Special estimated tax rules.

Special estimated tax rules that deny certain individuals the use of the 100% of preceding year's income safe harbor become effective for second quarter 1992 estimated payments. The special rules apply to taxpayers with adjusted gross income (AGI) for the current year of more than $75,000, and "modified AGI" for the current year that is more than $40,000 greater than the preceding year's AGI, and who made an estimated tax payment (or had been assessed a penalty) in any of the three preceding years.

An application of an overpayment on a tax return to the following year's estimated tax payments is not an estimated tax payment in testing whether the special rules apply. Sec. 6654(d)(1)(c)(ii)(III) specifically excludes the overpayment from estimated taxes for purposes of the third prong of the test.

A taxpayer with a less-than-ownership 10% interest in a limited partnership or an S corporation is allowed to compute modified AGI using the entity's preceding year passthrough items (income, deductions, gains and losses). Read literally, Sec. 6654(d)(1)(d)(i) appears to require a taxpayer to eliminate from income the actual passthrough items from all eligible entities for the current year, and add to income any passthrough items from all entities that would have been eligible entities in the preceding year. Thus, modified AGI could include income from entities in which the taxpayer does not have an interest in the current year but did have an interest in the preceding year. Similarly, a C corporation that elected S status for the current year would have had no passthrough items in the preceding year, and would thus not produce any current year modified AGI.

Apparently, the IRS will not enforce the statute so literally. Based on conversations with IRS personnel, and the limited discussion of the issue in IRS Publication 505, Tax Withholding and Estimated Tax, current-year passthrough items from eligible entities should be eliminated in computing modified AGI, and only items shown on the preceding year's tax return from these same entities that were eligible entities in the preceding year should be added in computing modified AGI. Thus, current-year modified AGI would disregard preceding year passthrough items from entities that have been disposed of, terminated or have changed form to an ineligible entity for the current year. A C corporation that elected S status in the current year would not produce any current-year modified AGI. An eligible entity in which the taxpayer first invested in the current year would produce no modified AGI.

A taxpayer cannot substitute the preceding year's S corporation or limited partnership income in computing modified AGI if the taxpayer has "at any time during such year" a 10% or greater ownership interest (measured by vote or value for an S corporation and by capital or profits interest for a partnership) (Sec. 6654(d)(1)(E)). Literally, an interest that fluctuates during the year and temporarily reaches 10% triggers the test, retroactively to January 1. This is not always something an investor can detect, especially from a year-end K-1. However, it is possible that a taxpayer will not be penalized for a quarterly installment payment in which modified AGI was computed using the preceding year's passthrough entity income if it is not known until later in the year that the taxpayer's ownership interest reached 10% during the year. It is important to be conservative in this determination. A taxpayer with a 10% interest at the end of the preceding year should presume that a 10% interest continues into the current year. Otherwise, quarterly payments can be made basing modified AGI on the preceding year's passthrough items until the taxpayer has actual knowledge that the interest has increased or some event suggests that the taxpayer should suspect the interest has increased. Once the 10% threshold is reached, it applies for the remainder of the year.

Generally, in an estimated tax annualization calculation, a taxpayer takes into account all partnership and S corporation items of income, deduction, gain and loss for the taxpayer's tax year through the end of the calculation month. Thus, for a fiscal year entity, passthrough items from months in the previous calendar year are taken into account by the taxpayer in January of the current calendar year (Regs. Sec. 1.6654-2(d)(2)).

Sec. 6654(d)(1)(C)(iv) allows taxpayers to test their liability to use the special estimated rules for any installment by using an annualization calculation in which the $40,000 prong of the test is based on annualized modified AGI. For this purpose, the passthrough items from eligible S corporations and partnerships shown on the previous year's return are to be accrued ratably over the current year. Prior year passthrough items from a fiscal year entity are therefore taken into account later in the current year than they were in the prior year, in computing modified AGI. This might help some taxpayers avoid meeting the $40,000 prong of the test for a quarter. However, in annualizing the $75,000 AGI prong of the test, the taxpayer must use actual passthrough items for the current year.

Estates and trusts required to make estimated payments (Sec. 6654(1)) must also test whether they are subject to the special estimated rules. Unfortunately, because the special estimated rules are based on AGI (a concept that does not apply to estates and trusts), the application of the rules for these entities is unclear. IRS National Office personnel have informed the authors that, for an estate or trust, AGI means "total income" - Line 9 of Form 1041, Fiduciary Income Tax Return. This is gross income, deducting only Schedule C, D, E and F and Form 4797 losses. it does not include any deduction for income distributions. Thus, estates and trusts with significant total income could be denied use of the 100% safe harbor, but have little tax liability because most of their income will be distributed.

The Senate version of the tax bill vetoed on March 20 included a provision to correct this situation. The bill would have defined AGI (and hence modified AGI) for purposes of applying the special estimated tax rules to trusts and estates by using the Sec. 67(e) definition used to determine nondeductible expenses under the 2% of AGI limitation. Thus, AGI would have been gross income, reduced by losses from business, partnership, property sales, etc., reduced by the trust or estate personal exemption (Sec. 642(b)), and further reduced by the deduction for distributions (Sec. 651 or 661). While the House-Senate conference did not adopt this provision as part of the tax bill vetoed by President Bush, the measure might still be included in any later tax bill enacted in 1992.