The Internal Revenue Service expects you to pay income tax as you earn the money, either through withholding or via estimated tax payments. If you fail to forward enough to the IRS, you’ll pay a penalty for the shortfall. This doesn’t come into play if you’re just off by a few dollars. If your underpayment was less than $1,000, or if you paid at least 90 percent of your tax for the current year or an amount equaled to 100 percent of the previous year’s tax, you won’t pay a penalty.
If you didn’t withhold enough, you’ll have to fill out IRS Form 2210, “Underpayment of Estimated Tax by Individuals, Estates, and Trusts.” The information there determines whether you have to pay the penalty and how you calculate it. Two different methods can be used to calculate the money owed. You can use the short method if you made no estimated tax payments, if your only payments were federal income tax withheld by your employer or if you paid the same amount of estimated tax on each of the quarterly due dates. In other cases, you’ll have to use the long form.
In the short form, you’ll take your underpayment for the year and multiply it by 0.01995. Enter that on line 15 of Form 2210. If you’re paying on or after April 15, that’s the penalty you owe for the underpayment. If you’re paying earlier, take that amount, multiply it by the number of days before April 15 that you’re paying the bill, and then multiply that by 0.00008. Subtract that amount from the total on line 15 and pay that amount in addition to the total of taxes you didn’t pay over the course of the year.
The long form usually is required when you’ve underpaid your taxes and paid a different amount in estimated taxes every quarter. This might have occurred because your business increased during the year and you kept altering the payment amount to compensate. To complete this portion of Form 2210, you’ll effectively need to determine the underpayment penalties for every quarter. It provides four columns -- one for each quarter -- and you’ll complete each and aggregate the results to determine your penalty.
The IRS can waive the penalty if you failed to make estimated tax payments because of a casualty, disaster or other unusual circumstance that would make it inequitable to impose sanctions. It also can waive the penalty if you retired after age 62 or became disabled during the tax year and the underpayment was not due to willful neglect. On the other hand, if the IRS determines you underwithheld on purpose, such as by willfully failing to declare taxable income, you face increasing civil and criminal penalties for fraud.