Underpayment Penalties and the Kinder, Gentler IRS
By James T. Connolly, CPA, Partner
I know what you’re thinking: “Is this a joke? The IRS…kinder…gentler? Why, they’re the American version of the KGB! And yet, Mr. Connolly, you describe them as ‘kinder’ and ‘gentler’?!?”
First of all, please call me James. Secondly, I’m not saying the IRS is not a formidable force capable of inflicting great pain (financial and otherwise) on citizens that run afoul of its rules, especially those who do so willfully. That is still true. And I’m not saying that it is an efficient machine with a customer service record equal to a Chick-fil-A restaurant. Sadly, it is not. Its phone hold times still often exceed two hours.
What I am saying is that deep within the belly of the beast there are at least a few (maybe more) civil servants that are not only reasonable, but might even have a little bit of a heart. Why do I say that? I’m glad you asked.
Almost everyone has heard about tax reform under the “Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.” What do you mean? You haven’t heard of that? Maybe you know it by its shorter, original name: “Tax Cuts and Jobs Act (2017).” Does that ring a bell?
Good. That Act, weighing in at a very modest 185 pages, is probably the most sweeping and consequential piece of tax legislation since the Tax Reform Act of 1986. It is significant not only in that it touches so many areas of the tax code but also because it fundamentally changes most of the areas that it touches.
“So, what does this have to do with underpayment penalties and the ‘kinder, gentler IRS’?” Glad you asked (and thank you for getting me back to the point). Our beloved (just go with it) Internal Revenue Service has been working feverishly since the Act was passed in December 2017 to provide guidance via regulations, notices and revenue procedures to help us implement the effects of the Act. It has been churning these out at a feverish pace all through 2018 and early 2019.
“So what…that’s what we pay them for?” I completely understand. But here’s the thing, with many of these documents not being issued until late 2018 or early 2019 or, if they were issued earlier, only being issued in proposed form, we’ve not fully known the rules of the game that we’ve been playing under for 2018. As such, many taxpayers have not been able to accurately estimate their taxes and make adequate estimated tax payments.
Here is where the kinder, gentler IRS comes in. It actually understands our plight. As a result, it has softened the underpayment penalty rules for the 2018 tax year.
Do you remember those rules? “Maybe…sorta…kinda.” We’ll allow time to briefly summarize those.
The Internal Revenue Code contains numerous penalties to help ‘encourage’ compliance with its rules. They are too numerous to list. One of the most relevant is found in Code Section 6654 “Failure by individual to pay estimated income tax,” better known as the “Underpayment Penalty.” The penalty is charged on taxpayers who have not paid in a sufficient amount of their taxes throughout the tax year.
There are two primary ways to escape the penalty:
- Pay in 100% of your prior year tax (110% for taxpayers with Adjusted Gross Income greater than $150,000) – aka “Exception 1”
- Pay in 90% of your current year tax – aka “Exception 2”
You may also escape penalty if your current year net tax due after withholding is less than $1,000 or if you had no tax liability for the prior year.
“So how is the IRS helping me with this?” Great question. To be sure, there has been no relief provided related to exception 1. Regardless of the tax law changes, you should have known your 2017 tax and could have relied upon it to escape the underpayment penalty.
However, for “Exception 2,” you may find some solace. On January 16, 2019 (after the 2018 tax year was already completed), the IRS issued Notice 2019-11, which effectively changed the percentage to be paid in under Exception 2 from 90% to 85%. What’s more is that this percentage only had to be checked at January 15, 2019 rather than each quarter throughout 2018. So, if your tax liability for 2018 turned out to be $100,000, and you decided to get in a payment of $85,000 on January 15, 2019, you would have saved yourself over $3,000 of underpayment penalty!
That’s all well and good. But, would you believe that the IRS issued another notice about this same issue a mere two months later, and this time they reduced the percentage even further – to 80%? In the above example, now you would have only had to pay in $80,000 rather than $85,000.
It’s as if the IRS felt a little guilty about everything, was not sleeping well at night and decided to issue the first ‘reprieve.’ Then another couple of months passed, and it still wasn’t sleeping well. So, it decided to enhance the reprieve even further.
If that doesn’t prove that we are dealing with a kinder, gentler IRS, I don’t know what does.
The fine print is that this reprieve is only temporary. It only affects the 2018 tax year. If you have questions about this reprieve or how to better manage and avoid underpayment penalties in any year, please reach out to your tax professional for further assistance.