Unexpected Income & Estimated Taxes

Absent any other information, they assume equal income and deductions throughout the year.

The amount isn't estimated, it's calculated based on the above assumption. Because your income was all lumped at the end of the year, you can reduce or eliminate the penalty by completing Schedule AI of Form 2210 and attaching it to your return.

No. Each year stands alone.

In TurboTax was playing around with Form 2210 (Underpayment of Est. Tax) and I checked "Check if you had no tax liability for 2006", and the penalty disappeared. Does this make sense for me to do? If so, should I still attach Schedule AI (I can do it easily with TurboTax)?

Great to know... this always confused me.

Thanks Phil!

Sorry, the fact that you had no 2006 tax liability and didn't file a return slipped past me the first time. All you have to do is check that box in TT. Note: IRS already knows you had no 2006 tax, so the form doesn't actually go with the return, so don't panic when TT doesn't produce a copy to send. See the 2210 instructions.

Thanks for the confirmation Phil!

This is the "safe harbor" rule: If your payments during the year (withholdings + estimated taxes) are at least the previous year's liability, there's no penalty for underpayment. This means that for the year after you had no tax liability, you don't have to make any payments until the return is due.

Last sentence is correct, but not "If your payments during the year (withholdings + estimated taxes) are at least the previous year's liability, there's no penalty for underpayment". First, it includes only your withholding. Second, if your AGI is above a limit, then the rule is 110% of the previous year's liability. And the requirements are more lenient for farmers and fisherman.

In this case, the previous year's liability was $0, so 100% or 110% of that is still zero.

What are the sources of backup withholding? I called my brokerage and asked if they could withhold taxes from my dividends and capital gains, and they said no. So the only backup withholding I know of is W2, and gambling withholding.

Sorry, but you're wrong. Timely equal ES payments are included in determining whether the prior-year safe harbor is met. Aside from the fact that I've used this one many times, it's covered in Pub 505. Perhaps you're thinking of the $1,000 balance due safe harbor, which considers only withholding.

Stop filing and paying long enough and you'll learn that your brokerage can withhold. They are not required, nor do they want, to voluntarily withhold.

There are basically two categories of backup withholding: "no TIN" and "noncompliance." (Withholding from gambling winnings isn't necessarily backup withholding. It's more like wage withholding, but with different rules.)

If a covered payor doesn't get a TIN from the payee, they must backup withhold. The onus here is on the payor.

Noncompliance backup withholding is initiated by the IRS. I don't recall all the criteria and notice stream, but it basically boils down to the payee isn't in full compliance (reporting and paying), IRS tells the payor to backup withhold, and it's a somewhat complicated process to get the backup withholding order revoked.

How does "safe harbor" relate to extensions on filing?

That is, suppose I have unexpected or unplanned income -- maybe lots of it -- but I've fully satisfied the safe harbor requirements, whatever they may be, based on my last year's return.

Am I then fully safe as regards this year's return, even if I request a

6 month extension?

Or am I only safe provided that I file this year's return by April 15 -- or at least pay the full amount needed to cover this year's return by April 15?

Safe harbor saves you from a penalty for being underwithheld. It has nothing to do with the April 15 deadline for paying the rest of what you owe. Filing an extension doesn't change this, either. You're always required to pay by April 15, the extension just allows you to send the paperwork (the tax return) later.

But line 6 on part I of form 2210 says "6. Withholding taxes. Do not include estimated payments", with "Do not" in bold. I created a scenario in my tax program: single filer with 200k income.

Scenario 1: no estimated tax paid line7 0000 (wages) line432066 (taxable income) taxI450 (tax) line64=0 (tax withheld) line65=0 (estimated tax) line77%21 (penalty)

Scenario 2: estimated of 60k paid (15k each quarter) line64`000 (estimated tax, each quarter) line77=0 (penalty)

Form 2210 in Scenario 2 is: Part 1.line1I450 (tax due) Part 1.line5D505 (90% of tax due) Part 1.line6=0 (withholding taxes, no estimated) Part 1.line8000 (tax due based on prior year) Part 1.line9D505 (required annual payment) Part 1.line9=Yes (you may owe a penalty, but do not file unless a checkbox is checked)

Part 2.checkboxes = none

As you can see estimated tax payments are not used in determining if the prior year safe harbor is met.

Part 3.line10D505 (required annual payment) Part 3.line12`000 (estimated tax) Part 3.line14=0 (total underpayment) Part 3.line17=0 (penalty)

So the penalty still turns to be zero, so it's as if the estimated tax was used in determining prior year safe harbor.

Why don't they want to? Customers like it as it may help them meet the safe habor.

Correct. Notice then that line 7 is the $1,000 balance due test. This is the "balance due less than $1,000" safe harbor, which considers only withholding.

How do you reach that conclusion? You haven't even figured penalty yet. All you know at this point is that there was a required payment. There's no conlusion yet drawn whether the safe harbor was met.

To quote our esteemed Vice President, "So?" How does that differ from what I said: "Timely equal ES payments are included in determining whether the prior-year safe harbor is met"?

My software then goes on to complete Part IV, where the zero penalty is computed since all required installments were timely paid.

Finally, going back to line 9, we find that when the prior year safe harbor is met through timely equal ES payments you don't have to file a 2210. That's because IRS already knows about them.

And we all know that brokerages, just like banks, exist only to satisfy their customers.

All kidding aside, it goes back to that famous word that has three double letters in a row: bookkeeping. It's a major hassle, and that's one reason they don't want to do it. Even worse for a brokerage. What if there's no cash in your account? Where are they going to come up with the cash to pay the withholding? Banks especially want to hang onto your money rather than paying it over to Uncle Sugar through withholding. After all, most people don't withdraw from their interest-bearing accounts to pay the tax due on those accounts' earnings. They come up with the money somewhere else.

I have some special historical insight into this since I was one of many involved with implementing backup withholding at IRS. No matter how much gin I apply to my brain cells, I haven't yet been able to blot out the memory. Actually, my efforts have been partially successful. I can't be

100% sure that dividends were included in the legislative proposal story that follows, but I know interest was.

TCMP (anyone remember TCMP?) had shown that there was abysmal reporting of interest and dividend income on returns. Automated underreporter was but a glimmer in its daddy's eye, and IRS proposed withholding on interest and dividends as a legislative change. Bob Dole (R-KS), then chairman of Senate Finance, liked it. Financial service providers hated it and went to DEFCON

5 with their lobbyists, a/k/a campaign cash spigots.

They managed to kill automatic withholding. But we Kansans can get nasty when you rile us. Thus was born backup withholding, and more than one rumor had Bob Dole saying, "That'll make 'em wish they had universal withholding."