Underpayment of estimated taxes penalty due to a Schedule K-1 for an inheritance?

[kmd]

I received a Schedule K-1 in 3/2017 for an inheritance I received in 9/2016.  It turns out that the estate had an annuity resulting in a considerable amount of income in 2016 of which I am paying a share per the Schedule K-1.  This increased my taxes owned to Feds and state about $5K and $2K, respectively, and triggered penalties of $10 and $35, respectively.  It does not seem fair that I should be penalized for unexpected beneficiary income on this Schedule K-1.  I was reading that I could have avoided this by paying 100% of estimated taxes paid in 2015, but I do not pay an estimate and instead have additional money taken from my salary per a W-4.  I noticed that I made slightly less in 2016 vs. 2015, so consequently, my taxes would have been less.  Is this where I went wrong?  How could I have avoided the penalties?

[dmertz · Accepted solution]

If you have a bone to pick, it is with the executor of the estate who failed to make it clear to you when you were given the money in 9/2016 that this would be taxable income to you on your 2016 tax return.  Whenever one receives an unexpected windfall, it's prudent to understand whether it is income that is taxable to you and then to determine if you must adjust your regular tax withholding or make an estimated tax payment to avoid an underpayment penalty.  It's just the way the US tax system works.  See IRS Tax Topic 306:  https://www.irs.gov/taxtopics/tc306.html

Making less in 2016 that in 2015 may have actually decreased your underpayment penalty since one of the safe harbors depends on your previous year's tax liability.

[kmd]

Thanks - yes, I just expected since inheritance under 5 mil is not taxed, I'd be ok (mine was well under that).  What I didn't know about is that the taxable income for the year is generally passed to the beneficiaries since they are generally taxed at a lower rate than estates.  I will be paying an estimate from here on out to avoid penalties.  Thanks for your response and the link.

[rk1]

When you get an unexpected windfall late in the year, also consider filing the form for annualizing income and payments. It looks at your income and payments quarter by quarter and see how they match up.  Since you got more of your total income in the second half of the year, your underpayment (and resulting penalty, if any) will be adjusted.