Estimate carefully to avoid penalties - federal tax

Nation's Business, May, 1989 by Gerald W. Padwe

Estimate Carefully To Avoid Penalties

Most corporations pay estimated taxes, and so do many individuals who have income--such as interest and dividends--that is not subject to withholding. Since an estimated tax payment for a given year may be due as much as a year in advance of determining the final tax liability for that year, the difficulties of making appropriate estimates are obvious.

The penalty for understimating your tax liability is significant. It is equal to the interest rate on tax deficiencies at any given date--currently 12 percent a year--for the period of the underpayment. Keep in mind that such payments are penalties and cannot be claimed as deductions.

At a 34-percent top corporate tax rate, the equivalent deductible interest charge that equates to a 12 percent penalty is 18 percent. This is a rather significant fee for missing the admittedly difficult task of estimating current-year tax.

Recognizing this difficulty, the law provides various safe harbors that, if met, can help you avoid any estimated-tax penalty even if the required estimated taxes have not been paid for the year. The most common safe-harbor exception involves basing this yearhs estimated tax on last yearhs actual tax. Depending on whether you are an individual or a corporation, a limited number of other exceptions may also apply.

Many penalties in the Internal Revenue Code also contain a subjective exception. Where a taxpayer acts in good faith and has "reasonable cause" for an action, the Internal Revenue Service, at its discretion, may waive certain penalties.

Until recently; estimated-tax penalty waivers were not possible, since there was no statutory provision allowing the IRS discretion in this area. In the past, if a taxpayer fell within the arithmetic boundaries of an estimated-tax underpayment, the penalty was automatic and final.

Interestingly, as the law has become significantly more complex over the past decade and the estimated-tax provisions themselves have become much more difficult to understand and comply with, Congress has finally begun to enact some limited waivers of estimated-tax penalties.

In some cases, they have not been at the discretion of the IRS but have been required by law.

Numerous amendments to the Internal Revenue Code included in the 1988 Technical and Miscellaneous Revenue Act (TAMRA) have effective dates going back to 1986. Because taxpayers were not permitted by the IRS to assume the passage of any technical-corrections bill and were required to report transactions on returns under a different set of rules than everybody "knew" would be the final law, there is a provision in TAMRA requiring waiver of some estimated-tax penalties. These waivers arose from installments of estimated taxes made earlier in 1988 that were correct based on the law when the installment was paid, but that turned out to be low based on the law retroactively applied after passage of TAMRA late last fall.

Accordingly, if you receive a notice from the IRS stating you owe a penalty for underestimating 1988 tax, talk with your tax adviser before paying the bill. It is just possible you may be entitled to a waiver if the penalty arose as a result of one of the retroactive TAMRA changes.