of two values:

• 100 percent of the tax reported on its return for the current year, or
• 100 percent of the tax reported on its return for the previous tax year.

However, “large corporations” are not permitted to calculate their required annual payment based on the tax from the previous year. A large corporation is defined as one with a taxable income of at least $1 million in any of the three preceding tax years, or for the entire duration of its existence if it has been operational for less than three years.

Corporations have the option to choose from four different methods to calculate their estimated tax payments and thereby avoid penalties for underpayment:

1. Current-Year Method: The corporation pays four quarterly installments, each amounting to 25 percent of the income tax it anticipates reporting on its return for the current year.
2. Preceding-Year Method: The corporation makes four quarterly payments, each equal to 25 percent of the tax reported on the return for the previous tax year. This method is only viable if the corporation’s return from the prior year covered a full 12 months and showed a positive tax liability. Large corporations are allowed to use the preceding year’s tax to calculate only their first estimated tax payment of the year and must adjust subsequent payments to cover any shortfall.
3. Annualized Income Method: This method permits corporations to calculate their estimated tax based on the actual income earned each quarter, potentially resulting in lower payments than the first two methods. It’s suitable for companies whose income varies throughout the year.
4. Adjusted Seasonal Income Method: Corporations with consistent seasonal income patterns may benefit from this method, which allows for the annualization of income based on the assumption that income is earned in a similar pattern to previous years. To use this method, a corporation must demonstrate through a mathematical test that its income is seasonally earned, offering a potential reduction in estimated tax payments compared to the first two methods.

When a corporation does not pay enough in estimated taxes, it incurs an estimated tax penalty on the shortfall. This penalty is calculated separately for each payment deadline, meaning a corporation could face a penalty for an early payment shortfall even if it later pays sufficient tax to cover the underpayment.

The penalty rate for corporations is identical to that for individuals: the federal short-term interest rate plus three percentage points.

However, for underpayments exceeding $100,000 during any taxable period, the penalty rate increases by an additional two percentage points, making it the federal short-term rate plus five percentage points. This heightened penalty rate starts accruing on the total underpaid amount—including tax, penalty, and interest—30 days following the issuance of a 30-day letter or a notice of deficiency.

Corporations calculate this penalty using Form 2220, “Underpayment of Estimated Tax by Corporations.” While generally, corporations are not required to file this form (as the IRS will determine the penalty and issue a bill), it must be completed and attached to the tax return if the corporation has utilized either the annualized income or adjusted seasonal installment method, or if it is a large corporation that based its first required installment on the previous year’s tax.

It’s important to note that corporations do not have a reasonable cause exception for the underpayment penalty, and unlike the case with individual taxpayers, the IRS does not offer penalty waivers to corporations under any circumstances.

KEY TAKEAWAYS

Key Insights from the Discussion:

1. Required Annual Payment Obligation: Both individuals and corporations are obligated to make a “required annual payment” to the IRS annually. Individuals can fulfill this through tax withholding, estimated tax payments, or a combination of both, whereas corporations are required to make estimated tax payments.
2. Estimated Tax Penalty: Any taxpayer, be it an individual or a corporation, that does not meet their required annual payment incurs an estimated tax penalty. This penalty is an interest charge calculated using the federal short-term interest rate plus three percentage points. Currently, the penalty rate is at 8 percent, the highest it has been in 16 years, and it is non-deductible. For large corporations, this penalty rate increases to 10 percent.
3. Avoiding the Estimated Tax Penalty: To evade this penalty, individuals must pay either 90 percent of the total tax due for the current year or 100 percent (110 percent for those with adjusted gross incomes over $150,000 or $75,000 if married and filing separately) of the previous year’s total tax. Corporations are required to pay 100 percent of the tax shown on their current or previous year’s return, noting that large corporations cannot base their payment on the previous year’s tax.
4. Quarterly Estimated Tax Payments: Individuals with insufficient tax withholding and all corporations must make quarterly estimated tax payments to the IRS. While most opt for equal payments throughout the year, the annualized income method is available for those with uneven income distribution across the year.
5. Waiver of Estimated Tax Penalties: The IRS may waive estimated tax penalties for individuals under specific circumstances, such as retirement, disability, or in the event of a disaster or casualty. However, such waivers are not available for corporations.

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1    IRC Section 6621.
2    Rev. Rul. 2023-17.
3    IRS Pub. 505, Tax Withholding and Estimated Tax (2023), dated Oct. 4, 2022, p. 22.
4    Ibid., p. 25.
5    IRC Section 6654(d)(2)(A)(ii).
6    IRC Section 6654(a).
7    IRC Section 6654(h).
8    Reg. Section 1.6654-1(a)(1).
9    IRC Section 6654(e)(3)(A).
10    Instructions for Form 2210 (2023), dated Jan. 19, 2024.
11    IRC Section 6654(e)(3)(B); Instructions for Form 2210 (2023), dated Jan. 19, 2024.
12    Mercer v Commr., TC Memo. 2003-12.
13    McLaine v Commr., 138 TC 228.
14    Nasir v Commr., TC Memo 2011-283.
15    IRC Section 6655.
16    IRC Sections 1366(a)(1); 1377(a)(1).
17    IRC Section 6655(a).
18    IRC Section 6655(d)(1)(B).
19    IRC Section 6655(d)(2)(A).
20    IRS Pub. 542, Corporations (2022), dated Feb. 25, 2022, p. 6; Instructions for Form 2220 (2022), dated Sep. 29, 2022.
21    IRC Section 6655(a).
22    IRC Section 6621(c).
23    Reg. Section 1.6655-1(a).