UNDERPAYMENT OF TAX PENALTY - HOW TO AVOID IT

Many taxpayers receive their tax returns from their CPA and find that, not only do they end up owing Federal tax, but they also have to pay an "underpayment of tax penalty." The rules surrounding underpayment penalties may seem complex, but with a little planning, taxpayers can avoid such a penalty.

The IRS not only requires individuals to pay tax, but it also insists that they pay it in during the year. Most taxpayers would like to wait as long as possible before paying taxes, say until April 15th of the following year. Although this option is available to taxpayers, they will likely be charged an underpayment penalty for doing so. Think of it as an interest charge for late payment. For the first quarter of 2008, the underpayment rate is 7%; for the second quarter, it is 6%.

One of the problems many taxpayers face is that they are not certain of their income until the end of the year. A taxpayer may receive a large bonus check in December, the partnership may have performed better than expected in the final two months of the year, or the broker may have sold some of the stock portfolio because the profits were too good to pass up.

The IRS has some "safe harbors" which, if met, will help taxpayers avoid the underpayment penalty. For 2008, taxpayers will be subject to an underpayment penalty unless total withholding and estimated payments equal the smaller of: 1) 90% of the tax shown on their 2008 return or, 2) 100% of the tax shown on their 2007 return (110% if 2007 adjusted gross income was over $150,000, ($75,000 for married filing separate)). Again, unless a taxpayer has a good idea of what their 2008 income will be, it may be best to use the second option (100% or 110% of 2007 tax).

The IRS requires that taxes be paid through withholding or through quarterly estimated payments. If a taxpayer uses the estimated payment method, quarterly payments are due on April 15th, June 15th, September 15th, and January 15th of the following year. (If the due date falls on a Saturday or Sunday, taxpayers will have until the following Monday to make the payment.)

The IRS considers withholding as being paid evenly throughout the year. If a taxpayer is an employee, he or she could conceivably have less withholding in the early part of the year, make it up in the latter part of the year, and not be penalized. Cash flows could present problems in this scenario, but there would be no need to worry about an underpayment penalty. In addition, with proper planning, withholding on bonuses could be used to mitigate underpayment consequences.

If a taxpayer is making estimated payments using the installment method, equal payments must be made each quarter. An overpayment made with the June voucher will not make up for a shortfall in the April payment. Unfortunately, the taxpayer will be charged a penalty for the period of time the shortfall existed. However if the taxpayer's income is not earned evenly throughout the year, unequal payments may be permitted. Taxpayers who do not earn their income pro-rata throughout the year may be able to take advantage of the "annualization" rules. The Source will discuss the annualization process in a future article.

Ms. Rulkiewicz may be reached at eruk@rubino.com. For more information about Rubino & McGeehin, please visit http://www.rubino.com/.