Paying taxes on nonpayroll income

Dear Tax Talk,
I know that a taxpayer gets penalized when filing taxes if he or she owes over a certain amount. So what should a taxpayer do if he or she makes a sizable profit (let's say $20,000 for argument's sake) on the sale of a stock, property, etc., early in the new tax year? At what point is the taxpayer legally obligated to pay tax (capital gains) on that profit -- April 15th or immediately? And does the answer to that question change if that profit knocks the taxpayer into a higher tax bracket? Thanks. -- Pat

Dear Pat,
The penalty you're referring to is the penalty for underestimating your tax. Most folks have taxes withheld from their paychecks and never have to worry about making estimated tax payments. Other folks who don't have taxes withheld (such as retirees or independent contractors) or derive a good amount of income from sources where there is no tax withholding (such as capital gains, dividends and interest) have to make quarterly estimated tax payments.

Form 1040-ES is used to remit estimated taxes to the Internal Revenue Service on a somewhat quarterly basis. Quarterly taxes for 2004 are due on the 15th day of April, June and September in 2004 and January 2005. Failure to make estimated tax payments can result in the IRS levying a penalty in the form of an interest charge for the tax payment shortage. The penalty averages around 3 percent of the underpayment.

When targeting your estimated tax, you can use one of two simple methods:

1. Pay 100 percent of the tax you owed in the prior year or
2. Pay 90 percent of the tax you expect to owe for the current year.

If your 2003 adjusted gross income was in excess of $150,000 ($75,000 if married filing separate), you have to target 110 percent of your 2003 AGI. Most people who expect to earn the same or more use the first option; those that expect decreases would have to use option 2 to avoid overpaying their taxes.

As an example, let's assume your 2003 tax was $10,000, your AGI was less than $150,000 and that your tax in 2004 on all income but the capital gain will also be $10,000. You expect to owe 15 percent of the $20,000 gain in addition to the $10,000, so your total tax for 2004 will be $13,000. Based on your current withholding, you expect to have $10,000 in tax withheld by the end of the year. Since your withholding covers your 2003 taxes, you do not have to make estimated tax payments.

Suppose your withholding will only come to $9,000. Now you're $1,000 short based on 2003's safe harbor. If you didn't have the capital gain, then you would be fine because you hit 90 percent of 2004's taxes through withholding. However, since you'll have the gain, you can expect a penalty of $30 (3 percent of the $1,000 you're short to be penalty proof) or you'll need to make estimates.

Note that the penalty is not based on what you owed with the 2004 tax return, but rather what you were short in order to be penalty proof. You could owe $1 million with your 2004 tax return and your penalty would only be based on the $1,000 that you were short.

Estimated tax can get very complex, especially when you have capital gains throughout the year that cause you to be short on your tax payments. As in the example, the person was penalty proof until they sold something that resulted in a gain. If the sale occurs in September, quarterly estimates would have been past due by the date of the sale. In that event, that person would need to use the seasonal income method to avoid paying a penalty on estimated payments due prior to the sale date of the item. This exception requires you to compute your tax for each quarter based on income received for that quarter. Trust me: You don't even want to attempt the seasonal income method unless you have a good accountant.