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Estimated tax changes: projections for 1992-1996.

On November 15, 1991, President Bush signed into law P.L. 102-164, the Emergency Unemployment Compensation Act. Among other things, this Act modified the estimated tax rules for 1992 through 1996. Of the roughly 2.5 million taxpayers who pay estimated taxes, approximately 500,000 will owe accelerated estimated taxes although a very high percentage will be subject to completing additional computations. This article reviews the conventional safe harbors and explains how they have been modified and concludes with tax planning suggestions.

Conventional Safe Harbors

Americans participate in a pay-as-you-go tax system through withholding and estimated taxes. Self-employed taxpayers fund their tax liability throughout the year by making quarterly payments on April 15, June 15, September 15 and January 15 of the following year. Employees with non-wage income (dividends, interest, rent, etc.) not covered by withholding also make these quarterly payments.

There are two prerequisites for an estimated tax obligation. First, the expected amount of tax (including alternative minimum tax and self-employment tax) after subtracting tax credits and income tax withheld must be $500 or more. Second, one's withholding must be less than the required annual payment. Under the general rule -- still in effect, the "required annual payment" is the least of:

1. 90% of the tax for the current year (90% safe harbor);

2. 100% of the tax for the prior year (100% safe harbor); or

3. 90% of the tax for the current year based on annualizing income (annualized income safe harbor).

This article refers to this set of safe harbors as "conventional" because they have been the only ones in effect until 1992. After 1991, some estimated tax payers will contend with a modified version of the conventional safe harbors.

Example #1 -- Conventional Safe Harbors. (For simplicity, examples ignore itemized deductions, exemptions, credits, and other taxes, such as alternative minimum tax and self-employement tax.)

Assume Joe Taxpayer is an investor. In 1990, he had net investment income of $50,000. With a tax rate of 28%, his 1990 tax liability was $14,000 (28% X $50,000).

Assume the current year is 1991 and Joe expects to double his net investment income to $100,000. As of March 31, Joe had received only $5,000 of the $100,000. If his tax rate is 31%, he expects to owe tax of $31,000 (31% of $100,000).

To avoid underpayment penalties in 1991, Joe must make the required annual payment that is determined by the safe harbors. Under the 90% safe harbor, Joe pays at least 90% of the tax for the current year. Because this tax liability is $31,000, the 90% rule calls for an annual payment of $27,900 (90% x $31,000). His quarterly payment would be $6,975 (25% x $27,900).

Under the 100% safe harbor, Joe pays at least 100% of the tax for the prior year. Because his prior year's tax liability was $14,000, the 100% rule calls for an annual payment of $14,000 (100% x $14,000). His quarterly payment would be $3,500 (25% x $14,000). The income of most Americans does not fluctuate significantly throughout the year. That is, they receive their income proportionately during the year. Taxpayers in this situation will rely on the 90% and 100% safe harbors. If Joe collected his investment income evenly throughout the year, his 1991 required annual payment would be $14,000 or $3,500 per quarter. This is the lesser of the 90% safe harbor amount ($14,000/$3,500) and the 100% safe harbor amount ($27,900/$6,975). If Joe paid less than this amount, he would be subject to penalties.

Joe, however, does not collect his income evenly throughout the year. His income fluctuates notably as evidenced by the fact that he collects only $5,000 during the first three months and collects $95,000 during the last nine months. Under these conditions, Joe may benefit, at least for the first installment, from using the annualized income safe harbor.

Under this safe harbor, Joe takes his regular taxable income received before the installment due date and multiplies it by an annualization factor. The outcome is a hypothetical annual taxable income upon which he calculates a hypothetical tax liability. The final step is to multiply this hypothetical tax liability by 90%. The result is the annual payment as derived under the annualized income safe harbor. If Joe were on the accrual method, he would include in regular taxable income all income earned but not necessarily received.

The annualization factors are:

1. 4 for income received through March 31;

2. 2.4 for income received through May 31;

3. 1.5 for income received through August 31; and

4. 1 for income received through December 31.

Apply the annualized income safe harbor to Joe. He received $5,000 of regular taxable income before March 31, 1991. After multiplying this figure by an annualization factor of 4, Joe's hypothetical annual taxable income is $20,000. Using a tax rate of 28%, his hypothetical tax liability is $5,600 ($20,000 x 28%). After multiplying this by 90%, his annual payment is $5,040. A quarterly payment, then, is $1,260 ($5,040 x 25%).

In conclusion, Joe's required annual payment is the least of:

1. $27,900 ($6,975/quarter)/90% safe harbor;

2. $14,000 ($3,500/quarter)/100% safe harbor; or

3. $ 5,040 ($1,260/quarter)/annualized income safe harbor.

In order for Joe to avoid penalties, his estimated tax payment on April 15, 1991, should be at least $1,260.

Underpayment Penalty

Those taxpayers whose estimated payments fail to satisfy any of the three tests just discussed must pay an underpayment penalty. The formula for this penalty is:

Amount of Underpayment x Underpayment rate x Days Overdue/365 / Underpayment Penalty

Payments outstanding after the due date of the return (April 15, 1992) are assessed an additional late payment penalty.

Example #2--Underpayment Penalty. Assume the same facts as those in Example #1 where Joe needs to pay $1,260 to avoid penalties. What if he pays $800 by the first installment due date (April 15) and he pays the other $460 four weeks late? Assume the underpayment rate is 10%.

Because Joe is underpaid by $460 ($1,260 - $800) for 28 days, his penalty is $3,53 as calculated below.

$ 460 x 10% x 28/365 / $ 3.53

New Rules

The new rules make the preparation of estimated taxes a two-step process. First, determine if the new rules apply. Second, if they do not, use the conventional safe harbors discussed above. But, if the new rules apply, taxpayers must use a modified version of the conventional safe harbors. This version all but eliminates the conventional 100% safe harbor.

The 100% safe harbor was, and continues to be for many taxpayers, the favorite method of calculating their estimated taxes. The computation is simple. It is based on information readily available, and it avoids the risk of penalties which may result from basing installments on projections of current year's earnings. Without the security of the conventional 100% safe harbor, taxpayers will have to make additioal computations based on projected information for the current period. For some taxpayers, these computations will have to be done not once, but four times a year.

The new estimated tax rules apply to taxpayers:

1. Whose current year's adjusted gross income (AGI) exceeds $75,000 ($37,500 for married taxpayers filing separately);

2. Whose current year's "modified adjusted gross income" (MAGI) exceeds by $40,000 the AGI of the prior year ($20,000 for married taxpayers filing separately); and

3. Who have made at least one estimated tax payment in the prior three years or who have been penalized for not doing so.

Taxpayers meeting all three conditions face a modified version of the conventional safe harbors. For these taxpayers, their required annual payment is the least of:

1. 90% of the tax for the current year (conventional 90% safe harbor);

2. The greater of:

a) 100% of the tax for the prior year (conventional 100% safe harbor); or

b) 90% of the tax for the current year based on modified adjusted gross income (new 90%-MAGI safe harbor);

3. 90% of the tax for the current year based on annualized income (conventional annualized income safe harbor).

The difference between the conventional safe harbors with the modified version appears in item 2 above. Although the conventional 100% safe harbor is a factor, in most cases it will be overshadowed by the 90%-MAGI safe harbor.

Modified Adjusted Gross

Income

Under the new rules, "modified adjusted gross income" (MAGI) is important for two reasons--it plays a role in the $40,000 threshold and in the 90%-MAGI safe harbor. MAGI is defined as the current year's adjusted gross income (AGI) less gain from sale of a principal residence, less gain from involuntary conversions and adjusted for "pass-through items" of partnerships and S corporations.

Pass-through items are any item of income, gain, loss, deduction or credit attributable to ownership interests in partnerships and S corporations. Gain or loss from the disposition of such an interest is not considered a pass-through item. If taxpayer's ownership interest is less than 10%, the amount included in MAGI comes from last year's return and the current year's information is disregarded. If the ownership interest is 10% or more, the amount included in the modified adjusted gross income is the projected figure for the current year.

The conventional 90% safe harbor and the new 90%-MAGI safe harbor will produce the same number for those taxpayers who do not have the modifications listed in the preceding paragraph (gain from the sale of a principal residence, etc.).

Example #3--New Rules (No Modifications that cause MAGI to differ from AGI). The current year is 1992 and Joe expects to earn $200,000 evenly throughout the year. His 1991 income was $100,000 and he paid his tax liability of $31,000 with estimated taxes.

Because there are no modifications to Joe's AGI, his MAGI and AGI are both $200,000.

Joe meets the three prerequisites for the new rules. His current year's AGI ($200,000) exceeds $75,000; his current year's MAGI ($200,000) exceeds last year's AGI ($100,000) by at least $40,000; and he made at least one estimated tax payment in the preceding three years.

Under the modified version of the conventional safe harbors, Joe's required annual payment is the least of:

1. $55,800 ($200,000 x 31% x 90%) or $13,950/quarter (conventional 90% safe harbor);

2. the great of:

a) $31,000 ($31,000 x 100%) or $7,750/quarter (conventional 100% safe harbor); or

b) $55,800 ($200,000 x 31% x 90%) or $13,950/quarter (new 90%-MAGI safe harbor); or

3. annualized income safe harbor not computed because Joe's income does not fluctuate.

(Note: the safe harbors in 1 and 2b produce the same number because there are no adjustments causing MAGI to differ from AGI.)

Under the new rules, Joe's first installment is $13,950. (See below for a discussion of an exception for the first installment.) Under the old rules, Joe's payment would have been $7,750. This example illustrates the main thrust of the new rules. Even though Joe's taxes are not increasing, their collection is accelerating.

Example #4 -- New Rules (Qualified Pass-Through Items). Assume the same facts as those in Example #3, except that some of Joe's income results from his owning less than 10% of a partnership.

Assume his 1991 income of $100,000 consists of $5,000 from the partnership and $95,000 from other sources. Also assume his 1992 income of $200,000 consists of $75,000 from the partnership and $125,000 from non-partnership sources.

Joe is not subject to the new rules because he does not meet the three prerequisites. Even through his current AGI ($200,000) exceeds $75,000 and he paid estimated taxes within the last three years, he fails the $40,000 threshold. Joe's MAGI for 1992 is $130,000: $125,000 (1992 non-partnership income) + $5,000 (1991 partnership income). As a result, his current year's MAGI ($130,000) does not exceed last year's AGI ($100,000) by more than $40,000. Not coming within the new rules, Joe calculates his first installment using the conventional safe harbors.

Exception for the First

Quarterly Installment

The new rules have an exception for the first quarterly installment. Under this exception, the first payment can be computed under the conventional safe harbors. any reduction that results from applying the old rules must be added to the second quarterly payment as determined under the new rules. Thus, this exception merely delays payment.

Example #5--Exception for First Installment. Assume the same facts as those in Example #3, where Joe's 1992 income of $200,000 is earned evenly throughout the year and does not contain any pass-thru items.

Under the new rules, Joe's quarterly payment would ordinarily be $13,950. Under the exception, however, his first installment is only $7,750. The latter figure results from the application of the conventional safe harbors. Joe's second quarterly installment will be $20,150: $13,950 (second installment under the new rules) + $6,200 (shortfall {$13,950 - $7,750} from the first installment).

Annualization and the New

Rules

The annualization technique applies to the thresholds of $75,000 and $40,000. In any period that annualized income does not equal or exceed $75,000 ($37,500 for married taxpayers filing separately), taxpayers can use the old rules to determine the current installment. Any underpayment resulting from use of the old rules must be made up in that period when the new rules become applicable. In any period that annualized MAGI does not exceed the prior year's AGI by $40,000 ($20,000 for married taxpayers filing separately), taxpayers can use the old rules to determine the current installment. Again, any underpayment resulting from using the old rules must be made up in that period when the new rules become applicable.

Example #6 -- New Rules (Annualization). Assume Joe's 1992 projected income is $200,000. Assume this income consists of $60,000 of interest (earned evenly throughout the year) and $140,000 of gain from sale of rental property. Assume the rental property sale will close in November.

Without annualizing, Joe satisfies both thresholds. His current AGI ($200,000) exceeds $75,000 his MAGI ($200,000) exceeds last year's AGI ($100,000) by more than $40,000. Assuming a 31% tax rate (capital gains rates ignored), each of Joe's installments would be $13,950 ($200,000 x 31% x 90% x 25%).

With annualizing, Joe does not satisfy the thresholds until late in the year. Because his annualized income is based on annualizing only the interest income earned evenly throughout the year, he fails the $75,000 test in the first, second and third quarters. The gain from the property sale is not considered until the fourth quarter. Because his annualized MAGI is based on annualizing only the interest income, his MAGI will not exceed last year's AGI by $40,000 until the fourth quarter.

Because the thresholds are not satisfied until the fourth quarter, Joe can base his first, second and third installments on the conventional safe harbors. Thus, his payment for each of these quarters is $7,750 ($100,000 x 31% x 25%). But, his fourth quarter payment will be $32,550: $13,950 (regular fourth quarter installment under the new rules) + $18,600 (shortfall {13,950 - $7,750} x 3 quarters).

Under both the old and new rules, taxpayers who receive a sifnificant portion of their income late in the year may, if willing to plow through the complexity of the annualized income safe harbor, delay estimated tax payments until the end of the year. Before the new rules, the annualized income safe harbor was ignored because of its complexity and the availability of the 100% safe harbor. But, the acceleration of payments caused by the new rules should cause taxpayers and practitioners to more carefully weigh the benefits of delaying payments against the costs of preparing annualized installments.

Consequences of the New

Rules

The new rules will mean more paperwork and higher professional fees. Instead of year-end tax planning, some taxpayers will have to engage in quarterly tax planning. Those affected will have to decide whether to sell appreciated property this quarter or next quarter.

In some cases, the new rules will result in an overpayment of taxes for which a refund will not be available for nearly a year.

Example #7 -- Delayed Refund. Assume Joe's income of $200,000 consists of long-term capital gain from a stock sale in May, 1992. Also assume Joe sustains a $200,000 long-term capital loss in October, 1992. Assume the applicable safe harbor is the new 90%-MAGI rule.

To avoid penalties, Joe must pay estimated taxes of $50,400 ($200,000 x 28% x 90%) by June 15, 1992. Even thought his October loss erases the earlier tax liability, he cannot get an immediate refund. He must wait until he files his return in April 1993 before he gets a refund.

Tax Planning

The new rules do not apply to taxpayers who have not paid estimated taxes in the preceding three years. This presents a tax planning opportunity. To illustrate, assume your client formed ABC Corporation some years ago. He may be a one-person operation, but he is still an "employee." As such, he is subject to withholding. Assume that for the last three years, your client has participated in the pay-as-you-go tax system through withholding and not estimated taxes.

Assume your client sold stock in 1992 for a $20,000 gain. Because this gain is non-wage income, it is not subject to withholding. Your client has a choice, he can pay estimated taxes on the $20,000 or he can increase the withholding on his corporate salary. If he pays estimated taxes, 1992 becomes tainted. That is, for years 1993, 1994 and 1995, if his income fluctuates upward by more than $40,000 and his AGI exceeds $75,000, he will be subject to the new rules for estimated taxes. But, if your client opts for the alternative, he will not taint 1992. If he handles everything through withholding, he will not be subject to the new rules.

Conclusion

As originally envisioned, the new estimated tax rules were to apply to the wealthy. As enacted, however, they'll apply to the middle class as well. The new rules will apply to anyone whose 1991 AGI was $35,000 and whose 1992 AGI exceeds $75,000. Irt is true the new estimated tax rules do not increase taxes, they merely accelerate their collection. However, taxpayers will end up spending more money because professional fees will rise due to the increased complexity.

Larry Witner, LLM, CPA, is an assistant professor at the University of Baltimore in Baltimore, Maryland.

Lucia Arruda, BS, MS, is an accounting instructor at Bryant College in Smithfield, Rhode Island.
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Author:Witner, Larry; Arruda, Lucia
Publication:The National Public Accountant
Date:Mar 1, 1992
Words:3179
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