Calculating penalties for underpayment of Estimated Taxes

[kp79]

I have always been a W2 employee, and for the first time in 2020, I worked as a sole proprietor / individual contractor with no employees. I have not made any estimated payments to the IRS so far.

In 2020, I made $100K from 1099 contract work as a sole proprietor / individual contractor (from Jan 1-Apr 31). However, I will not receive a 1099 form until February 2021, and looking at some sample 1099-MISC forms (sample: https://cdn-0.smallbiztrends.com/wp-content/uploads/2014/01/1099-misc-sample-large.jpg), it looks like the form is not going to report / capture the dates when income was earned. 

I recently learned that the Q4 estimated tax payments are not due until Jan 15, 2021, and am trying to figure out if I will owe any penalty for underpayment / no payment of estimated taxes. If the interest clock has already started and I am being penalized every day, then I will need to take action immediately (instead of by Jan 15, 2021, which would give me more time and I am obviously hoping is the case).

Would the IRS assume that the income was evenly earned throughout the year? Or will they give the independent contractor the benefit of the doubt and start calculating estimated tax underpayment penalties (at 3-5% of taxes owed) after Dec 31, 2020?

(I found that the IRS website has a long, complicated document and worksheet on figuring this out, but I could not find an answer to my question. I also posted a similar (albeit slightly different question) here and @Critter-3 pointed me to some helpful links. I ended up getting a paid subscription to https://selfemployed.intuit.com/ but was underwhelmed by the tools available - it does not calculate or tell me anything about estimated tax penalties..so I am asking a more targeted question here.)

Would I owe estimated taxes for 2020?  If there is an underpayment penalty, what will it be (based on the numbers I shared) and is there a way to avoid it now?

Note: I had a small $100-200 underpayment penalty (as a W2 employee) in 2018, which I paid immediately (as part of TurboTax) when I did my taxes in Apr 2019. I mention this because I would also like to know about the penalty relief waiver mentioned here, and whether I would qualify.

@VolvoGirl @IreneS @TomYoung I am tagging you because you seem to have answered similar questions earlier. I would appreciate your input.

[Carl]

Here's my two cents.

Would the IRS assume that the income was evenly earned throughout the year?

Yes. However, there are forms (included in the TurboTax program) that allow you to specify your business income/expenses for each quarter, and that can reduce or in some cases totally eliminate the late payment penalties. For example, if you opened your business in the 2nd quarter of the year, the IRS will assume otherwise and the program may figure a non-payment penalty for the first quarter. But using options in the program you can indicate that you made 0$ income in the first quarter, and the penalty for that quarter would just "go away".  I'm not getting into the program details of that right now, because those details flat out do not matter until you actually start your 2020 tax return, next year.

(I found that the IRS website has a long, complicated document and worksheet on figuring this out,

In my personal opinion, (and we all know what those are like!) don't waste your time with those worksheets. But you most certainly can if you like inducing self inflicted permanent brain damage. 🙂  I've been self-employed for over 15 years now. What I do is send the IRS 20% of my *GROSS* business income each quarter. Then at tax filing time I am "always" well within $1000 of my total tax liability. The IRS rules are, if what you owe at tax filing time is more than $1000 or more than 10% of your total tax liability, whichever is *HIGHER*, then an underpayment penalty will be assessed.

With my self-imposed 20% rule, I have always been within $500 of my tax liability with only two years where I owed the IRS, instead of getting a refund. Of those two years I owed, the highest I owed was $472. Not an issue. I just wrote the check payable to United States Treasury and called it good. So did the IRS. No penalties, late fees, interest or anything of the such.

Would I owe estimated taxes for 2020?

If your business has W-2 employees, then you are "required" to submit payroll taxes to the IRS at least quarterly, and if the wages are high enough it could be required monthly.  Same holds true for your state, if your state taxes personal income. State taxes are completely separate from federal taxes, so you can not pay state taxes at "ANY" irs.gov website.

As for estmiated taxes on "your" business income, if you don't pay estimated taxes and at tax filing time what you owe is over the thresholds mentioned above, then yes you need to pay estimated taxes. The sooner you pay those taxes for the quarters you're late on, the better. You can pay the IRS "right now" if you want, at www.irs.gov/payments. Pay attention to details on that website so that you pay for the correct tax year. If you pay for the wrong year or wrong quarter, there is "NO" "POSSIBLE" "WAY" to fix it.

I would also like to know about the penalty relief waiver mentioned here, and whether I would qualify.

I don't see why you wouldn't qualify, provided to pay your "catchup" quarterly taxes as soon as feasibly possible. But understand that the IRS can only waive penalites and fines. The IRS can not and will not waive any interest, because the law (i.e.; Congress, who made the law) says they can't. So the sooner you pay past due quarterly payments, the better.

[VolvoGirl]

By the way there is a new 1099 form for 2020.  Instead of 1099Misc it is a 1099 NEC for non employee compensation.  https://www.irs.gov/pub/irs-pdf/f1099nec.pdf 

When you file your tax return if you have a penalty you can try to reduce or eliminate it by filling out form 2210.  Have you seen that one?  You will need to scroll down and use page 3 or 4,

https://www.irs.gov/pub/irs-pdf/f2210.pdf 

Instructions  https://www.irs.gov/pub/irs-pdf/i2210.pdf 

[VolvoGirl]

And yes Turbo Tax will fill out form 2210.   You didn't find it?

It's under
Federal or Personal (for H&B version)
Other Tax Situations
Additional Tax Payments
Underpayment Penalties - Click the Start or update button

[Critter-3]

filling in the 2210AI is not that difficult if you use  a bookkeeping system where you can print off P&L reports for the needed time frames

[VolvoGirl]

You better send in an estimated payment ASAP!

To prepare estimates for next year you need to be in your current return. If you can't get your return open, Try this, you can sign back onto your account, click on Add a State. This should get you back into your return. Be very careful not to change anything in your actual return.

You can just type W4 in the search box at the top of your return , click on Find. Then Click on Jump To and it will take you to the estimated tax payments section. Say no to changing your W-4 and the next screen will start the estimated taxes section.

OR go to
Federal Taxes or Personal (Self Employed or H&B version)
Other Tax Situations
Other Tax Forms
Form W-4 and Estimated Taxes - Click the Start or Update button

Say No to W4. When you get to the W4 and Estimated Taxes section, say you want to adjust your income to go though all the screens.

If you didn't owe or missed making the prior quarterly estimated payments and need to just calculate starting now, you can go though the Estimated Taxes section and just put $1 (one dollar) in for the quarters you missed. Then it will only figure the current and remaining quarters.

Here are the 1040ES instructions and blank forms (where to mail is on page 4)
http://www.irs.gov/pub/irs-pdf/f1040es.pdf

Or you can pay on the IRS website. Be sure to pick 2020 1040ES payment
https://www.irs.gov/Payments

[tagteam]

---

@Carl wrote:

.....The IRS rules are, if what you owe at tax filing time is more than $1000 or more than 10% of your total tax liability, whichever is *HIGHER*, then an underpayment penalty will be assessed.

---

Those are not the IRS rules, which are correctly reproduced immediately below.

In general, taxpayers don’t have to pay a penalty if they meet any of these conditions:

• They owe less than $1,000 in tax with their tax return.
• Throughout the year, they paid the smaller of these two amounts:
  • at least 90 percent (however, see 2018 Penalty Relief, below) of the tax for the current year
  • 100 percent of the tax shown on their tax return for the prior year – this can increase to 110 percent based on adjusted gross income.

See https://www.irs.gov/newsroom/basics-of-estimated-taxes-for-individuals

[TomYoung]

"I recently learned that the Q4 estimated tax payments are not due until Jan 15, 2021, and am trying to figure out if I will owe any penalty for underpayment / no payment of estimated taxes."

That's the due date for the last of 4 estimated tax payments for 2020.  The estimated tax due dates for 2020 were April 15 – extended to July 15, 2020, June 15 - Extended to July 15, 2020, and September 15, 2020.  Since you earned your $100K pretty much entirely in the 1st quarter of 2020, you should have been making payments at each of those dates, assuming that you needed to.

"Would the IRS assume that the income was evenly earned throughout the year?"

Yes, and that works to your benefit here.  Instead of having income of $100K in the first quarter - meaning that every quarter the penalty will be based on $100K earned "year to date", the penalty will be calculated on $25K in the first quarter, $50K in the second quarter, and so on.

"Would I owe estimated taxes for 2020?"

Almost certainly.  There are instances where you wouldn't need to pay estimated taxes, e.g., this was the first tax return you were ever required to file, but that's not the case here.  Figure out a rough estimate of taxes owed - income taxes and SE taxes - and pay it as soon as you can.  I can't think of any way of avoiding the penalty.

[VolvoGirl]

Since you are new to self employment here is some general info......

You will need to keep good records.  You may get a 1099Misc or 1099NEC at the end of the year if someone pays you more than $600 but you need to report all your income no matter how small.  You might want to use Quicken or QuickBooks to keep track of your income and expenses.

There is also QuickBooks Self Employment bundle you can check out which includes one Turbo Tax Online Self Employed  return....

http://quickbooks.intuit.com/self-employed

When you are self employed you are in business for yourself and the person or company that pays you is your customer or client.

To report your self employment income you will fill out schedule C in your personal 1040 tax return and pay SE self employment Tax.  You will need to use the Online Self Employed version or any Desktop program but the Desktop Home & Business version will have the most help.

Here is some IRS reading material……

IRS information on Self Employment

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Self-Employed-Individuals-Tax-Center

Pulication 334, Tax Guide for Small Business

http://www.irs.gov/pub/irs-pdf/p334.pdf

Publication 535 Business Expenses

http://www.irs.gov/pub/irs-pdf/p535.pdf

[kp79]

@Carl  Thank you for the detailed reply!

• "can reduce or in some cases totally eliminate the late payment penalties" - do you mean penalties only, and not interest on my late payments? Is there a way to avoid the interest?
• How can I do this from TurboTax - I didnt see an option for this in the "Estimated Taxes" section when I "amended" my 2019 return.
• Taxes surely can be "self inflicted permanent brain damage", which is why I appreciate your reply and products like TurboTax so much. 🙂 Thank you for sharing your "self-imposed 20% rule", that is something I will keep in mind. I also didnt know about the "W-2 employees" rule for estimated taxes, another thing I will keep in mind, should I be so lucky that my business becomes successful.

@Critter-3 thank you

@tagteam  thanks for the clarification!

[kp79]

@TomYoung Thank you for that, greatly appreciated.

Please correct me here, but if I pay off all my estimated taxes due on (say) Oct 15, 2020 for Q1-Q3, then it sounds like I will owe:

• 5% interest for Q1 from July 15, 2020 (date of extension) through Oct 15, 2020 (the date I pay off the Q1 installment)
• 5% interest for Q2 from July 15, 2020 (date of extension) through Oct 15, 2020 (the date I pay off the Q1 installment)
• 5% interest for Q3 from Sept 15, 2020 through Oct 15, 2020 (the date I pay off the Q1 installment)
• 3% interest for Q4 starting Jan 15, 2021 (will not be applicable if I make this payment on time)

So if my 1099 income is 100K for 2020, and my taxes due are $40K (lets say, 40% tax rate), then the IRS will charge interest:

• 5% of 10K for Q1 (for 3 months, July 15 - Oct 15) = $125
• 5% of 10K for Q2 (for 3 months, July 15 - Oct 15) = $125
• 5% of 10K for Q3 (for 1 month, Sept 15 - Oct 15) = $41.67
  Total interest for late payment: $291.67

Am I off-track here? Anything I am missing?

Also I'm confused when the interest starts accumulating, according to this article: https://www.irs.gov/businesses/small-businesses-self-employed/interest-for-individuals

it says that "interest starts on April 15, if your return shows you owe tax."
But it also says: "Interest on the failure to pay, estimated tax, and dishonored check penalties starts on the notice date of that penalty amount." - I haven't received any notices from the IRS.
Is there a way to find out how much interest I owe for my late payment? Or do I have no choice but to wait until tax time (April 2021) when I file my return?

@TomYoung  @Carl thank you for any further clarification here.

[kp79]

@VolvoGirl 

Thank you so, so much for that. For the life of me, I could not figure out how to prepare estimates for next year. I also didn't know a 1099-MISC is replaced with a 1099 NEC.

Your steps greatly helped. Using your instructions, I signed back onto my TurboTax account, and got back into the estimated tax payments section. Then I went through the TurboTax steps for "amending" my 2019 return (AFAIK I don't think I saved the changes)

In 2020, I have worked as both a sole proprietor / individual contractor with no employees and as a W2 part-time employee. I entered my 1099 (self-employed / independent contractor) income, my part time W2 income and my investment income.
These are the results and the Turbo Tax screens I saw:

• 2020 Taxable income: $229,897
• 2020 Taxes: $67,156
• 2020 Federal Taxes that will be withheld (from part time W2 income): $17,795

Screenshots from TurboTax "Estimated Payments" section:

• (screen 1) Estimated bill for 2020: https://www.webpagescreenshot.info/#v2=s1vREaPOA
• (screen 2) Payments I expect to make: https://www.webpagescreenshot.info/#v2=CtA98XuIv
• (screen 3) Estimated payments calculation method: https://www.webpagescreenshot.info/#v2=y18GYP68-
• (screen 4) Estimated payment numbers and vouchers: https://www.webpagescreenshot.info/#v2=vGWXVyFYA
• (screen 5) final screen (amended 2019 return): https://www.webpagescreenshot.info/#v2=h_ui5IB9y

It seems I owe estimated payments of: $10,662*4 = $42,648 for 2020.

They seem to have got this number using: (90% of $67,156*) - $17,795 (Federal Taxes that will be withheld)
Is there a disadvantage or penalty to using 90% instead of 100% on "(screen 3) Estimated payments calculation method"? What do you recommend?

2. (this is also what I sent to @TomYoung above)

I'm confused when the interest starts accumulating, according to this article: https://www.irs.gov/businesses/small-businesses-self-employed/interest-for-individuals
It says that "interest starts on April 15, if your return shows you owe tax."
But it also says: "Interest on the failure to pay, estimated tax, and dishonored check penalties starts on the notice date of that penalty amount." - I havent received any notices from the IRS.
Is there a way to find out how much interest I owe for my late payment? Or do I have no choice but to wait until tax time (April 2021) when I file my return?

3. Most importantly, what do I do next? The next steps are a bit confusing after screen 5 (above) in TurboTax .

Do I:

• print vouchers somehow from within TurboTax?
• Or do I directly go and pay on the IRS website (and pick 2020 1040ES payment)? https://www.irs.gov/Payments
  Anything I am missing?

Can I get rid of my "Intuit Self Employed" subscription (I believe this is the same as / like Quickbooks)? I just subscribed to figure out how much I owed in estimated payments for 2020. I guess it could be useful to keep accurate records for the business going forward.

Thank you for helping again!

[TomYoung]

Because of the Covid-19 changes I know the calculation of all interest rate penalties have changed and the IRS has issued rules in this regard, but I haven't followed along.  The 5% rate is correct for the first 2 quarters but changed to 3% for the third quarter.  The interest is calculated on a daily basis and compounds daily, and it's based on the cumulative unpaid estimated taxes.

It's not going to be a hell of a lot of money in any case, and depending on your situation the $40K estimate might not really be the right number to use because your 10/15 payment might get you into a "safe harbor", (or not).  Let the IRS calculate it for you.

[Carl]

Is there a way to avoid the interest?

By federal law the IRS can not waive interest, even if they want to.

How can I do this from TurboTax?

In TurboTax 2019 select "Other Tax Situations" and under that elect to start/update "Underpayment Penalties" and work it through.

your "self-imposed 20% rule", that is something I will keep in mind.

That 20% rule is what works for me. It could be higher for you. Let me explain.

When working the SCH C I get a fair number of business deductions from my business income. Office expenses, home office depreciation, vehicle mileage, supplies, parts, etc. These deductions give me my "taxable" business income which for me will be quite a bit less than my gross business income.

Based on my tax bracket, on that taxable business income I will pay up to 22% in "regular" taxes on that.

In addition to the regular tax, I will also pay an additional 15.3% self-employment tax on something like 97.8% of that taxable income. Be aware that the SE tax is basically paying 12.4% of the SE tax to "MY" social security account. 6.2% is the "employee" contribution and the other 6.2% is the "employer" contribution.  I look at it as paying my "future self" for social security which I will get when I reach retirement age.

The remaining 2.9% of the SE tax is the Medicare tax that goes into the Medicare general fund.

That means I could "potentially" be paying 37.3% in taxes on that taxable income.  However, I'm sending in 20% of my "gross" earnings before deductible business expenses. When I actually do my taxes, what I sent the IRS each quarter will be damn close (if not over) to 37% of my "actual" taxable business income.

So if in your first year of business you feel that 20% isn't enough, then send more. Maybe 25%? For someone that will gross more than $160K (80K if filing single) I recommend 25%. When starting a new business it can take a few years to find that "happy spot".

Finally, if your state also taxes personal income then you must also send quarterly payments to your state. The highest state tax rate I am aware of at this time is California at 13.3% on personal income. So in that first year of business you should send your state a percentage of your gross income that is equal to the highest tax rate of your state. Then in later years you can lower it as appropriate.

[Carl]

Am I off-track here?

The estimates are descent. But remember, there's no way to know the "exact" amount until you actually complete and file your tax return. But even then, you won't know that "exact" figure anyway. When it comes to figuring penalties and interest the TurboTax program can only "estimate". That's because the interest does not stop accumulating until the day the IRS actually receives your payment. (That may not be the day you send it either.)  Additionally, the Turbotax program has no possible way of knowing when you will pay it, or when the IRS will receive it. In such a case, the IRS will send you a bill in the U.S. mail with any additional interest and/or penalties due, if such is "in fact" due under federal law. When that happens, you're generally talking an amount less than $25.

Also I'm confused when the interest starts accumulating,

Hey, the only thing I can respond with to that is this:

He who claims to totally understand the situation and all aspects of it, is obviously not paying attention. 🙂