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New rules for estimated tax payments.

On Nov. 15, 1991, President Bush signed legislation to extend unemployment benefits.(1) To raise revenue to help pay for these benefits, Congress accelerated estimated tax payments for certain individuals, effective for tax years beginning after 1991.

Generally, all individuals must make estimated tax payments if they have income that is not subject to withholding. This article will discuss the change to the estimated tax requirements for such individuals--those who are self-employed; retired; have investment income, such as interest, dividends and capital gains; and are partners or S corporation shareholders.

Old Law

Individuals may compute their current year's estimates based on their prior year's tax even though they expect their current income to be higher.(2) This method ("Exception 1") is a safe harbor that eliminates IRS underpayment penalties.

Exception 1 provided individuals with a practical and uncomplicated method for determining their current year's estimated tax. However, it also allowed individuals to defer tax payments for the year in which their income increased over the prior year. This was identified as a "loophole" by a desperate Congress seeking revenue to pay for the extension of unemployment benefits.

Example 1: Husband H and wife W file joint returns for 1991 and 1992. H is a general partner of a partnership, with his share of the earnings approximating $90,000 a year. W is an employee earning approximately $50,000 a year. H and W have made quarterly estimated tax payments for years because of his partnership earnings. Taking advantage of the old law, H and W postponed the sale of unimproved real estate from December 1991 to January 1992. The gain on the sale was $100,000.

Under the old law, H and W would have been able to base their 1992 quarterly estimated tax payments on their 1991 tax, without the $100,000 gain, because the sale did not occur until 1992. Payment of the $28,000 capital gains tax would not be due until Apr. 15, 1993. Simply by postponing the sale until 1992, H and W would have use of the money without interest for 15 1/2 months.

New Law

Individuals may continue to use Exception 1 for their first estimated tax installment payment.(3) However, individuals can no longer use this method for their remaining three installment payments if their current year's adjusted gross income (AGI) --exceeds $75,000 ($37,500 for a married individual filing a separate return); and --increases by more than $40,000 over the preceding year ($20,000 for married filing separately).(4)

Assuming the same facts as in Example 1, under the new law, the $28,000 tax from H and W's January sale must be paid by June 15, 1992, because Exception 1 applies only to H and W's first estimated tax installment payment.

However, Exception 1 remains available to an individual who, for any of his three prior tax years, did not --make any quarterly estimated tax payments; or --receive an IRS penalty assessment for failure to pay estimated tax.(5)

If Exception 1 cannot be used, estimated tax payments must equal the lesser of --90% of the current year's tax;(6) or --90% of the tax on income currently received to date (computed on an annualized basis).(7)

General partners of a partnership, limited partners owning a 10%-or-more partnership interest, and shareholders owning a 10%-or-more interest in an S corporation must obtain quarterly income information to determine whether the $40,000 AGI threshold has been exceeded and to compute their current year's estimated tax payments.(8) Under the facts in Example 1, accordingly, H and W must base their June 15, 1992 quarterly estimate on the actual income earned by H's partnership through May 31, 1992, rather than on last year's income even if H's income from his partnership has not increased by more than $40,000. Observation: Limited partners and S shareholders owning less than 10% of their companies can use the prior year's income from these entities when calculating the $40,000 AGI threshold and computing their current year's estimates.

Gains from the sale of a personal residence or from an involuntary conversion also are not considered in determining whether the $40,000 AGI threshold has been exceeded and in computing current year's estimates.

The flowchart on page 204 may be used to determine whether taxpayers are subject to the new rules.

What Happened to Tax Simplification?

The new law can make compliance with quarterly estimated tax requirements extremely complicated and burdensome, especially for sole proprietorships and many partnerships and S corporations.(9)

Full adherence to the new law generally will require these "passthrough" entities to determine net income as of May 31, August 31 and December 31 of each year for their owners' estimated tax obligations using the same adjustments and computations required at year-end. These entities will have to determine net income within 15 days of those dates to enable their owners to make timely estimated payments. Partnerships and S corporations will have to undertake this additional interim work even if there is only one individual general partner or one more-than-10% limited partner or S shareholder. Accordingly, there will be many situations in which the penalty for underpaying estimated taxes is less than the cost of the additional work required, as illustrated in the following examples.

Example 2: Individual A is the owner of a large catering business operating as a sole proprietorship. Food and supplies are A's largest cost and are purchased in bulk, stored and used as needed. A determines his food and supply cost for the year by taking a physical inventory of what is on hand at the end of each year, a process that usually takes a full day with the help of several employees. A has 10 vans, a few of which are usually traded in each year. A's accountant determines depreciation on the vans when preparing A's tax return and Schedule C, usually in March.

Since A's annual AGI is more than $75,000 and can increase by more than $40,000 unexpectedly, A will have to determine, or make a fairly accurate estimate of, his net income within 15 days after May 31, August 31 and December 31 in order to assure himself that he will not be subject to an underestimated payment penalty for the year.

Considering the additional time and cost involved in making more frequent determinations of net income, it may be advisable for A to continue to base his current year's quarterly estimate on last year's tax. Even if he underestimates annual income by as much as $100,000, the federal tax on $100,000 would be $31,000 and the underestimated penalty on that amount, at the current rate of 9% and assuming income is earned evenly throughout the year, would be no more than approximately $1,500.

Example 3: ABC is a law partnership with a sizeable litigation department, accustomed to fluctuations in income each year. It files its tax return using the cash basis. Although the partnership prepares fairly accurate monthly and quarterly statements of accrual and cash basis net income, it is not until December when it can more accurately project its net income for the year. Based on that projection, at the end of December it distributes bonuses to associates and support staff. ABC also awards bonuses to partners, determined in February of the following year, based on annual performance under a formula point system. Accordingly, it is not until after February of the following year that a partner is able to determine his income for the preceding year.

To provide its partners with the certainty that they will not be subject to an underpayment penalty, the partnership will have to inform its partners of their distributive share of cash basis net income as of May 31, August 31 and December 31 within 15 days after those dates. The information provided as of May 31 and August 31 will not take into account the deduction for the year-end bonuses to employees. The information provided the partners for the fourth quarter ending December 31 would have to include their bonus under the point system. Because of the enormous burden this places on the partnership, it should consider instructing its partners to continue to use Exception 1 for all quarters and should adopt a policy of reimbursing them for any underestimated penalty they may incur.

Example 4: X Company is a family-owned S corporation engaged in the commercial construction business. Individual A is the only shareholder owning more than 10% of the outstanding stock. X computes its income using the percentage of completion method for its long-term contracts. Because A's AGI is more than $75,000 and often increases by more than $40,000 over the preceding year, beginning this year X will have to determine its net income as of May 31, August 31 and December 31, within 15 days thereafter, in order for A to make accurate and timely estimated tax payments. That will require X to evaluate the costs and revenues on all its long-term contracts several times during the year instead of the one time it has conducted such a complete review in the past.

It would be more practical for A to continue to use Exception 1 and pay any underestimated tax penalty.

Conclusion

Despite the potential use of Exception 1 to defer the payment of tax, there are practical compliance reasons why that method of determining quarterly estimated tax payments has been part of the pay-as-you-go tax system since its inception in 1943.(10) The AICPA and other concerned groups have offered to the Treasury and Congress other alternatives for accelerating estimated tax payments of individuals while retaining the use of the prior year's tax to base current year's estimates. One alternative for example, is to require individuals with AGI in the prior year over a certain amount (e.g., $75,000) to base their current year's estimate on more than 100% of their prior year's tax (e.g., 105%).(11) At the present time, practitioners and their clients can only hope that Congress will soon realize the complexity and burden created by the new law for both individual taxpayers and the IRS and replace it with a more workable method. (1) P.L. 102-164, 102d Cong., 1st. Sess. (1991). (2) Sec. 6654(d)(1)(B)(ii). (3) Sec. 6654(d)(1)(C)(iii), added by Section 403 of P.L. 102-164. (4) Sec. 6654(d)(1)(C)(ii)(I) and (II). (5) Sec. 6654(d)(1)(C)(ii)(III). (6) Sec. 6654(d)(1)(C)(i). (7) Sec. 6654(d)(1)(C)(iv). (8) Sec. 6654(d)(1)(E)(ii). (9) Certain estates and trusts are also affected by the new law (Sec. 6654 (1)(1)). The problems fiduciaries and beneficiaries of estates and trusts will have in order to comply with the new estimated tax rules are beyond the scope of this article. (10) The requirement to make estimated tax payments was incorporated in the 1939 Code by amendments contained in Section 5 of the Current Tax Payment Act of 1943. (11) As this article goes to press, a provision is included as part of the Democratic tax legislation passed by the House that would allow taxpayers to base their current year's estimates on 115% of last year's tax. However, that provision would apply to taxpayers at all income levels.
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Author:Luchs, Lorin D.
Publication:The Tax Adviser
Date:Apr 1, 1992
Words:1901
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