Q: I am a business consultant who works part-time out of my home. The past few years my income has ranged between about $42,000 and $74,000. This year, the income was about the same for the first three quarters ($59,000 of gross receipts, but that’s before any expenses, so it may be more like 90 percent of that figure). I just received a $36,000 payment for a project. This is a windfall that I do not expect to see again, but it means that my net income may be over $100,000 for the entire year. My question relates to the estimated taxes that I have to pay on this windfall income. Is there a rule of thumb that is used, and what happens if I don’t pay in enough money?
A: There is no rule of thumb, other than following one of the provisions that allows you to avoid an underpayment penalty. There are typically two ways that you can use to avoid any penalty.
First, just to explain the issue, the tax law requires everyone to pay their tax liability throughout the year, which is often called “pay-as-you-go.” Most people satisfy this requirement through employer withholding from their pay.
People with self-employment income, or with investment income, need to ensure that they have paid in enough to avoid any penalty. Retirees generally need to make estimated payments.
Regardless of how you satisfy your payment obligation, a penalty is avoided if you pay at least 100 percent of your prior year’s liability (this is 110 percent if your prior-year adjusted gross income was more than $150,000) or 90 percent of your current-year liability.
Payments are measured quarterly, so the requirement is actually to pay 25 percent of the prior year’s tax each quarter, or 22.5 percent of the current year’s tax each quarter. Penalties may apply for one quarter but not for another, based on when you make payments.
The penalty is assessed as if it were interest on underpaid tax, although it is classified as a penalty. The rate used to compute the penalty is currently 3 percent, which means you pay the government interest at 3 percent of the underpayment.
The easiest way for you to avoid any problem would be to pay based on your 2011 tax liability, since you are not sure what your 2012 tax will be and you expect it to be higher than 2011.
So if you look at line 61 of your 2011 tax return (total tax), and divide by 4, that’s what you need to pay each quarter to avoid a penalty. Since we’re now in the fourth quarter, if you did not pay in the right amounts in the first three quarters you could still be penalized.
Any withholdings are deemed to be paid ratably throughout the year, so if you have any ability to have taxes withheld, you could fix the penalty for the early quarters, if that’s an issue.
Q: I just paid my property taxes to the county using my credit card. I probably won’t be able to pay off the charge until next year. Does that mean I can’t deduct the property taxes until 2013?
A: As an individual dealing with personal expenses, you would use what is called the “cash method” of accounting. This means that you deduct any otherwise deductible expenses when paid.
A payment made by credit card is considered to be a payment by a cash method taxpayer. The term “cash method” implies a payment in cash, but it is possible to borrow money for the purpose of paying a deductible expense.
The IRS has challenged deductibility of items paid by borrowing from a lender for the purpose of paying that same lender. For example, if I owe a lender $100,000 plus 5 percent interest each year, I get no deduction for interest paid if the lender simply adds $5,000 to the amount owed.
But courts have allowed taxpayers to deduct interest paid to lender “A” using funds borrowed from lender “B” on the theory that the taxpayer could have used lender B’s funds for any purpose.
So borrowing from whatever bank issues your credit card so you can pay the county taxes will be considered a “payment” for tax purposes.
James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.