Taxpayers must pay their taxes throughout the year either through payroll withholding or by making quarterly estimated payments; otherwise, tax underpayment penalties are assessed. However, underpayment penalties are avoided if any of the following situations apply:
Small balance due after federal income tax withholding: The tax, after reducing it for federal income tax withheld, is less than $1,000 (Sec. 6654(e)(1)).
No prior-year tax liability: The taxpayer had no tax liability for the prior tax year, was a U.S. citizen or resident for that entire year, and the prior-year return, if the taxpayer was required to file one, was for a full 12 months (Sec. 6654(e)(2)).
Exception 1--using prior-year tax: For installment payments made for 2017, a taxpayer with 2016 adjusted gross income (AGI) greater than $150,000 ($75,000 if married filing separately (MFS)) paid through withholding and/or timely estimates an amount equal to 110% of the prior-year (2016) tax liability (Sec. 6654(d)(l)(C)(i)). For taxpayers with 2016 AGI of $150,000 ($75,000 if MFS) or less, the safe harbor is 100% of the 2016 tax. The taxpayer must have filed a prior-year return for a full 12-month tax year showing a tax liability. A late-filed return does not preclude a taxpayer from taking advantage of this exception; payments may be based on the tax indicated on a late-filed prior-year return (Rev. Rul. 2003-23).
Exception 2-90% of current-year tax: The taxpayer paid through withholding and/or timely estimates an amount equal to 90% of the current-year tax (Sec. 6654(d)(l)(B)(i)).
Exception 3--annualization method: The taxpayer paid through withholding and/or timely estimates an amount equal to 90% of the current-year tax computed based on annualization of actual year-to-date income for each quarter of the year (Sec. 6654(d)(2)).
Taxpayers who want to maximize their cash flow should make payments at a rate no greater than required to avoid underpayment penalties. Using the various exceptions in the most tax-efficient manner helps meet this goal. In some cases, this involves using a combination of the allowable exceptions.
Note: Planning strategies that minimize the amount of estimated payments made throughout the tax year are generally done in anticipation of each required payment. However, these strategies may also help reduce or eliminate underpayment penalties in after-the-fact situations when a taxpayer faces the possibility of being assessed penalties. Also, when a taxpayer fails to meet any of the safe-harbor exceptions, the underpayment penalty is computed based on the least amount of tax that would have applied under the exceptions.
Minimizing quarterly payments by alternating safe-harbor exceptions
A taxpayer is not required to use the same safe-harbor exception for each quarterly payment. Instead, a taxpayer can use whichever exception produces the smallest required installment for that quarter (Secs. 6654(d)(1)(B) and (d)(2)(A)). Thus, taxpayers can alternate between safe harbors and still avoid underpayment penalties. However, they must recapture (i.e., pay back) any savings from the prior periods the annualization method was used (Sec. 6654(d)(2)(A)(ii)). Therefore, any reduction in an estimated tax payment resulting from the use of the annualization method must be added to the next estimated payment (if any) not based on annualization.
The ability to use different exceptions is particularly beneficial...