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Jeremy Wells: Sams 2025 tax liability was $24,000, and Sam didn't have any withholding and made no estimated payments during the year. But after getting a projection based on some preliminary tax documents, Sam on January [00:00:30] 15th of 2026 paid the entire $24,000 liability. So Sam's tax is fully paid. But when the return is prepared, the software shows a balance due because of an underpayment penalty, and Sam understandably can't figure out why. If the balance is paid in full by January 15th, that he would have to pay any penalty. This [00:01:00] is a situation that I, as a tax return preparer, have been in several times. I've had clients where they had very close to an even amount of payments versus the actual tax liability. I've even had clients in a refund position where I've had to explain that they have an underpayment penalty. What exactly is the underpayment penalty? How can we avoid the underpayment penalty? How does it get calculated? And what are some strategies that we [00:01:30] as tax professionals could recommend to our tax payer clients to to avoid that penalty? And once we know there's a penalty, is there really anything we can do about it? Is there any kind of forgiveness, uh, possibility for that? So in this episode, we're going to figure out who has to make estimated payments in order to avoid that underpayment penalty. How that penalty is actually calculated [00:02:00] and what we can do to minimize it. And then look at if there are any possibilities to get that penalty abated, and if so, what it actually takes to get there because the bar is relatively high.
Jeremy Wells: It's a penalty that acts more like interest than a penalty. And the abatement opportunities that are available for other common penalties actually aren't available for this one in particular. So that's going to be the topic of this episode. And after [00:02:30] listening to this, you should be able to do the following. Determine whether an individual needs to make estimated tax payments for federal taxes and the amount of those required installments. We'll talk about the safe harbor calculations, what those are, where they come from. We'll look at the section 6650 for underpayment penalty and look at how form 2210 helps us calculate that penalty along with the accompanying [00:03:00] worksheet to that form. And then we'll evaluate the statutory grounds for waiver and identify the procedures available to contest that penalty. And like I said, it's a relatively high bar to get that penalty abated or reversed. We need to start off with the basic underlying principle here, and that is that federal income tax should be paid as it as the income that [00:03:30] generates that tax is earned. Taxpayers generally prepay their annual tax liability through federal income tax withholding and estimated tax payments. This is what's known as the pay as you go system that we have in our federal tax system. So for calendar year taxpayers, the estimated tax installments are generally due on April 15th, June 15th, September 15th, and [00:04:00] January 15th of the following year.
Jeremy Wells: Now, if a due date falls on a Saturday, Sunday or legal holiday, then under IRC section 7503, the taxpayer can make that payment by the next business day, same as any other payment for federal tax purposes, almost any other payment. Now the annual income tax return. We need to we need to think of that as just a reconciliation [00:04:30] of either what happened or was supposed to happen during the prior year. It's not ordinarily the first time that the taxpayer is expected to actually pay the tax for taxpayers that are used to having withholding coming out of their paychecks from their employers, especially those that then transition to self-employment. That can be a tough lesson for at least the first [00:05:00] year or two of self-employment. Understanding that they have been paying as they go all along, and just because they no longer have that withholding, doesn't mean that they aren't still expected to pay as they go. And even those who know that they're supposed to make estimated payments or quarterly payments, as they often get called, they don't know how much to pay, where the amount comes from, why they're paying it in, and a lot of times how to actually make those payments. [00:05:30] So this can be a confusing topic for a lot of especially first time self-employed people. And it can get kind of expensive if they don't understand the rules and how to handle them.
Jeremy Wells: Now we commonly call these four payments the quarterly estimated payments, but that description is actually misleading The payments aren't due once every three months. April 15th. June 15th, which is just two months. September 15th and then January [00:06:00] 15th, which is four months. And in fact, that's the way the payment deadlines work and the way the periods covered by those payment deadlines are the similar time period. So that first payment, April 15th, covers January through March 3rd months, but then that June 15th payment just covers May and April and May. So just two months, even though all four payments are going to be for equal [00:06:30] amounts. And then September 15th covers July covers June, July and August, and then the January 15th payment covers four months, September, October, November and December. So again, they're all four equal payments, but one of them is just for two months. One of them is for four months, the other two are for three months. Right now the dates matter because they're actually statutorily defined in IRC section 6654. [00:07:00] But they also require us to view each of those four periods, those four payment deadlines separately. And we'll talk about that more when we talk about how the penalty is actually calculated. And what ends up happening is the taxpayer is expected to pay a sufficient amount to cover the tax liability for each of those periods by the due date for that period. [00:07:30] Now, the estimated payments depend on the shortfall, not the source for that period.
Jeremy Wells: So an individual generally must make estimated tax payments if two conditions both apply. First of all, the taxpayer expects to owe at least $1,000 after subtracting, withholding and refundable credits. And [00:08:00] two withholding and refundable credits are expected to be less than the taxpayer's required annual payment. Now, if both of those things are true, then the individual needs to make estimated tax payments. No estimated payments are required. If the taxpayer had no prior year tax liability, provided that the prior year covered 12 full months and the taxpayer was a US citizen or resident throughout that year. [00:08:30] So the obligation to make estimated payments isn't determined by the type of income the taxpayer receives. I just mentioned that transition from employment to self-employment usually throws a lot of taxpayers off when it comes to making estimated payments, and so that sort of generates an assumption that if you're self-employed, you have to make estimated payments. That's not exactly the way the rule works. Any taxpayer that expects a shortfall between the withholding and [00:09:00] refundable credits and their actual tax liability, if there's a gap there of more than $1,000 and the taxpayer had a prior year tax liability, then that taxpayer needs to make estimated payments. So it's actually possible for someone who is a W-2 employee and has regular withholding, but may also have some other sources of income or may have set their withholding via their W-4 to a level [00:09:30] that is so low that there's a significant enough gap between the liability and the actual withholding.
Jeremy Wells: In that case, that taxpayer needs to make estimated payments, too. So just saying that a taxpayer is self-employed doesn't necessarily mean that taxpayer has to make estimated payments. And just because a taxpayer is full time employed doesn't necessarily mean that taxpayer doesn't need to make estimated payments. It's really about the shortfall, not necessarily the actual source of [00:10:00] the income. Now, there are a couple safe harbors here when it comes to estimated payments that determine the taxpayer's target for total withholding credits and payments for the year. So the required annual payment is generally the smaller of 90% of the current year tax, or 100% [00:10:30] of the prior year tax. Now, for certain taxpayers who have a higher AGI, that might be 110% of the prior year tax, the prior year return has to cover 12 months. So if the prior year return covers a full tax year or calendar year, then the taxpayer is required to make an annual total payment of at least 90% of the current year, [00:11:00] or 100, or maybe 110% for a higher earning taxpayer. Percent of the prior year tax. So let's assume back to our example for this episode. Let's assume Sam's 2024 return. So the prior year return covered. The full 12 months covered the full year, and the 2024 AGI did not exceed that threshold to require 110% of the prior year tax. So Sam needs to make either have [00:11:30] annual payments of either 90% of the current year or 100% of the prior year, whichever is smaller.
Jeremy Wells: And let's say Sam's required annual payment is $20,000, right? Which would be the lower of 90% of the current year, 24,000. But 90% of that is $21,600. Or if 100% of the prior year tax was $20,000, then that would be the lower of the two numbers, and [00:12:00] that would be the annual payment that Sam would be required to make. Now, that said, right, it's possible that Sam makes that prior year 100% annual payment of $20,000, but because Sam's actual tax liability will be $24,000, there will be a balance due of $24,000 minus that [00:12:30] $20,000 or $4000 come April 15th, if Sam doesn't pay it by then. So if Sam waits until after April 15th to pay that balance due. Now we're talking about the failure to pay penalty, which is a completely separate penalty. All we're talking about here is mitigating the underpayment penalty. So there won't be an underpayment penalty. But that doesn't mean there won't be any other kinds of penalties unless Sam pays the balance due by [00:13:00] the original due date the following year. Now, there are two points here worth mentioning. First, for the purposes of this talk, tax is broader than just regular income tax. It also includes things like self-employment tax, the net investment income tax, the alternative minimum tax and any additional Medicare tax not collected through withholding. So all of those taxes that get calculated on the 1040, those are included as well. [00:13:30]
Jeremy Wells: And this is where the self-employed taxpayers, especially those sole proprietors and partners and partnerships can really run into trouble because even if they relatively closely project out the income tax implications, if they don't also include the self-employment tax in those calculations, then they could be off by quite a bit and therefore still have the problem of an underpayment penalty, even though [00:14:00] as far as the income tax, they might be pretty close. And then the same is true of net investment income tax for those earners who have a significant amount of income from capital gains or businesses in which they don't actively participate. So those can always cause problems as well. And second, the exception for having no prior year tax liability, that means zero relevant tax, not just zero balance due. So a taxpayer whose prior [00:14:30] year tax was completely covered by withholding still had a tax liability. Right? So we're not saying a balance due in the prior year. We're saying no tax liability. In other words, if that taxpayer had no tax liability whatsoever, even if they had some income, but say that income was below the standard deduction, and so there was no taxable income and therefore no tax. That's what we mean by that exception for [00:15:00] those with no tax in the prior year. Let's quickly talk about what can happen with married couples who change their filing status.
Jeremy Wells: And this is a situation that comes through my firm every now and then. And it can throw a little bit of a wrinkle into the determination of these penalties. So for a change in joint filing status from one year to the next, that will affect the prior year safe harbor. So [00:15:30] if the taxpayer filed jointly for either the current year or the prior year, but not both. And the prior year amount is smaller than the current year amount. Then you're going to do one or the other of the following to calculate that prior year safe harbor. So on the current year joint return. So if this married couple is going from separate to joint, then you combine both spouses [00:16:00] prior year taxes. If you're going the opposite direction, if you're going from prior year joint to current year separate, then you use the taxpayer's share of the prior year joint tax. And that's basically going to be taking the two spouse's incomes and then using that as a ratio to determine their shares of the prior year joint tax. There's actually a an allocation formula [00:16:30] provided in IRS publication 505 To help with that, so you first calculate the tax each spouse would have owed on separate prior year returns using the current year filing statuses. Then you multiply the prior year joint tax by a fraction with the numerator is the taxpayer's hypothetical separate tax, and the denominator is the spouse's combined hypothetical separate taxes. So you're using [00:17:00] the ratio of their taxes in order to determine their allocable share of tax.
Jeremy Wells: And so that's how that works for each taxpayer in a married couple that is changing their filing status from one year to the next in terms of determining whether what their payment amounts should be based on their prior year tax. Now back to Sam. For [00:17:30] Sam, we determined that his annual payment was the lesser of that 90% of the current year tax, or $21,600, or 100% of the prior year tax, $20,000. We take the lesser of those two. So it's $20,000, and we divide that evenly across the four payment periods or payment deadlines. So that would be $5,000 per installment. So Sam should have paid $5,000 [00:18:00] by April 15th, June 15th, September 15th, and then the January 15th of the following year. And cumulatively, that would have gotten him to $20,000. Now that would have completely negated any underpayment penalty had he done that. He didn't do that. What he did instead was paid $24,000 by January 15th. He actually paid more than the total of the Annual [00:18:30] requirement. And of those four periods, he paid more than that. Yet he still wound up with a penalty. And that reflects the logic of the pay as you go system and the way this underpayment penalty is calculated. And we'll talk about a bit more about that. Now, again, those due dates are determined by statute. They are listed out in section 6654. But [00:19:00] section 7503 still applies.
Jeremy Wells: If any of those dates falls on a weekend or legal holiday, then the payment deadline is actually the next business day. It's also important to keep in mind, and this is just an aside, because this show focuses on federal tax law, but it's important to keep in mind if you're advising taxpayers in states that have their own income taxes, that states can have their own [00:19:30] underpayment penalties and their own ways of calculating those penalties. In other words, states have their own rules and don't assume that they follow 1 to 1 the federal rules. So California, for example, allocates its required annual payments differently. It uses the same due date, but California requires 30% of the annual payment by that first April [00:20:00] 15th deadline, not 25%, 30%, 40% by the second deadline, June 15th, 0% for the third deadline or September 15th, and then 30% for the fourth deadline. So whereas federal is 25% for each of the four deadlines, California is 30%, 40%. 0%. 30%. [00:20:30] Now why California needs to do it that way. Who knows? I'm sure there's a reason, an explanation. I didn't look into that for this episode, but it's something that I always have to keep in mind when I'm advising clients that are based out of California, because they're going to have two different estimated payment schedules. One is going to be April 15th, June 15th, September 15th, January 15th, and one and an even amount for each of those.
Jeremy Wells: And another one is going to be one amount by April 15th, a different [00:21:00] amount by June 15th, no amount for September 15th, and then the April 15th amount again before the next January 15th. And sometimes that gets a little confusing. Uh, also some states might differ a little bit on the actual payment deadline. So for example, Virginia, their first payment is actually due May 1st, not April 15th. So Virginia give it gives its taxpayers about two more weeks to make that first payment, which I think since a lot [00:21:30] of taxpayers might also have a payment due by April 15th for the balance due for the prior year, giving them a little bit of time before that first estimated payment is due. Probably not a bad idea. In fact, April 15th can be making that first estimated payment of the year can be tough for, especially for self-employed people, because they're expected to not only pay their balance due from the prior year if they have one, but also pay off. Uh, make that first [00:22:00] estimated payment for the current year. That can be April 15th can be an expensive day for some taxpayers. Now paying later. And again, this goes back to the principle of this pay as you go system. Paying later does not erase an earlier underpayment. Once a taxpayer has a. As a deficit for a period and passes the deadline [00:22:30] for that period. There is no way, without doing some of the advanced things that we'll talk about later, there's generally no way to apply any payment backwards to that prior period that has an underpayment.
Jeremy Wells: So for each installment, the underpayment is the difference between the required installment and the payments credited by that due date. So the penalty depends on the actual underpayment. [00:23:00] There's also the applicable rate and the amount of time unpaid. And then each installment each of those four periods is tested separately. So a way to think about this penalty under section 6654 is less of a penalty and more of a timing rule, a timing provision. Again, it's pay as you go, so you need to be paying in over time, [00:23:30] even if you pay all at once. But if that payment is late in the year, there's effectively no way other than what we'll talk about later in this episode to go back and apply those payments to any of those earlier periods with an underpayment. So the system doesn't ask just whether the taxpayer eventually paid the correct amount. It asks whether the taxpayer actually paid the required amount for each of those [00:24:00] installments. Now, technically, the code calls this resulting penalty an addition to tax. So it's actually called multiple things right in the code. In the actual statute it's called an addition to tax on form 2210 and then on form 1040. Page two. It's called a penalty, but it actually operates kind of more like an addition [00:24:30] to tax in some ways, in that it's not subject to abatement, which we'll talk about in a bit.
Jeremy Wells: And it also acts more like interest in that the penalty increases based on the amount of time. And it's actually refactored on a daily basis, just like interest is. So in some ways it's an addition to tax. In some ways it's a penalty. And in some ways it's interest. It's kind of all three at the same time. Now [00:25:00] the penalty is determined by applying the underpayment rate, which is established under IRC 6621, to the amount of the underpayment for the period, it remained unpaid. And because interest rates change during the underpayment period form 2210, which we'll talk about in a minute, has a worksheet that actually divides the computation into separate rate periods. Now, Sam was required to pay $5,000 on each installment [00:25:30] date. He didn't pay anything in April, June, or September. So each of those three dates created a separate $5,000 underpayment, and the eventual penalty or addition to tax is going to be calculated based on each of those underpayments. So when he pays $24,000 on January 15th, the payments applied against the oldest unpaid installment. [00:26:00] First, it satisfies the April underpayment, then the June underpayment and then the September underpayment. And then if there's enough, it satisfies the In January installment on time. So think about what happens. He passes the April 15th deadline with no payments, passes the June 15th deadline with no payments, passes the September 15th deadline with no payments.
Jeremy Wells: Each of those under [00:26:30] payments of separate $5,000 underpayments from each of those periods then, is going unpaid every day past that period's deadline. And then once he makes a payment by January 15th, that payment is actually not first applied to January 15th. It's actually first applied to the underpayment from April 15th, but not until he actually makes the payment in January 15th. [00:27:00] So that payment went unpaid from April 15th to January 15th. And then the June 15th payment went unpaid from June 15th to January 15th, and then the same for the September 15th payment. So for each of those underpayments, and then the length of time that it went unpaid, and then there's going to be a rate and essentially an interest rate for that period that that underpayment [00:27:30] went unpaid. So Sam has those three underpayments and they're each outstanding for a different time. Right? The April underpayment was unpaid from April to January and so on. Now the January payment stops the penalty from continuing to accrue once it's made, once that payment is made. But it doesn't erase the time during which the three installments were unpaid. So that $5,000 payment in January that gets applied to April's [00:28:00] balance due doesn't apply on April 15th, when the payment should have been made. It just gets applied to the April 15th balance due on January 15th. And that's why Sam can wind up having no underlying tax due. Right. The tax liability has been paid in full, but there's still an underpayment penalty.
Jeremy Wells: And in fact, Sam made [00:28:30] a total payment that was in excess of his required annual payment and therefore the sum of his four installment payments. He paid more than that by January 15th, but he still has an underpayment for each of those periods. So now how do we actually wind up with what this penalty is? And this is where form 2210 comes into play. But actually, interestingly enough, [00:29:00] most taxpayers, even when they have an underpayment penalty, they don't actually need to file form 2210. It's kind of an unusual form because owing that penalty doesn't actually require filing the form. So the form has three parts to it and it performs three functions. So the first part determines the required annual payment. So the analysis we did earlier of the 90% of the prior year tax [00:29:30] or the 100 or 110% of the current year tax, depending on AGI. That's all done in part one. Part two identifies any special reason. The form must be filed, and we'll talk about that in a bit. And then part three calculates the underpayment and then the resulting penalty. Now if a taxpayer owes a penalty but none of the boxes in part two applies, then the [00:30:00] taxpayer generally should not prepare an attach form. 2210 in fact, the IRS will calculate the penalty for the taxpayer if it's not included on the return, and then send the taxpayer a notice with a bill for that amount, the taxpayer can calculate the penalty voluntarily and report that on form 1040.
Jeremy Wells: So in that situation, part three can be used as [00:30:30] a worksheet but still form 2210 is not attached. Now what happens in my firm is we automatically calculate the penalty if there is one. We automatically include that in the tax liability. Again this is also an addition to tax. So it's automatically included on page two of the form 1040. And we explain what that amount is and why it's there to the taxpayer. We also include a proforma uh, [00:31:00] copy of the 2210 with the client's copy of the return. Even though it's not going to be part of the e-file, or if we have the paper file, it's not going to be part of the what actually gets transmitted or mailed to IRS. Now, the filing requirements change. If anything in part two is actually included. If there's a box, check there. So box A requests a waiver of the entire penalty. We'll [00:31:30] talk about how a taxpayer can qualify for a waiver later on. Box B requests a waiver of only part of the penalty. Box C uses the annualized income installment method, which we'll talk about. Box D uses the actual dates on which tax was withheld because that might produce a lower penalty. Again, we'll talk about that. And then box E applies when the taxpayer filed jointly for either the current or preceding year, but not both. [00:32:00] And that's the exception we talked about a few minutes before with married couples who changed their filing status.
Jeremy Wells: Now Sam doesn't have a waiver request. The income was earned evenly throughout the year. There's no withholding, and there's no change involving a joint return. So none of the part two boxes apply to Sam. So in this case, Sam doesn't have to prepare and file form 2210. And Sam also doesn't have to include the underpayment penalty in the tax liability that's calculated [00:32:30] on the form 1040. So what actually happened with Sam. Let's look at how that penalty actually gets calculated. And because we're talking about tax year 2025, there was IRS had a 7% underpayment penalty rate throughout the entire year. So the underpayment for April 15th of $5,000 that went 275 days [00:33:00] unpaid, right. Because that was from April 15th through to January 15th when he finally made the payment that got applied to the April 15th underpayment. So the penalty was for that April 15th installment. The penalty is the $5,000 required payment times 275 days divided by 365 days in the year. So we're [00:33:30] taking the portion of the year that that balance due went unpaid, that that that installment due went unpaid. And then we're multiplying that by 7%. So it's $5,000 times 275 days divided by 365 days. And then that amount times 7%. And that gives us approximately $264. So even if Sam had skipped the April payment, made the June, September and then January payments, and then in January [00:34:00] paid the $5,000 that he missed for April, he still would have had that $264 of an underpayment penalty that still would have happened.
Jeremy Wells: Notice how this works? The earlier installments, because they go unpaid for longer, will result in more penalty than the later periods. So if a client has to choose between paying earlier or later in terms of the underpayment penalty [00:34:30] by itself, the preference should always be toward an earlier payment. Pay your April 15th installment and then if you have to for cash flow reasons, skip your June, September and January payments, right? If you have to choose. Now, if they can pay all four, that's great. And if they can pay them on time, that's the best situation as far as the underpayment penalty goes. But we'll talk about later on why that may not always be the best situation for the taxpayer from a financial perspective. Now that [00:35:00] can, depending on how the rounding works totaling for all three periods that had that underpayment. April. $5,000 went 275 days unpaid. June $5,000 went 214 days unpaid. So that results in a $205 penalty. And then September $5,000 122 days unpaid. That results in a penalty of $117. So altogether, the total penalty is [00:35:30] about $586. Depending on the rounding, it might be 583 within a couple dollars of that. Right. So notice what is happening here, right. He didn't incur a flat percentage penalty on the $24,000 tax liability. He didn't even incur a flat liability, a flat penalty on the $20,000 minimum annual payment.
Jeremy Wells: Rather, it is a rolling penalty applied [00:36:00] to each separate installment, right? So the earlier an installment is due, the longer it remains unpaid and the larger its contribution to the penalty. Now, I mentioned earlier, there's no way to go back and apply an estimated payment to an earlier period. And that's true. But you can do that with withholding estimated payments in federal with income tax withholding operate differently [00:36:30] when it comes to the calculation of the underpayment penalty. Now that underpayment tax payment is credited when it's actually paid. So any payment made during the year is credited as being paid by the next upcoming period due date. So if I make a payment on April 10th, that's going to get credited toward my April 15th installment. If I make a payment on April 16th, Assuming [00:37:00] 7503 doesn't apply that that due date actually was April 15th for that payment, but I didn't make it until the next day. Then it's going to apply to the June 15th installment. That's how estimated payments work. But withholding gets a much more favorable treatment. So under section 6654 G, federal income tax withheld during the year at any point is generally divided into four equal amounts [00:37:30] and treated as paid on each installment date, regardless of when the withholding actually occurred. So if I make a $20,000 estimated payment on January 15th, that's going to get credited as $20,000 toward my January 15th installment.
Jeremy Wells: However, if I have $20,000 of withholding and all of that gets paid in by January 15th, I'm going to get credited with $5,000 of withholding. On April [00:38:00] 15th, June 15th, September 15th, and January 15th, withholding gets split up evenly, right? So let's think about how we could use this to benefit a taxpayer, especially one who is a shareholder employee of an S corporation. Now, a shareholder employee of an S corporation is going to have both wages and the pass through income from that's corporation coming on the K-1. Now, normally what you would think [00:38:30] to do with an S corporation shareholder employee in this case is have them have withholding that's calculated by payroll on the wages and then the net profit, right. The taxable income that's going to pass through on the K-1. Have them make estimated payments to cover the tax from that amount on the K-1. But what that shareholder employee could do instead is apply more of the wages toward withholding, [00:39:00] and then either not make estimated payments or make smaller estimated payments and have the withholding cover, not just the tax from the wages, but also some or maybe even all of the tax from the income passing through on the K one. How does this help the taxpayer? Well, if they haven't made estimated payments all year, then you're probably going to have some periods with an underpayment, [00:39:30] which means an underpayment penalty. Even if they make a big estimated payment late in the year.
Jeremy Wells: However, if instead you run that same amount through payroll and apply it toward withholding, then that will get evenly applied to all of those installment periods and could mitigate, if not completely eliminate, any underpayment for those periods. Now the the [00:40:00] counter there is that if you do this with additional payroll, then the taxpayer is going to pay payroll tax on that additional amount of wages paid, which that's probably going to cost more than the underpayment penalty would have. However, if the shareholder employee needed to run those wages anyway in order to reach reasonable compensation or to make a retirement plan contribution or for [00:40:30] whatever reason, then it might be better off to go ahead and apply those wages toward withholding anyway, and then use distributions to shore up the difference in cash flow throughout the year. So that's one way that you can help an S corporation shareholder employee mitigate the underpayment penalty without Significantly causing problems for cash flow. Now, that said, this is not permission to manufacture [00:41:00] or backdate payroll. We should not be going in after the end of the year and modifying or even amending payroll tax returns for what's already been filed. So I wouldn't do this once we're already past, say, January 15th. But if we can do this through a combination of tax projections and planning and advisory that's happening, say, just prior to the holidays, maybe say, in October or even early [00:41:30] November, where we've still got plenty of time before the actual end of the year to run 1 or 2 additional payrolls? Well, then that's absolutely fine, right? To run some additional wages, apply some or all of those additional payrolls to withholding, and then that could generate a better outcome for the taxpayer.
Jeremy Wells: Now, a prior year overpayment that gets applied as [00:42:00] a as a refund that gets applied as an estimated payment to the current year sometimes counts as an April 15th estimated payment, but not necessarily so a prior year overpayment applied to the current year. So in lieu of getting a cash refund, the client instead applies that overpayment as an estimated payment to the current year is generally treated as paid on April [00:42:30] 15th. So it covers that first installment period. But if the overpayment was created by a payment made after April 15th, then it's treated as paid on the later date. So let's say on April 15th, I have a balance due of, say, $10,000. So on May 1st, I pay $20,000 because I didn't know yet. Maybe my return wasn't [00:43:00] prepared yet and I didn't know how much to pay. So I paid $20,000. And then my return gets prepared later in the year. And I find out that my, my, my balance due was actually $10,000. So I've got a $10,000 overpayment. Well, I just made that estimated payment. I don't want to turn around and get the cash right back. And I know I was supposed to make estimated payments for the current year.
Jeremy Wells: So let's just apply that $10,000 overpayment as a payment toward my current year estimated payment. [00:43:30] Now, even though it's an overpayment and it's getting applied as an estimated payment, I didn't make the payment until May 1st, so it doesn't get applied to my April 15th installment. Instead, it gets applied to the next installment, due date, which is June 15th, so I still would not have made my April 15th installment if I didn't make any estimated payments prior to then, right? So that can have an effect on when [00:44:00] the liability is, uh, actually when the underpayment for that installment is actually due and when the payment is actually applied to it. Right. So whenever you're looking at applying a prior year overpayment, verify when the overpayment actually arose, especially if that return was filed after April 15th. Right. Then it may not have been made by April 15th. And so it wouldn't apply [00:44:30] to the April 15th installment. It's an important review point, especially when you're relying on the software to apply that overpayment. Late year income doesn't necessarily have to create an early year underpayment. And this is where we get into the annual installment method. So remember, there are four periods January through March, April and May, June, July, August and then September, October, November, December. [00:45:00] So those four periods, what the annual installment method lets us do is in a situation where we have a significant amount of income coming later in the year, that income would normally get spread out evenly across all four installments.
Jeremy Wells: And therefore we might have an underpayment in those periods, even though we spent most of the year not expecting or knowing that we were going to get that income or how much [00:45:30] it would be. So what the annual installment approach does is it lets us recalculate the underpayment based on the timing of when we got that income. So for this we need actual records of when income was earned. So we're going to look at the income that was earned through the end of March. And that's going to determine the required payment by April 15th. [00:46:00] Then we're going to look at the amount of income earned January through May, and that the amount of that required payment, minus the amount of the required payment by April 15th. That would give us the required payment by June 15th and so on. So notice what happens if we don't have much income relative to our annual total up through, let's say, August? Then [00:46:30] for those three periods we won't have much income, therefore we won't have much underpayment. And then if the bulk of our income comes later in the year, it's going to push more of that income and therefore more of the required installment into those later periods. And we want that because the longer an underpayment goes for. In other words, the earlier in the year that underpayment is generated, the higher the penalty.
Jeremy Wells: So what could cause this [00:47:00] to happen? So for example, a late year capital gain. We sell some property some capital asset late in the year. Seasonal business income. If you have a business that gets most of its income in quarter three or quarter four, such as something related to the holidays or the weather, then most of that income might come in late in the year, a large year end retirement distribution, and then other income that's concentrated in one period. So if you've got a taxpayer that has [00:47:30] that sort of lumpy income throughout the year where it's not evenly earned, it might be worth considering whether the annualized amount versus the required installment for those periods, depending on the income earned in that period. Makes sense. But now keep in mind, we're talking about penalties that are usually on the order of a few hundred, maybe, maybe a couple thousand dollars. If it's [00:48:00] taking you a substantial amount of time to recalculate the income because you're chasing the client for information, you're doing these complex calculations, it may not be worth the tax savings compared to what you might wind up charging the client to do those calculations. Or even if it's already baked into your fee, you might be doing a significant amount of calculations to save the taxpayer a marginal amount of [00:48:30] money, especially if that client did not engage you for tax preparation, tax planning, or tax projections in the prior year.
Jeremy Wells: It may not be worth doing that work for them now. There is an opportunity to mitigate some of the penalty by filing early, so no penalty applies to the fourth installment, only the fourth installment. The other three penalties aren't affected by this, but no penalty applies [00:49:00] to the fourth installment. If the taxpayer files the return by January 31st and pays the amount shown as due in full by January 31st or under section 7503 the next business day. Now the earlier installment penalty is remain. This, practically, though in today's world, is unlikely because most taxpayers are not going to have all their information by January 31st. Now farmers and fishers play [00:49:30] by different rules. They only have one installment required. The current year threshold drops from 90% to 66 and two thirds percent, and then filing and paying by March 1st can eliminate the penalty. So for 2025 returns, the filing and payment deadline was March 2nd, 2026. For that one installment, I mentioned penalty relief, general reasonable cause abatement, first time abatement, [00:50:00] and the new automatic exemption from penalty do not apply to the section 6654 underpayment penalty or addition to tax, so relief is limited to the following. A postponed deadline for a federally declared disaster or a statutory waiver under section 6654 E three. Now, a waiver is available only when the taxpayer meets either of the following either [00:50:30] a casualty disaster or other unusual circumstance that makes the imposition of the penalty Inequitable or the taxpayer retired after age 62 or became disabled, and the underpayment resulted from reasonable calls rather than willful neglect.
Jeremy Wells: Now, both of those are going to be relatively high bars for a taxpayer to actually meet. And in the case of Sam that we've been talking about, neither of these is going to apply. Now, [00:51:00] the principal procedural rule here is that the addition is generally outside deficiency procedures. When a return was filed, written supervisory approval is not required for the penalty. And then the IRS bears the burden of production in a court proceeding involving an individual. So if you are dealing with deficiency or collection [00:51:30] due process or tax court situations, then those issues might come up. But in general, um, not going to be, uh, necessarily important for a lot of taxpayers, a lot of our taxpayers, they're just going to have the penalty imposed and need to pay it. Now a tax projection can help mitigate next year's penalty. So this is a little bit of practice management advice. If you're not already offering and providing tax projections to clients, especially self-employed [00:52:00] clients who need the benefit of avoiding, uh, the underpayment penalty by making estimated payments, then a projection could be a good service to offer them. If you have a taxpayer who is regularly paying more than 500, even more than $1,000 in underpayment penalties each year, then selling that client a three, 4 or $500 tax projection might [00:52:30] be worth it to that taxpayer.
Jeremy Wells: So what would that projection look like? Well, first of all, you would forecast the current year tax based on whatever information they have available up to the point, probably looking at the bookkeeping records, if they're decent enough to use, calculate both the safe harbor amounts, right? You can always use the 110% of last year's balance due. Now I'm using the higher amount. Even if they're not above the AGI threshold, it might still make sense to use the higher amount [00:53:00] and be more cautious about that. So 110% of the prior year liability, or at minimum 100% of the prior year liability, and then reconcile the payments and the withholding already made, recommend the amount, method and timing of the additional payments, and then update the projection whenever the facts change. So if they actually make a payment or if they report more income or less income than expected, update that projection. Now again, that should be a separately scoped [00:53:30] paid service or it should be listed as a separate job in your workflow. Should not be additional work that's just baked into the normal return preparation fee if that's how you're charging in your firm. Okay, so a few key takeaways from this episode. Now, in general, a lot of clients, even self-employed ones when they have this penalty, like I've mentioned before, it can be relatively small, depending on if they've made any estimated [00:54:00] payments and what their actual tax liabilities are. I routinely see underpayment penalties from taxpayers who just choose not to make estimated payments of a couple hundred bucks, and to them managing the cash flow throughout the year and having that cash instead of paying it to IRS, makes more sense to them than paying it to IRS and waiting a full year to know if they paid in enough or not.
Jeremy Wells: They can make more money off of keeping [00:54:30] their money and paying a little bit of underpayment penalty to the IRS. Now, I don't necessarily agree with that position, but it's not my position to take. It's the taxpayers. So let's look at some key takeaways here. First of all, calculate the required annual payment using both safe harbors and compare them. The smaller one is the one that's actually going to determine whether or not there is a penalty. When it comes to projections and tax planning later in the year. Do whatever you can [00:55:00] to convince your taxpayers to, if they want to avoid penalties. If they want to not pay more tax than they absolutely have to, to pay in at least up to the smaller of the safe harbors, pay the required amount by each installment date. Make sure they understand that if they skip the first 2 or 3 installment due dates, even if they make a bigger payment later on, it may not completely eliminate the penalty check, [00:55:30] the withholding allocation and annualization before accepting the penalty again. That schedule AI might generate a lower penalty. On the other hand, even if it generates a lower penalty, it may not be a substantial enough difference to be worth the additional time and effort to actually calculate it.
Jeremy Wells: Don't expect any kind of ordinary reasonable cause relief getting this penalty, this addition to tax reversed [00:56:00] or abated. There's a very high bar for that, and it's almost impossible and generally not even worth the effort trying to do that unless there are some serious extenuating circumstances involving that taxpayer. And then finally use tax projections, right, to prevent this problem from even occurring in the first place. Combine the safe harbors with the prior year tax return with projections during the current year to try [00:56:30] to mitigate as much of the penalty as possible. I've said it a couple times now. It's a relatively small penalty. It's usually not as much as the failure to pay or especially failure to file penalties, but it is an addition to tax. It's more federal tax than the taxpayer absolutely has to pay. So it might be worth paying a little bit more throughout the year in order to reduce or even eliminate it. If you found value in this episode, please let me know by liking [00:57:00] and leaving a comment in your podcast application or, uh, podcast application of choice or on YouTube. So for the next episode, we're going to look at what happens when a client's loan goes bad and how to determine the tax implication of the resulting loss or forgiveness.