Steps to Avoid Year End Tax Penalties
No one enjoys paying taxes but even worse is getting a penalty because you didn't meet the IRS's rules for paying your taxes. Here's a three-step guide for how you can review your overall tax situation during the last few months of this year to minimize any potential threat of penalties.
Avoid underpayment penalties
You can be hit with penalties for underpayment if your total tax due is $1,000 or more when you file your return. However, here are a couple of "safe harbors" that can help protect you from penalties even if the amount you owe is $1,000 or more:
• You won't be subject to underpayment penalties if your total withholding and estimated payments are at least 90% of your tax liability for the year.
• You also can avoid underpayment penalties if your tax withholdings are at least equal to the taxes you paid for last year. (Exception: If you have adjusted gross income of more than $150,000, you'll have to pay 112% of your taxes last year to qualify for this safe harbor.)
This second exclusion can be helpful for people who are seeing a sharp increase in their incomes this year. Even if your taxes double this year you'll be protected against underpayment penalties as long as you've made the required payments based on your previous year's tax bill. Pay the remaining tax that you owe by April 15, and you will, in essence, have gotten a short-term interest-free loan from the government.
Avoid cash crunches
The other potential problem for many individuals and small businesses is simply one of planning. It's not always easy to realize that you're building up a substantial tax liability.
With some people, if they don't make the payments on a quarterly basis, they're not going to remember to set aside the money to pay when they file their returns. You can't cover yourself against underpayment penalties by just waiting until the end of the year and then making a large estimated tax payment. The government wants to get payments for taxes you'll owe on at least a quarterly basis — on April 15, June 15, Sept. 15 and Jan. 15 (the January payment is for the fourth quarter of the previous year).
Filers subject to corporate income tax face similar rules, except that their estimated taxes are due on the 15th day of the fourth, sixth, ninth and 12th months in their fiscal year. For corporations that are calendar-year taxpayers, this translates to quarterly estimated tax dates of April 15, June 15, Sept. 15 and Dec. 15.
Use the withholding rules
There's an even better strategy available for people who receive payroll checks, including those who are small-business owners. They can make up earlier underpayments by adjusting their paycheck withholding for the last few months of the year. That's generally a better deal because of the way in which the IRS credits you for payroll tax withholdings. The government looks at payroll withholding as having been paid equally throughout the year, no matter when it was actually withheld.
So, if your additional withholding in the last few months of the year brings your total payroll withholding up to the safe-harbor limits, you can avoid underpayment penalties. This is a great way to avoid penalties.
Year-end tax planning is critical for several reasons, minimizing your tax liability and avoiding any potential tax penalties. As always, our advice is to contact your tax professional and be prepared for year-end.