Estimated Tax Tips

Taxpayers who have income that is not subject to withholding not only have to deal with paying income taxes (and possibly self employment taxes) on their 2009 income; we also have to pay in advance for taxes on our 2010 income.

This can be a huge shock to people who first enter the murky tax world of the self-employed -- which has happened to a lot of employees who were laid off in 2009. But it also affects people who have income from foreign investments, controlled foreign corporations or foreign trusts. First there is the discovery that they won't be getting a refund anymore. Instead, they have to pay all their 2009 income and self-employment tax by April 15th of 2010. (The alternative is some substantial penalties and interest.)

But, to add insult to injury, they also have to decide whether to make advance payments of their 2010 taxes and they have to find a way to estimate what their tax will be for 2010. The tax law provides a safe harbor from penalties and interest on an underpayment of estimated taxes that is based on the previous year's total tax bill. Basically, if a taxpayer bases his 2010 tax estimate on his 2009 total taxes, s/he can avoid the penalties for an underpayment of estimated taxes. (For high income taxpayers, the estimate has to be 110% of the previous year in order to avoid penalties.)

Many newly self-employed taxpayers have not yet computed their 2009 taxes. But they are required to prepare an estimate in order to request an extension with Form 4868. That extension is only valid if the estimate is considered "reasonable" by the IRS, but they tend to allow quite a bit of latitude in that regard. So the first step is to estimate federal and state income taxes and self-employment taxes for 2009 and to pay whatever amount is due no later than 4/15/2010. (Penalties of up to 25% of the tax plus interest can be imposed for a late payment of the tax, in addition to any possible penalties for an underpayment of quarterly taxes for 2009.)

The next step is to use that same estimate for 2010. That creates a situation where it is as if the taxpayer is having to pay twice as much tax, although the 2010 tax can be paid in four installments. (4/15, 6/15, 9/15 and 1/15/11)

What if the income for 2009 was a windfall and is not likely to occur again?

The law does not require taxpayers to base their current year tax estimate on the previous year's tax. That is only a safe harbor from interest and penalties. Another way to make estimates is to keep track of any income (less expenses) each quarter and to estimate the total itemized deductions and other items that affect the tax bill. Those assorted deductions can be allocated to each quarter. Then the tax can be computed on a year-to-date method, based on what has actually been received. This may not eliminate the possibility of some penalties (in the form of interest) but it will avoid having to make an estimate based on a one-time windfall from the previous year.

By the way. The IRS doesn't tell you this very clearly, but the penalty for an underpayment of quarterly estimated taxes is in the nature of interest that is computed from the due date of each quarterly tax payment until April 15 of the following year. When money is really tight, it may be cheaper to underpay the quarterly taxes instead of borrowing on a credit card or from some other high interest lender. But if the taxes are not paid in full by next April 15th, the penalties and interest can be very painful.

These comments are a very non-technical summary and generalization of the specific rules. For more precise information about estimated taxes see IRS Publication 505. (http://www.irs.gov/pub/irs-pdf/p505.pdf)

Vern