By Bob Parrish CPA (C) Copyright
¶3330.100 Client Letter
Estimated Tax Requirements for Individuals
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Dear Individual Client:
This letter is in response to your request for
general information concerning your obligation to pay estimated federal income tax.
As you know, you are required to prepay your income and employment taxes (collectively,
"tax") during the course of the taxable year as your income is earned. To the
extent taxes withheld from your income are not sufficient for this purpose, estimated tax
payments must be made. Accordingly, if your income is substantially from wages, you may
not be required to make estimated tax payments. On the other hand, it is likely you will
have to pay estimated tax if you have significant self-employment or investment income.
When required, estimated tax payments are due on April 15, June 15, September 15 of the
taxable year, and January 15 of the following year. If a due date falls on a Saturday,
Sunday, or legal holiday, the payment date is extended to the next business day.
The amount of any required installment of estimated tax is the smallest amount determined
under three alternative methods. Under the first method, the amount of any required
installment is equal to 22.5% of the tax shown on your tax return for the current taxable
year. The payment under the second method is 25% of the tax shown on you return for the
immediately preceding year (this percentage changes each year through 2002 if your
adjusted gross income on such prior year's return was more than $150,000 ($75,000 if you
were married and filed separate return)). The second alternative, however, cannot be used
if you did not file a return for the prior taxable year. In addition, the amount of any
installment computed under either of the two alternatives described above must be
increased by any saving realized by using the third method to compute any previous
estimated tax installment for the taxable year (to the extent not previously recaptured).
If your income fluctuates during the taxable year, you may be able to reduce the amount of
a required estimated tax payment by using the third alternative. Under this method, the
amount of an installment payment is equal to the excess of 22.5% of the tax based on
annualizing your income for the months in the taxable year preceding the due date for the
installment multiplied by the installment number, over the aggregate amount of any prior
required estimated tax payments for the taxable year.
In each case, the tax is computed without regard to the credit for taxes withheld at the
source. Rather, such amounts are treated as payments of estimated tax.
Special rules apply in various situations, including with respect to farmers and
fishermen, nonresident aliens, and short taxable years.
Failure to timely make any required payment of estimated tax will subject you to penalty.
The amount of the penalty is equal to the product of the amount of the underpayment, the
period of the underpayment (but not beyond the due date of the return for the taxable year
(without extension), when interest on any underpayment of tax would begin to run), and the
interest rate on underpayments.
Notwithstanding the foregoing, no estimated tax payment is required with respect to a
taxable year if your tax for the taxable year, after subtracting credits and taxes
withheld, does not exceed $1,000. In addition, you do not have to pay estimated tax if you
had no tax liability for the prior taxable year, the prior taxable year covered a 12-month
period and you were a U.S. citizen or resident for the entire year. Although there is an
additional exception where it would be "against equity and good concience" to
impose the penalty or when you retire or become disabled, that should not be used as a
planning device to compute your required payments.
For your convenience, I have enclosed a flowchart relating to when estimated tax has to be
paid, an example showing some of the estimated tax computations and a worksheet which can
be used to compute the amount of any required payment.
Please feel free to call me if you have any questions or comments with respect to any of
the foregoing. When we get closer to April (and the first estimated tax installment
payment date), we should meet to discuss the particulars of your situation in greater
detail.
Sincerely,
Double click to view the following graphic illustration:
"Estimated Tax Flowchart for Individuals"
Individual Example
For 1996, A, a single individual, expects to have $60,000 of taxable income (before
exemption), including $40,000 of net earnings from self-employment. One-fifth of such
amounts are earned during the period January 1 through March 31, 1996. A reported $15,000
of income and self-employment taxes on his 1995 tax retrun. On these facts, A's April 15,
1996 required estimated tax installment payment is $3,201, computed as follows:
Method 1: Current year's tax
Taxable income before exemption $60,000
Less: Exemption ( 2,500)
--------
Taxable income 57,500
Income tax $13,093
Net earnings from self-employment $40,000
Self-employment income after
deduction (40,000 x 92.35%) 36,940
Self-employment tax (15.3%) $ 5,652
Total tax $18,745
Method 1 required payment (22.5%) $ 4,218
Method 2: Prior year's tax
Tax on prior year's return $15,000
Method 2 required payment (25%) $ 3,750
Method 3: Annualization of income
Taxable income for 3 month period $12,000
Annualized income (12,000 x 12/3) 48,000
Less: Exemption ( 2,500)
Annualized taxable income 45,500
Income tax $ 9,705
Net earnings from self-employment
for 3 months $ 8,000
Annualized self-employment income
(8,000 x 12/3) 32,000
Self-employment income after deduction
(32,000 x 92.35%) 29,552
Self-employment tax (15.3%) $ 4,521
Total tax $14,226
Method 3 required payment
(22.5% x 14,226 - 0 prior payment) $ 3,201
If a subsequent installment for 1996 is computed under Method 1 or Method 2, the amount of
the estimated tax payment would have to be increased by $1,017 or $549, respectively,
being the savings realized by using Method 3 to compute the first installment (if not
previously recaptured).
CLICK TO LINK TO PUB. 505 FOR SAMPLE WORKSHEET.