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Safe harbor for higher income taxpayers

September 21, 2016

My last update on Sept 8 2016 (Saving taxes through payroll) briefly touched on the timing differences between estimated quarterly taxes and withholding through payroll. This week I will extend and elaborate upon the concept of estimated taxes, in particular how higher income taxpayers can ballpark their 2016 taxes and avoid underpayment penalties and interest.

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IRS Publication 505 provides guidance for taxpayers regarding estimated taxes and withholding. The following excerpts introduce these concepts: 

 

"The federal income tax is a pay-as-you-go tax. You must pay the tax as  you earn or receive income during the year. There are two ways to pay as  you go:

1. Withholding. If you are an employee, your employer probably withholds income tax from your pay. In addition, tax may be withheld  from certain other income, such as pensions, bonuses, commissions, and  gambling winnings.

2. Estimated Tax. If you do not pay your tax through withholding, or do not pay enough tax that way, you might have to pay estimated tax.  People who are in business for themselves generally will have to pay  their tax this way. Estimated tax is used to pay not only income tax, but  other

taxes such as self-employment tax and alternative minimum tax."

 

So who needs to pay estimated tax? The IRS is so glad you asked...

 

IRS Publication 505 provides the following "general rule":

"In most cases, you must pay estimated tax for 2016 if both of the following apply:

1. You expect to owe at least $1,000 in tax for 2016, after subtracting your withholding and refundable credits.

2. You expect your withholding and refundable credits to be less than the smaller of:

a. 90% of the tax to be shown on your 2016 tax return, or

b. 100% of the tax shown on your 2015 tax return."

 

So what if you are going to owe a whole lot more than $1,000 in taxes? The IRS is glad you asked, because they have a special rule that might apply to you. "Higher income taxpayers," or taxpayers whose adjusted gross income for the prior year (2015 in this case) was more than $150,000 ($75,000 if married filing separately), are required to pay in the smaller of: 

a. 90% of the tax to be shown on your 2016 tax return, or

b. 110% of the tax shown on your 2015 tax return.

 

The amounts above (90%/100% and 90%/110%) represent what is known as safe harbor. "Safe harbor" is the amount of tax that needs to be paid in to the IRS by Jan 15 of the following year in order to avoid underpayment penalties and interest (which the IRS is happy to calculate for you).

 

Additionally, the IRS will assess penalties if the taxes are not paid in as the income is earned/received. For example, assume a taxpayer earns $200,000 of self-employment income evenly throughout the year. Each quarter, the taxpayer would owe taxes on $50,000 of income, at roughly a 40% tax rate (approximately $20,000 in taxes a quarter).  If the taxpayer waits until the fourth quarter to pay 90% of the total $80,000 in taxes due, there will be penalties assessed for not having anything paid in for the first three quarters of the year.

 

Now, let's revisit Saving taxes through payroll. Consider the flexibility granted to the taxpayer by structuring the business as an S Corporation and paying taxes through payroll withholding rather than through estimated quarterly tax payments. In this scenario, the higher income taxpayer could wait until the fourth quarter to pay in 90% of the total taxes due (which we know will be less than the $80,000 above because of the tax savings from the 'S Corp' structure), AND, since the taxes are withheld through payroll, they are treated as having been paid in evenly throughout the year.

 

To bring it all together - Payroll can help small business taxpayers save money on taxes while affording greater flexibility to meet safe harbor requirements. 

 

So what else is payroll good for? I'm glad you asked! Over the next few postings I will explore additional tax savings opportunities through payroll benefit plans, such as Solo 401(k) and Section 105 Medical Reimbursement Plans.

 

If you have any questions about this week's or any prior week's tax blog, please email me at gmcmichael@cpa.com. I look forward to hearing from you!

 

Grant

 

 

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