As a professional tax preparer, you understand that estimated tax penalties can be a headache for both you and your clients. In this article, we’ll cover the ins and outs of estimated tax penalties and most importantly, strategies to protect your clients from underpayment penalties.
What is an estimated tax penalty?
Estimated tax penalties are fees imposed on taxpayers for underpayment throughout the year. Since traditional W-2 employees usually have taxes automatically withheld from their paychecks, they do not need to make estimated tax payments unless they have other sources of income not subject to withholding. Instead, these penalties typically affect self-employed individuals, small business owners, and anyone with significant income from sources like interest, dividends, alimony, or capital gains.
How much is the penalty for not paying estimated taxes?
The estimated tax penalty is calculated based on the amount that was underpaid, when the payment was due, and the current interest rates set by the IRS. The IRS sets the interest rate every quarter, and as of 2023, the rate is 7% for Q1 – Q3, and 8% for Q4. Interest rates compound daily for late payments, so if your client misses a payment deadline, it’s essential that they pay the amount in full as soon as possible to minimize the penalty.
Four strategies to protect your clients from estimated tax penalties
Accurate record keeping
You can’t calculate estimated tax payments without first knowing your client’s income. Encourage your clients to maintain accurate records of all their income and expenses throughout the year. If you offer bookkeeping or financial planning services, this is a great opportunity to pitch these services to your clients.
Regular estimations
Based on your client’s records, you can calculate their estimated withholding percentage using the Estimates Calculator included in your TaxSlayer Pro software. This can prevent underpayment and, in turn, estimated tax penalties.
Note that the Estimates Calculator does not account for the Qualified Business Income Deduction (QBID). If your client qualifies for this deduction, you’ll need to calculate it separately and deduct the amount from their estimated tax payments.
Take advantage of safe harbor rules
Calculating estimated tax payments can be tricky, so fortunately the IRS offers safe harbor rules that protect taxpayers from estimated tax penalties. Even if your client has not paid their full tax liability through their quarterly tax payments, they will usually not be penalized if:
- They paid at least 90% of their tax liability
- They paid more than or equal to 100% of the previous year’s tax liability
- They owe less than $1,000 in taxes
Make quarterly estimated payments
With your client’s estimated tax payments calculated, the last step is to submit payments to the IRS each quarter. Payment due dates for Q1-Q4 are typically April 15, June 15, September 15, and January 15 of the following year, respectively.
While the IRS still accepts payments by mail, the IRS encourages all individuals and businesses to use the Electronic Federal Tax Payment System (EFTPS) to pay quarterly taxes.
How to dispute a penalty
Despite your best efforts, your client might still face an estimated tax penalty. In such cases, you can guide them through the process of attempting to remove, reduce, or dispute the penalty. If they have a valid reason for the underpayment, such as significant financial hardship or natural disasters, they can file IRS Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts. For clients whose income varies throughout the year, you can file Form 2210, Schedule AI, Annualized Income Installment Method.
If the underpayment was a result of incorrect written advice directly from the IRS, you can help your client dispute the penalty altogether by sending in a letter explaining why the advice was incorrect and how it contributed to the underpayment.
How to avoid a penalty
The best way to avoid a penalty for the underpayment of estimated taxes is to plan ahead, keep accurate records of income and expenses, and make estimated tax payments each quarter before the due date. When in doubt, take advantage of the safe harbor rules mentioned above and make sure that your client has paid at least 100% (or 110% for some high-income clients) of the previous year’s tax liability to avoid a penalty.
If your client’s tax situation is complex, encourage your clients to stay up to take advantage of bookkeeping or accounting services that will help them stay organized and maintain accurate records.
Conclusion
Estimated tax penalties are entirely avoidable with careful planning and accurate record-keeping. As a professional tax preparer, you can demystify estimated tax payments for your clients and help them protect their hard-earned money from IRS penalties and interest.
