Generally, if someone is an employee of a company, the withholding that is taken out of their paycheck should cover the tax liability at the end of the year. If a person is self employed, this is not the case and estimated payments much be made each quarter. This is generally called a declaration of estimated tax for which the taxpayer indicated their intent to make estimated payments.
Understanding an Underpayment
If the total amount of tax paid through withholding and estimated tax payments is not enough, an underpayment penalty will be imposed. The underpayment is calculated on a quarterly basis by the IRS and the interest penalty is then applied to these quarterly underpayments. The charge runs until the amount is paid or until the due date of the return, whichever comes first.
Avoiding a Penalty
An individual taxpayer can avoid the penalty for underpayment if the payments if estimated tax are at least as large as any one of the following:
1. 90 percent of the tax shown on the return or 100 percent of the tax shown on the return for the preceding taxable year.
2. An amount equal to 90 percent of the tax of the taxable year computed by annualizing the taxable income
received for the months in the taxable year ending before the month in which the installment is required to be paid.
The underpayment penalty can be waived if the underpayment is due to casualty, disaster, or other unusual circumstances in which the taxpayer has been subject to. It can also be waived if it has occurred during the first two years after a taxpayer retired after reaching the age of 62, or they have become disabled.
A penalty is imposed on corporations for any underpayment of estimated corporate tax. However no penalty is imposed if the corporation pays estimated tax at least as large as any of the following:
1. The tax shown on the return of the corporation for the preceding year.
2. The tax based on the prior year’s income by determined under the current year’s rates.
3. The tax shown on the return of the corporation of the current year.
4. An amount equal to at least 100 percent of the tax due on the current year’s taxable income for specified cutoff periods and on an annualized basis.
It should be noted that large corporation do not qualify for #1 and #2 of the points listed above.