Estimated Tax Payments: Should You Use Annualized Income?

by Katherine Gustafson on March 6, 2014

Making estimated tax payments comes with the territory when you strike out on your own. If business is predictable, it’s easy enough to send the IRS a set amount on a quarterly basis. But if your income fluctuates throughout the year, how do you ensure you don’t get penalized for underpayment?

The general rule is: You may owe a penalty if your total withholding and estimated tax payments do not equal at least (1) 90 percent of the tax you owe for the current year or (2) the full amount of tax you owed the previous year, whichever is less.

Separate penalties are applied to each estimated tax payment and due date, so you could end up facing multiple penalties — or get slapped with one for underpaying in April, even though you paid the balance of what you owed in September. Underpaying is classified as missing the due date for a full payment. This holds true even if you end up getting a refund when you file your return. It isn’t a trivial problem: In 2012, U.S. businesses were assessed over $936 million in late fees for failing to file business income tax on time.

So, how can you avoid paying penalties when your income varies?

As with everything involving taxes, the IRS has a form to fill out. Follow the process outlined on Form 2210 [PDF] to determine whether you owe a penalty. (Get instructions here.) Whether you owe will depend on whether you use the regular amendment calculation or the annualized income installment method. The form will help you figure out which one best fits your business.

If your income varies during the year, then figuring your tax burden using the annualized income installment method will allow you to show why your business should be able to lower (or eliminate) one or more of the required estimated tax installments. Submitting your justification via this form — if you meet the criteria to submit it — can often get an underpayment penalty reduced or eliminated.

Filling out the annualized income method section of the form takes more time than using the quick or regular amendment method, but it gives highly volatile businesses more leeway for errors and holds out the prize of reduced penalties. You should use annualized income when calculating your estimated state income taxes as well.

Of course, hiring a good accountant to help you may save you a lot of headaches. And being able to anticipate the high and low quarters your business is likely to experience in a given year can also help you avoid penalties in the future. Regardless of how you manage your tax planning, you now know that even if you have a massive windfall in Q4 next year, you have a means to set the record straight.