How to Avoid Estimated Tax Penalties: Part Oneby
Many of my clients are freelancers who are legally required to make estimated tax payments. I remind them that the IRS takes a dim view of freelancers, self-employed individuals and others who miss deadlines for these. In fact, miss just one, and the agency might exact a sizable, nondeductible penalty.
So, who is in the IRS’s crosshairs? The answer: Individuals who receive income from sources not subject to withholding and whose tax liability exceeds $1,000, including any self-employment tax.
Folks in these categories are particularly at risk:
- Freelancers and other self-employed persons who operate businesses or professions as sole proprietorships, in partnerships with others or as independent contractors
- Investors who receive interest, dividends and capital gains from sales of investments and the like
- Property owners who receive rents or royalties
- Retirees who opt not to have tax withheld from pension payments, Social Security benefits or withdrawals from tax-deferred retirement plans
- Recipients (women, predominantly) of alimony paid as a result of divorce or separation agreements signed in 2018 and before. The Tax Cuts and Jobs Act ended the taxability of payments under agreements reached after 2018.
In 2019, the first deadline for estimated tax payments is April 15.
The other deadlines for the 2019 tax year are June 17 (the 15th falls on a Saturday: when the usual due dates fall on a Saturday, Sunday or legal state holiday, they’re extended until the next weekday) and Sept. 16, 2019 and Jan. 15, 2020. The IRS allows individuals to skip January’s payment, provided they submit their 1040 forms and pay their tax in full by Feb. 3.
Suppose your client moonlights as a writer and has a full-time job elsewhere. They’re not excused from making estimated payments just because they only freelance part time.
There is, however, an IRS-approved way to avoid making those estimated payments on the writing income: Your client could file a revised W-4 with their employer and increase the income tax withheld from their regular paycheck. This maneuver works when 2019’s withholding is enough to cover the taxes on their salary and on their writing.
Be mindful the IRS imposes penalties for failing to pay sufficient tax during the year through withholding or estimated payments, as well as for failure to pay the required installments on time. It matters not that the final estimated payments are sufficient to erase any balance due when 2019’s 1040 form is submitted in early 2020.
Suppose your client is in danger of being penalized for making insufficient estimated payments throughout the year. Will the IRS forget about penalties for underpayments in the three previous quarters if the individual pays the shortfall through an increase in their last quarterly estimated payment?
No, that won’t work.
What does work, however, is making up the shortfall through increased withholding from wages (or from sources such as Social Security benefits, pensions and money removed from tax-deferred retirement plans) toward the end of the year.
The IRS allocates withholding equally over each of the four payment periods. Consequently, boosting withholding can retroactively lessen or eliminate penalties, while a similar increase in an estimated payment might not.
What if your client underpays their federal taxes by more than $1,000—and they’re potentially facing penalties? They may be able to sidestep the penalty if 2019’s combined estimated and withheld taxes equal at least 90 percent of the actual taxes they owe for 2019—or, alternatively, if the taxes paid over the course of year equal to 100 percent of 2018’s total tax liability.
Let’s say the payments total $12,000 for 2018 and $12,000 for 2019. With those kinds of numbers, your client is home free, no matter how much they owe when they file for 2019.
Next week, I’ll discuss other ways to avoid penalties.
A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 275 and counting).