Abating the IRS Underpayment of Estimated Tax Penalty

The Underpayment of Estimated Tax by Individuals Penalty applies to individuals, estates, and trusts who do not pay enough estimated tax throughout the year or pay it late. This penalty can apply even if you ultimately receive a refund when you file your tax return. This post breaks down how you know you owe the penalty, how it’s calculated, and crucially, how you can get it abated using IRS Form 2210 and the annualized income installment method.

How You Know You Owe the Penalty

The IRS will notify you if you owe the penalty. This notice will detail the amount you owe and the reason for the penalty. For more information on understanding these notices, refer to the “Understanding Your IRS Notice or Letter” resource provided by the IRS.

How the IRS Calculates the Penalty

The penalty amount depends on:

• The amount of the underpayment.
• The period during which the underpayment was due and underpaid.
• The interest rate for underpayments, which the IRS publishes quarterly.

The calculation is based on the tax shown on your most recent tax return, minus any refundable credits.

Interest on a Penalty

Interest is charged on penalties, and it starts accruing from varying dates, depending on the type of penalty. This interest will continue to add up until your balance is fully paid.

Paying a Penalty

To prevent future penalties and accumulating interest, ensure you pay your estimated taxes in full and on time.

Removing or Reducing a Penalty

Sometimes circumstances beyond your control may lead to underpayment:

• Retirement or Disability: If you or your spouse recently retired after reaching age 62 or became disabled, resulting in underpayment or late payment, you could qualify for a penalty reduction.
• Significant Income Variations: If your income varied during the year, you could qualify for a penalty reduction.

You will need to complete IRS Form 2210 to request a reduction or abatement of the penalty.

Using IRS Form 2210 for Penalty Abatement

Form 2210 is the key tool you can use to figure out if you owe a penalty for underpaying your estimated tax and to request a waiver or reduction of that penalty. Here’s a step-by-step guide on how to effectively use this form:

1. Check Eligibility: Determine if you qualify for penalty reduction by verifying if any of the special circumstances (like retirement or significant income variations) apply to you.
2. Complete Schedule AI for Annualized Income Installments:
   • Why Use Schedule AI: If your income varied significantly during the year, using the annualized income installment method can lower or eliminate some required installments.
   • Step-by-Step Usage:
     1. Complete Schedule AI, Part I (and Part II, if necessary). Enter the amounts from Part I, line 27, columns (a) through (d), into the corresponding columns of Form 2210, Part III, line 10.
     2. Complete Part III of Form 2210 to figure the penalty by filling out the penalty worksheet in the instructions.
     3. Check box C in Part II of Form 2210.
     4. For each period shown on Schedule AI, calculate your income and deductions based on your accounting method. Ensure you include all income received and deductions paid during each period.
     5. Attach Form 2210, Parts I, II, and III, along with Schedule AI, to your tax return.

Annualized Income Installment Method (Schedule AI)

If your income fluctuates significantly through the year, the annualized income installment method can help you calculate a fairer estimated tax payment. Here’s how to use it:

• Figure Each Payment Period: Calculate your total income minus adjustments for each period. Include partnership or S corporation income or loss items if you’re self-employed.
• Adjust Deductions: If itemizing deductions, multiply them by the number of months in each period and enter the results.
• Qualified Business Income Deduction: Include this deduction according to the instructions for Forms 8995 and 8995-A.

Special Considerations

• Casualty or Disaster: If underpayment was due to a casualty, disaster, or unusual circumstances, you might qualify for penalty abatement.
• IRS Written Advice: If the penalty resulted from incorrect written advice provided by the IRS in response to your written request, you might be eligible for an adjustment. Submit a statement detailing your reliance on this advice along with copies of your correspondence.

Avoiding a Penalty

To avoid the underpayment penalty, ensure that:

• You owe less than $1,000 on your filed tax return.
• You paid at least 90% of the current year’s tax or 100% of the prior year’s tax, whichever is lesser.

Special Rules for Farmers and Fishermen

For individuals, estates, and trusts with at least two-thirds of their gross annual income from farming or fishing, there are specific rules:

• File and pay taxes by March 1 to avoid estimated tax payments.
• Alternatively, make an estimated tax payment by January 15 to avoid penalties.