Getting estimated taxes right to avoid a tax audit and penalties

Self-employed and independent contractors need to think about taxes a few more times a year than most. The underpayment of estimated taxes can easily result in an unexpectedly high tax bill and tax penalties.

Self-employed individuals and independent contractors paid via 1099 need to think about tax payments four times a year. Because federal, state and FICA taxes are not withheld, an individual needs to calculate and pay estimated payments throughout the year. Underpayment can result in tax penalties.

When starting up a business or if an unexpectedly large disbursement comes through at year-end, it may be hard to get estimated payments right. Re-investing or trying to keep a business afloat may mean inadequate cash flow to pay estimated taxes.

Business-related tax debts

Even politicians have tax issues. A Connecticut state senator who ironically co-chairs the tax writing finance committee recently admitted paying back taxes through an Internal Revenue Service installment agreement. According to a lien on file against his home, the senator owed almost $50,000 in back taxes from 2008 and 2009.

The senator explained that the debt related to a business situation. He had owned a billboard company. He had an unexpected tax bill after leaving the company. He did not elaborate, but it could have been that he received a large disbursement and did not pay sufficient tax on it.

Minimizing penalties for underpayment

It is necessary to make estimated payments on any income that is not subject to withholdings. This may include income earned from self-employment, alimony, rent, interest, awards and prizes to name a few.

An individual only pays estimated taxes if more than $1,000 is owed during 2014 after taking into account withholdings and "refundable credits." A taxpayer who switched from a salaried position to independent contractor status can avoid an underpayment penalty by paying 100 or 110 percent of the prior year's tax bill depending on whether he or she earned more or less than $150,000. Paying at least 90 percent of the tax owed in 2014 is another way to avoid the penalty.

Make estimated payments prior to the following dates in 2014:

  • April 15
  • June 16
  • September 15
  • January 15, 2015

For those who receive income unevenly during the year, annualizing income and making varying payments is a way to avoid or lower the penalty.

There may be options to reduce tax penalties and interest owed if you were unable to make timely tax payments. Several narrow circumstances exist when the agency will waive a penalty. The first is when a casualty, disaster "or other unusual circumstance" caused the failure to pay. The second is for individuals who retire or suffer a disability in a tax year when estimated payments were due.

When ignored, a tax debt increases as penalties and interest compound. Before the IRS files a lien against your property or seeks to levy assets, speak with a tax lawyer. An experienced tax attorney can discuss available options and assist in negotiating the best possible outcome.

Keywords: Estimated taxes, IRS tax penalties