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Most taxpayers who earn less than $100,000 a year have their income tax withheld in their paycheck. But a sizable number of people who earn more than that estimate and pay taxes quarterly. The more entrepreneurial your business or the higher your income, the more likely it is you'll do estimated taxes.
This tax-estimation process is more complicated than usual this year because of what has happened to stock prices. Those taxpayers who made lots of stock sales to try to preserve profits in a sliding market are facing a double whammy: a shrinking stock portfolio and a bigger-than-usual tax bill on the capital gains of the stock sales. There are a couple of ways to deal with the problem.
Let's say you were heavily invested in technology shares early in 2000. The stock market, especially the Nasdaq, took a major tumble in the spring. You sold shares in April to preserve some profit on stocks you purchased a year or two ago at much lower prices. You may not have lost your shirt in the bear market, but there's still some bad news: "The craziness in the stock markets has caused some unpleasant tax consequences," says Larry Torella, a CPA with Richard A. Eisner & Co. in New York.
MAJOR CRUNCH.
If you're a taxpayer who estimates your tax bill, you may owe more than you think on June 15 (today is the second-quarter deadline for payment of estimated taxes). If that's not enough to ruin your day, don't forget that if you underpay estimated taxes, you face a 10% nondeductible penalty on the underpaid portion of the tax bill. Self-employed taxpayers are all too familiar with the problem. But this year's cascading Nasdaq prices have introduced the problem to many more folks.
If you've never done a quarterly estimate, it can be a challenging math problem and could cause a major cash crunch. The simplest method for most taxpayers is to pay 100% on a quarterly basis of what you paid the previous year to protect yourself against penalty. For example, let's say you sold shares in April, 2000, for $75,000. Since they were worth $100,000 in February, 2000, at the market's peak, it's easy to forget that you only paid $35,000 in 1997.
The bottom line: You've got a $40,000 long-term capital gain which is taxed at 20%, or $8,000. You don't have to pay taxes on that gain until Apr. 15, 2001, as long as you're on schedule paying your estimated taxes. To see if you're on track, take a look at your cumulative withholding through May 31 and "annualize" it by multiplying the total by 2.4. If your withholding is not keeping up with last year, then you need to make an estimated payment on June 15. If you're a few days late, the IRS may charge you several days' interest.
NO IRS INTEREST.
And it gets trickier. If your gross income -- minus alimony, IRA contributions, and a few other adjustments -- was more than $150,000 in 1999, Congress has decreed that those paying estimated taxes must fork over 108.6% of last year's tax to avoid penalties. The problem with paying 100% (or 108.6%) of last year's taxes on a quarterly basis is that you might overpay and, of course, the government won't be paying you interest for the extra money. There's another method: to pay 90% of what this year's taxes will be. But for people who are selling stocks, it's hard to predict what yearend income will be. And if you end up being short, you'll be charged 10% interest on the shortfall, just as if you borrowed money from the bank.
Still, you would prefer the second method if your 2000 income were projected to be much lower than your 1999 income. Bernie Kent, a CPA with PricewaterhouseCoopers in Detroit, is used to dealing with wealthy individuals. One client made millions in 1999 after exercising his stock options. This year, the client had $1.4 million of long-term capital gain for the first five months of 2000. Kent says he didn't want his client to pay 108.6% of 1999 income -- that would be way too much tax in 2000. So he estimated a 20% capital gains tax on the $1.4 million, which is $280,000, and advised him to pay $70,000 each quarter.
"The problem is that if my client has additional capital gains during the rest of the year, then he will be underpaid for the second quarter," says Kent. That's because the IRS totals up all of the income at the end of the year -- regardless of the timing within the year -- calculates the tax, and expects a quarter of the payments to be made on Apr. 15, June 15, Sept. 5, and Jan. 16, 2001.
LIVING WITH LESS.
But what happens if you forget to pay your estimates? One way to catch up on late payments is to have your employer increase your year 2000 withholding tax. Regardless of the actual timing, the increased withholding tax payments would be treated as if they were paid throughout the year. But who wants to live with less of a paycheck? No matter how you slice it, paying estimated taxes can cause some cash-flow pain.
"I have one client who will never pay estimated taxes, says Torella, "under the theory that he can earn investment returns greater than 10%" on the money. Of course, the way the markets have gone in 2000, that's no longer a foregone conclusion.
Weiss is a CPA and a freelance business writer living in Portland, Ore.
EDITED BY BETH BELTON
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