Underpayment Penalty

Underpayment penalty is a tax penalty assessed by the IRS when estimated tax payments and/or income withholding are lower than minimum tax payments thresholds set by the IRS. The underpayment penalty stems from the fact that the US tax system is a “pay-as-you-go” tax system. Taxpayers must pay taxes as they earn income through the year (e.g. via withholding or estimated tax payments or combination of both) so inaccurate tax payments throughout the year can result in an underpayment penalty. In some cases, however, the underpayment penalty can be avoided. For example:

1. If throughout the tax year, the taxpayer paid the smaller of (a) 100% of the preceding year’s tax liability or (b) no less than 90% of the current year’s tax liability, such taxpayer will generally not be have to pay an underpayment penalty.
2. If total taxes owed for the current tax year minus withholding and credits are less than $1,000, underpayment penalty may be avoided.
3. If no tax liability was owed the preceding year, the underpayment penalty is not assessed.

When an underpayment penalty is owed however, the underpayment penalty can be waived under the following circumstances:

1. If failure to make accurate estimated tax payments was the result of a disaster, casualty or other circumstance which would make imposing the underpayment penalty unfair or inequitable, the IRS may waive the underpayment penalty.
2. If retirement (after the age of 62) or disability occurs during the tax year or the preceding year in which estimated tax payments were due, IRS may waive the underpayment penalty. This is provided the tax underpayment was not a result of willful neglect but reasonable causes.

To avoid an underpayment penalty, the IRS recommends that taxpayers make estimated tax payments in equal quarterly payments. Taxpayer can use Form 2210 (i.e. “Underpayment of Estimated Tax by Individuals, Estates, and Trusts) to determine if an underpayment penalty is owed due inadequate tax payments and whether or not such taxpayer is required to file form 2210 (e.g. taxpayer may owe an underpayment penalty and not be required to file Form 2210.)

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