Planning around the new estimated tax rules.

Beginning in 1992, certain high income individuals are no longer allowed to use the 100% of prior year tax safe harbor for making estimated tax payments. (For a detailed discussion of the new rules, see Luchs, "New Rules for Estimated Tax Payments" (TTA, Apr. 1999., at 203).) However, other opportunities still exist for individuals to defer payments of estimated tax during the year.

The new rules apply if (l)the taxpayer's "modified" adjusted gross income (AGI) for the current year exceeds the prior year's AGI by more than $40,000 ($20,000 for married individuals filing separately), (2) the taxpayer has AGI in the current year exceeding $75,000 ($37,500 for married individuals filing separately)and (3) the taxpayer has made a payment of estimated tax (or has been assessed an underpayment penalty) with respect to any of the three preceding tax years (Sec. 6654(d)(1)(C)(ii)).

An individual who meets all of these requirements is generally required to make estimated tax payments equal to 90% of his "modified" current year tax liability (and cannot use the 100% of prior year safe harbor), beginning with the second quarter of 1992. (Note: Sec. 6654(d)(1)(C)(iii)allows taxpayers subject to the new rules to use the 100% safe harbor for the first quarter with a "catchup" in the second quarter if necessary). Thus, certain individuals with significant increases in taxable income in the current year will no longer be able to defer the tax on such income until the following April 15. However, these individuals can defer estimated tax payments until year-end on such income by adjusting tax withholding on their wages.

Sec. 6654(g)(1) deems wage withholdings as being paid equally on each installment due date (unless the taxpayer establishes the actual withholding date). Thus, any underpayments of estimated tax in the first, second or third quarters could be covered retroactively through increases in wage withholdings at year-end. (This assumes, of course, that the individual is approximately equally underpaid in each of these quarters.)Although this technique is not as effective a deferral as the 100% safe harbor, an individual subject to the new rules can defer payment of estimated tax on income not subject to withholding (e.g., capital gains, income from passthrough entities, etc. ) by increasing wage withholdings at year-end.

Another benefit of using wage withholdings rather than estimated tax payments is that it may enable an individual presently subject to the new rules to begin using the 100% safe harbor again at some point in the future. Sec. 6654(d)(1)(C)(ii)(ii) does not consider wage withholdings to be estimated tax payments for purposes of the third prong of the test outlined. Thus, by adjusting wage withholdings rather than making estimated tax payments, a taxpayer would no longer be subject to the new rules after one to three years (depending on the last year in which an estimated tax payment was made or an underpayment penalty was assessed). This would be true even though the taxpayer meets the $40,000 and $75,000 thresholds in any given year because he would not have made an estimated tax payment in the three preceding years. Of course, it will be important to avoid any underpayment penalties in those years, since this would continue to subject the individual to the new rules for at least three more years.

Another effective method to defer payments of estimated tax during the year is the new "annualization exception" (not to be confused with the "annualized income installment method" of Sec. 6654(d)(2), which was not changed by the new rules). Sec. 6654(d)(1)(C)(iv) provides an exception to the new rules for any quarter in which an individual establishes that annualized AGI for the months preceding an installment due date (i.e., ending May 31 for the June 15 installment, and August 31 for the September 15 installment) does not exceed the $40,000 and $75,000 thresholds. Any reduction in the installment by reason of the annualization exception must be recaptured in the next succeeding installment (unless the taxpayer meets the annualization exception in the succeeding quarter).

Accordingly, individuals who expect to be subject to the new rules in the current year due to the occurrence of a significant taxable transaction can defer estimated tax payments on the transaction by completing it as late as possible in the current year. In most cases economic considerations will determine when a transaction will be completed, however, when a transaction is expected to be completed near the end of a month preceding an installment due date (i.e., May 31 or August 31), the taxpayer may want to consider postponing the transaction [if possible) until after the end of such month. By doing so the taxpayer may be able to meet the annualization exception for the quarter and, thus, defer the payment of estimated tax on the transaction by three or four months.

Thus, with careful planning, the effects of the new estimated tax rules can sometimes be mitigated and/or avoided. But the new rules add considerable complexity to estimated tax payment computations, and the cost/benefit relationship of planning around them has to be considered. Note: As this item went to press, additional changes to the individual estimated tax payment rules are being considered. Practitioners are advised to watch for further developments that could affect 1992 estimated tax payments.

From Gregory E. Morrow, CPA, Pittsburgh. Penn.