When our clients experience a spike in income, such as a large gain on the sale of stock, they typically come to us with two reactions. The first is excitement over the profits, but that is often quickly tempered by their second response—uncertainty about the tax implications. While taxes should not turn an otherwise positive experience into something negative, it is important to be aware of what the cost will be and, as importantly, when the taxes have to be paid. Furthermore, good planning can enable you to pay as little tax as possible during the year while still avoiding penalties.
Taxes often can be paid later than expected. The IRS provides specific rules on when to pay a tax liability and following those rules closely can provide taxpayers with the longest and best use of their income. In addition, the changes to tax law and the withholding tables for 2018 mean taxpayers should pay extra attention to their scheduled payments for this year to avoid an over-, or under-, payment.
IRS tax payment requirements
In general, the best way to manage a tax liability is to pay as little of the tax during the year as needed to avoid a penalty, with the balance paid when the tax return is filed. There are two targets taxpayers can aim for in order to avoid a penalty, and they can use whichever one allows them to pay the least during the year:
(1) Pay 90% of the current year liability.
(2) Pay 100% of the prior year liability. If the taxpayer’s adjusted gross income (AGI) for the prior year was more than $150,000, this target is increased to 110%.
As long as the taxpayer hits one of these two targets, the IRS generally will not assess an underpayment penalty, regardless of how much tax is ultimately paid at the tax return due date (typically April 15). If both are missed however, the IRS will charge interest on the underpayment amount. The interest rate charged on those is reviewed quarterly and is currently at 5% as of the second quarter of 2018. This is an annual interest rate, but the penalty is calculated based on the number days of underpayment.
In both cases, taxpayers must include not just the income tax calculated on their tax return, but also things like alternative minimum tax, self-employment tax, net investment income tax, etc. On the other hand, various tax credits—such as the foreign tax credit, child credit, and the child care credit—can be used to reduce the targeted amount.
Basing current year tax payments on the prior year tax liability provides taxpayers with a specific target to hit. Because of this, this method is often referred to as the “safe harbor” method. In other words, it does not matter what is owed when the tax return is filed—as long as the payments during the year exceed the safe harbor amount there will be no penalty. Targeting 90% of the current year liability may mean a lower payment amount now, but it also requires carefully estimating the eventual tax expense.
ABOUT CAROPRESE & COMPANY
Caroprese & Company is a certified public accounting firm that provides innovative and strategic services to a diverse client base of individuals, families, small and medium size businesses, government entities, non-profits and multi-national corporations. Our dynamic professionals perform at a high intensity and are laser focused on providing excellence to our global clientele.
CONTACTING CAROPRESE & COMPANY
This publication is provided by Caroprese & Company as a service to its clients and colleagues. The information and content included in this publication should not be construed as technical advice. Questions regarding any matters discussed in this publication should be directed to Brandon Caroprese whose contact information is listed below:
Brandon Caroprese, CPA, MST