Governments will try to get away with almost anything during wartime. In the Civil War, President Abraham Lincoln suspended the writ of habeas corpus so federal authorities could lock up suspected Confederate sympathizers and throw away the keys. This action was more than mere ink on paper; it was very vigorously enforced, especially in Maryland and other Border States. He also signed the Revenue Act of 1861, which put an income tax into effect. The government gave up in 1862, partially due to Constitutional concerns regarding the Apportionment Clause (all taxes must be apportioned between the states), but mostly because the Revenue Act simply didn’t raise much money.
Congress took care of that Constitutional technicality with the 16th Amendment in 1913. But it wasn’t until 1943 (yet another war) that the money started rolling in. That was the year President Franklin Roosevelt signed the Current Tax Payment Act. According to government historians, source withholding made it much easier to raise income taxes. It’s the same reason that you use coupons at the County Fair. Just like it’s a lot easier to charge folks $10 for thirty seconds on the Ferris wheel if they fork over a handful of coupons instead of cash, it’s easier to charge people a gazillion dollars in income taxes if their payments are just a line on a form.
So, for wage-earners, underpayment is never a problem. Some people even over-withhold, either to hide money from their soon-to-be-ex-spouses, which is not exactly legal, or as a means of forced savings, which is not exactly smart. But for business-owners, self-employed people, pension recipients, and others who are similarly situated, the underpayment penalties can be almost as bad as not paying the tax at all. This is a subject that starts to weigh heavily on people’s minds about this time of year, as we approach the fourth quarter.
Safe Harbor Defenses to Underpayment
To avoid a penalty, which is always more than the bank interest rate, the IRS must receive regular quarterly payments that are sufficient to satisfy the entire balance for the current tax year. It is not enough to put yourself on a payment plan that involves paying a bit now and the rest on April 15 of the next calendar year. Similarly, the Service does not allow make-up payments; you can’t pay nothing on April 15 and $50,000 on June 15. Fortunately, there are two recognized defenses to underpayment.
First, there’s the 90 percent current year rule. There is no penalty if advanced tax payments equal at least 90 percent of the taxpayer’s total liability for the current year. The problem with this defense is that the second part of the equation – the current tax liability – is probably an unknown amount. For this reason, most taxpayers rely on the second safe harbor defense.
The 100 percent prior year rule, which means what it says: there is no underpayment penalty if even quarterly tax payments equaled 100 percent of the prior year’s tax bill. Taxpayers who earn more than $150,000 annually must pay 110 percent to qualify.
Affirmative Defenses to Underpayment
These safe harbors are the best defenses, but there are a couple of affirmative defenses as well. While they are considerably broader than the safe harbors, they are also considerably more difficult to prove.
Fishermen, farmers, and others who received income unevenly throughout the year may be eligible for special waivers pursuant to Publication 505. To claim the waiver, the underpayment must be due to reasonable cause and not willful neglect. In a similar vein, taxpayers who experienced a “casualty, disaster, or other unusual circumstance” are entitled to waivers if “it would be inequitable to impose the penalty.”
As always, reach out to me right away if you have questions or concerns, so we can get ahead of the problem.