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Return to safe harbor.

In November 1991, Congress repealed the estimated tax safe harbor for certain individuals and small businesses. The repeal creates a serious problem for many individuals, who now cannot be sure until the end of the year whether they qualify for the safe harbor or if they are required to pay 90% of their current year liability.

To solve this problem, Senator Dale Bumpers (D-AR) has introduced a new bill allowing individuals with large income increases in a given year to protect themselves by paying 100% of their prior year's liability. Senator Bumper's proposal creates a safe harbor for high-income individuals with large increases in taxable income which will always be based on the prior year's tax liability.

The Problem

Under existing regulations, most taxpayers will not be subject to underpayment penalties in the current year as long as they paid 25% of their previous year's liability in each quarter. However, taxpayers with higher incomes who also see a large increase in taxable income during the year face a serious problem. Taxpayers who meet the following four requirements must file estimates based on 90% of their current year liability:

1. The taxpayer must have current year adjusted gross income (AGI) exceeding $75,000 ($37,500 for married filing separate);

2. The taxpayer's current year AGI, less any gain from the sale or exchange of a principal residence or an involuntary conversion, must exceed the prior year's AGI by more than $40,000;

3. In any of the three preceding tax years, the taxpayer must have either made an estimated tax payment or been assessed a penalty for failure to make an estimated tax payment; and

4. Ninety percent of the taxpayer's current year liability must exceed 100% of the taxpayer's previous year liability.

The problem with this system is that items one, two and four are not certain until the end of the current year. As a result, many individuals must project their current year income for estimated tax purposes throughout the year on the possibility that they might be subject to disqualification from existing safe harbor provisions. Preparation of these estimates requires an extra investment of time on the part of both the tax preparer and the client--an investment that in many cases proves to be unnecessary if, at year-end, they find that the client would have been protected under the original safe harbor provisions. The problem with the current system is this reliance on year-end information to determine current-year estimated tax liability.

Proposed Solution

Recognizing this problem, Senator Bumpers has proposed legislation ending the requirement that any individuals file estimated taxes based only on current year income. While still allowing estimates based on 90% of the current year's liability, the Bumpers proposal would allow a safe harbor for all taxpayers based on prior year's tax liability, with some high-income taxpayers who have large income increases paying a higher percentage of their previous year's liability.

The proposal looks at estimated taxes over a three-year period, as opposed to the present regulations' focus on only two years. Under the Bumpers plan, year one becomes the base year. In year two, a taxpayer who pays estimates based on 100% of year one's income will not be subject to penalty, regardless of year two's income. In year three, however, taxpayers whose AGI in year two was over $150,000 and whose income in year two exceeded their year-one income by over $40,000 will be required to pay estimates based on 110% of their year two liability in order to qualify for the safe harbor. The option of paying 90% of the current year's liability remains available to all taxpayers throughout the cycle.

For example, in year one, T has an adjusted gross income of $100,000 and a tax liability of $20,000. In year two, T pays four quarterly installments of $5,000 each. When calculating his tax at year-end, T discovers that he had $160,000 AGI and a $35,000 tax liability. Under the Bumpers proposal, T is not subject to penalties for underpayment of his estimates because he paid in 100% of his year one liability.

Because his AGI is over $150,000 and it increased by more than $40,000 from year one to year two, T crosses the threshold into the proposal's higher safe harbor requirement. If T wants to take advantage of a safe harbor in year three, he will have to pay in 110% of his year two liability in order to avoid underpayment penalties. His quarterly payments will be $9,625 (|$35,000 x 110%~ / 4). If his year three income is substantially lower than year two, T may profit from estimating 90% of his current year liability instead.

Senator Bumpers' proposal cures the existing problem because it allows a safe harbor for all taxpayers based on the prior year's income. While increasing some taxpayers' quarterly estimates, it will reduce the time accountants must spend preparing the estimates. The reduction in professional time could result in a savings to the taxpayer that compensates for any increase in the quarterly obligation.

Endorsement Only As Is

Senator Bumpers developed his proposal with input from numerous business representatives in Washington, DC. The coalition he worked with to create the bill has resulted in widespread endorsement for the final product. NSPA has endorsed the bill, as have the American Institute of Certified Public Accountants, the National Federation of Independent Businesses, and the National Association of Enrolled Agents.

All these groups concur with the Senator that this proposal represents the limit that small business and individuals should be expected to bear in order to resolve the safe harbor problem. As Sen. Bumpers notes:

"It is, in fact, quite outrageous to ask the small business community to pay any price to remedy the problem Congress created. By proposing a reform that raises $600 million in revenue for the government, the small business community expects that the reform will be enacted expeditiously and in the form proposed ... The small business community will not be suckered into paying a higher price for reform of the estimated tax payment mess."

Senator Bumpers introduced the bill (S739) in the Senate on April 2. Be sure to watch your NSPA publications for information as it moves through Congress.
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Title Annotation:Capitol Corridors; tax shelters for high-income individuals
Author:Lear, Jeffrey
Publication:The National Public Accountant
Date:Jun 1, 1993
Words:1044
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