After determining their tax liabilities, taxpayers must file a tax return and pay any additional tax due or receive a refund. When they don’t pay enough taxes during the year or are late filing their tax return or paying their taxes due, they may be subject to certain penalties.
Prepayments
The income tax must be paid on a pay-as-you-go basis. This means it must be prepaid via withholding from salary or through periodic estimated tax payments during the tax year. Employees pay tax through withholding, and self-employed taxpayers generally pay taxes through estimated tax payments. Employers are required to withhold taxes from an employee’s wages based upon the employee’s marital status, exemptions, and estimated annual pay. Wages include both cash and noncash remuneration for services, and employ- ers remit withholdings to the government on behalf of employees. At the end of the year, employers report the amounts withheld to each employee via Form W-2. Estimated tax payments are required of employees only if withholdings are insufficient to meet the tax- payer’s tax liability. For calendar-year taxpayers, estimated tax payments are due on April 15, June 15, and September 15 of the current year and January 15 of the following year. If the due date falls on a Saturday, Sunday, or holiday, it is automatically extended to the next day that is not a Saturday, Sunday, or holiday.
LO 8-5
Courtney’s gross tax liability for the year, including federal income tax, alternative minimum tax, and self-employment taxes is $28,134 (see Exhibit 8-6), and her net tax liability is $25,634 after the $2,500 child tax credit (see Example 8-17). However, because she had only $21,634 withheld from her pay- check by EWD (per her Form W-2 received from her employer), she underpaid $4,000 for the year ($25,634 – $21,634). Because Courtney did not pay her full tax liability, she may be subject to un- derpayment penalties discussed below. If she had been aware that her withholding would be insuffi- cient, she could have increased her withholding at any time during the year (even in her December paycheck) or made estimated tax payments of $1,000 on April 17, June 15, and September 17 in 2018 and January 15, 2019 ($4,000/4).
What if: If Courtney were self-employed (instead of employed by EWD) and thus had no tax withhold- ings by an employer, she would be required to pay quarterly estimated tax payments. In this scenario, she would need to pay $6,408.50 ($25,634/4 = $6,408.50) by April 17, June 15, and September 17 of 2018 and $6,408.50 by January 15, 2019, to cover her gross tax liability of $25,634.
Example 8-24
What if: As we describe in Example 8-2, Gram’s gross tax liability is $199. For illustrative purposes, let’s assume Gram is entitled to an $800 nonrefundable personal tax credit, a $700 business tax credit, and a $600 refundable personal tax credit. What is the amount of Gram’s refund or taxes due?
Answer: $600 refund. Gram would apply these credits as follows:
Description Amount Treatment of Excess Credit Gross tax liability $ 199 Example 8-2
Nonrefundable personal credits (199) $601 ($800 − $199) excess credit expires unused Business credits 0 $700 carried back one year or forward 20 years
(10 years for foreign tax credit) Refundable personal credits (600) Generates $600 tax refund to Gram
Example 8-23
Underpayment Penalties When taxpayers like Courtney fall behind on their tax prepayments, they may be subject to an underpayment penalty.39 Taxpayers with unpre- dictable income streams may be particularly susceptible to this penalty because it is dif- ficult for them to accurately estimate their tax liability for the year. To help taxpayers who may not be able to predict their earnings for the year and to provide some margin of error for those who can, the tax laws provide some safe-harbor provisions. Under these provi- sions taxpayers can avoid underpayment penalties if their withholdings and estimated tax payments equal or exceed one of the following two safe harbors: (1) 90 percent of their current tax liability or (2) 100 percent of their previous-year tax liability (110 percent for individuals with AGI greater than $150,000).
These two safe harbors determine on a quarterly basis the minimum tax prepayments that a taxpayer must have made to avoid the underpayment penalty. The first safe harbor re- quires that a taxpayer must have paid at least 22.5 percent (90 percent/4 = 22.5 percent) of the current-year liability via withholdings or estimated tax payments by April 15 to avoid the underpayment penalty for the first quarter. Similarly by June 15, September 15, and January 15, the taxpayer must have paid 45 percent (22.5 percent × 2), 67.5 percent (22.5 percent × 3), and 90 percent (22.5 percent × 4), respectively, of the current-year liability via withholding or estimated tax payments to avoid the underpayment penalty in the second, third, and fourth quarters.40 In determining taxpayers’ prepayments for a quarter, tax withholdings are gener- ally treated as though they are withheld evenly throughout the year. In contrast, estimated tax payments are credited to the taxpayer’s account when they are remitted.
39§6654.
40As an alternative method of estimating safe harbor, (1) taxpayers can compute 90 percent of the current liability using the seasonal method. This method allows taxpayers to estimate 90 percent of their current tax liability by annualizing their taxable income earned through the month prior to the payment date (e.g., through March for April 15, May for June 15, and August for September 15). Taxpayers with uneven taxable income throughout the year with smaller taxable income earlier in the year benefit from this method.
Example 8-25
Because all Courtney’s prepayments were made through withholding by EWD, the payments are treated as though they were made evenly throughout the year. What are Courtney’s actual and re- quired withholdings under the 90 percent safe-harbor provision throughout the year?
Answer: See the following table:
(1) (2) (1) − (2)
Dates Actual Withholding Required Withholding Over- (Under-) Withheld
April 17, 2018 $5,409 $5,768 $(359)
($21,634 × .25) ($25,634 × .9 × .25)
June 15, 2018 $10,817 $11,535 (718)
($21,634 × .50) ($25,634 × .9 × .50)
September 17, 2018 $16,226 $17,303 (1,077)
($21,634 × .75) ($25,634 × .9 × .75)
January 15, 2019 $21,634 $23,071 (1,437)
($25,634 × .9 × 1)
It looks like Courtney is underwithheld in each quarter.
The second safe harbor requires that by April 15, June 15, September 15, and January 15, the taxpayer must have paid 25 percent, 50 percent (25 percent × 2), 75 percent (25 per- cent × 3), and 100 percent (25 percent × 4), respectively, of the previous-year tax liability (110 percent of the previous-year tax liability for individuals with AGI greater than
$150,000), via withholding or estimated tax payments, to avoid the underpayment pen- alty in the first, second, third, and fourth quarters.
A taxpayer who does not satisfy either of the safe-harbor provisions can compute the underpayment penalty owed using Form 2210. The underpayment penalty is determined by multiplying the federal short-term interest rate plus 3 percentage points by the amount of tax underpayment per quarter. For purposes of this computation, the quarterly tax underpayment is the difference between the taxpayer’s quarterly withholding and es- timated tax payments and the required minimum tax payment under the first or second safe harbor (whichever is less). If the taxpayer does not complete Form 2210 and remit the underpayment penalty with the taxpayer’s tax return, the IRS will compute and assess the penalty for the taxpayer.
In the previous example, we discovered that Courtney was underwithheld in each quarter based on the first (90 percent of current year) safe-harbor provision. Assuming Courtney was underwith- held by even more under the second (100 percent of prior year) safe-harbor provision, she is re- quired to pay an underpayment penalty based on the underpayments determined using the first safe-harbor provision. Assuming the federal short-term rate is 5 percent, what is Courtney’s under- payment penalty for 2018?
Answer: $72, computed as follows:
First Second Third Fourth Description Quarter Quarter Quarter Quarter
Underpayment $359 $718 $1,077 $1,437
Times: Federal rate + 3% (5% + 3%) × 8% × 8% × 8% × 8%
$ 29 $ 57 $ 86 $ 115
Times one quarter of a year41 × 25% × 25% × 25% × 25%
Underpayment penalty per quarter $ 7 $ 14 $ 22 $ 29
That’s a lot of work to figure out a $72 penalty: (7 + 14 + 22 + 29)
Example 8-26
As a matter of administrative convenience, taxpayers are not subject to underpay- ment penalties if they had no tax liability in the previous year, or if their tax payable is less than $1,000 after subtracting their withholding amounts (but not estimated payments).
Gram’s tax liability for the year is $199 (Example 8-2), but she did not have any taxes withheld during the year, and she did not make any estimated tax payments. What is Gram’s underpayment penalty?
Answer: $0. Because Gram’s $199 tax payable after subtracting her withholding amounts ($199 tax – $0 withholding) is less than $1,000, she is not subject to an underpayment penalty.
Example 8-27
Filing Requirements
Individual taxpayers are required to file a tax return only if their gross income exceeds certain thresholds, which vary based on the taxpayer’s filing status and age. However, a taxpayer may prefer to file a tax return even when she is not required to do so. For example, a taxpayer with gross income less than the threshold may want to file a tax
41Form 2210 actually computes the penalty per quarter based on the number of days in the quarter divided by the number of days in the year. For simplicity, we assume this ratio is per quarter.
THE KEY FACTS Taxpayer Prepayments
and Underpayment Penalties
• Taxpayers prepay their tax via withholding from salary or through periodic esti- mated tax payments during the tax year.
• Estimated tax payments are required only if withholdings are insufficient to meet the taxpayer’s tax liability.
• For calendar-year taxpay- ers, estimated tax payments are due on April 15, June 15, and September 15 of the current year and Janu- ary 15 of the following year.
• Taxpayers can avoid an un- derpayment penalty if their withholdings and estimated tax payments equal or ex- ceed one of two safe harbors.
• The underpayment penalty is determined by multiply- ing the federal short-term interest rate plus 3 percent- age points by the amount of tax underpayment per quarter.
42§6012. Filing requirements for individuals who are dependents of other taxpayers are subject to special rules that consider the individual’s unearned income, earned income, and gross income. See IRS Publication 17,
“Your Federal Income Tax.”
43§6651.
44§6651. As we discussed in the Tax Compliance, the IRS, and Tax Authorities chapter, the tax law also assesses interest on any tax underpayments until the tax is paid (§6601).
return to receive a refund of income taxes withheld. In general, the thresholds are simply the applicable standard deduction amount for the different filing statuses.42 With the increased standard deduction amounts in 2018, fewer taxpayers are now required to file.
Individual tax returns are due on April 15 for calendar-year individuals (the fifteenth day of the fourth month following year-end). If the due date falls on a Saturday, Sunday, or holiday, it is automatically extended to the next day that is not a Saturday, Sunday, or holiday. Taxpayers unable to file a tax return by the original due date can request (by that same deadline) a six-month extension to file, which is granted automatically by the IRS.
The extension gives the taxpayer additional time to file the tax return, but it does not ex- tend the due date for paying the tax.
Late Filing Penalty The tax law imposes a late filing penalty on taxpayers who do not file a tax return by the required date (the original due date plus extension).43 The penalty equals 5 percent of the amount of tax owed for each month (or fraction of a month) that the tax return is late, with a maximum penalty of 25 percent. For fraudulent failure to file, the penalty is 15 percent of the amount of tax owed per month with a maxi- mum penalty of 75 percent. If the taxpayer owes no tax as of the due date of the tax return (plus extension), the tax law does not impose a late filing penalty.
Late Payment Penalty An extension allows the taxpayer to delay filing a tax return but does not extend the due date for tax payments. If a taxpayer fails to pay the entire bal- ance of tax owed by the original due date of the tax return, the tax law imposes a late payment penalty from the due date of the return until the taxpayer pays the tax.44 The late payment penalty equals .5 percent of the amount of tax owed for each month (or frac- tion of a month) that the tax is not paid.
The combined maximum penalty that may be imposed for late payment and late filing (nonfraudulent) is 5 percent per month (25 percent in total). For late payment and filing due to fraud, the combined maximum penalty for late payment and late filing is 15 percent per month (75 percent in total).
Example 8-28
Courtney filed her tax return on April 10 and included a check with the return for $4,072 made pay- able to the United States Treasury. The $4,072 consisted of her underpaid tax liability of $4,000 (Example 8-24) and her $72 underpayment penalty (Example 8-26).
What if: If Courtney had waited until May 1 to file her return and pay her taxes, what late filing and late payment penalties would she owe?
Answer: Her combined late filing penalty and late payment penalty would be $200 ($4,000 late payment × 5 percent × 1 month or portion thereof—the combined penalty is limited to 5 percent per month).