Understanding the IRS’s Tax Underpayment Penalty and How to Avoid It

Whether you are a freelance worker or an owner who earns money from your business, if you didn’t pay the estimated tax properly, you could end up paying an Internal Revenue Service (IRS) tax underpayment penalty. 

This article covers what can trigger a penalty and what you can do to avoid penalties in the future. 

What is a tax underpayment penalty and how does it work?

Though you only file one tax return each year, federal income tax is technically a pay-as-you-go system. You’re expected to pay tax on your income as you earn it throughout the year. Ordinarily, your employer does this for you through income tax withholding. However, if you are a freelancer, you must make your own tax payments throughout the year.

A tax underpayment penalty is a fine imposed by the IRS on individual or corporate taxpayers who don’t pay enough of their estimated taxes, don’t have enough withheld from their wages, or who pay late. The purpose of this penalty is to promote on-time and accurate estimated tax payments from taxpayers. 

The IRS may charge the tax underpayment penalty if you owe more than $1,000 in tax when you file your tax return. They may also apply this penalty if the payments you made add up to less than 90% of the tax you owe. For example, suppose that you owe $10,000 worth of tax on your 2020 tax return, but you only made $8,000 in estimated tax payments. In this case, since your tax payments only amounted to 80% of the tax due, the IRS could apply a penalty. 

The tax underpayment penalty isn’t a static percentage or flat dollar amount. Suppose the taxpayer realizes that they have underpaid taxes. In that case, they must then pay the difference plus a penalty calculated based on the remaining balance owed and how long the amount has been overdue. 

The failure-to-pay penalty that applies to tax underpayments is 0.5 percent of the amount owed for each month (or another time frame) the tax is not paid. This underpayment/failure-to-pay penalty won’t exceed 25% of the unpaid amount. 

Along with a penalty, tax underpayments (as well as overpayments) generate interest. The IRS sets the interest rate every quarter for most individual taxpayers, based on the federal short-term rate plus 3%.

The interest payment rates for Q4/2021 (announced on Aug. 25, 2021) are:

  • 3% for individual underpayments
  • 5% for large corporate underpayments (exceeding $100,000)

Exceptions for underpayment penalties

There are certain exceptions when the underpayment penalty doesn’t apply, which are: 

  • A taxpayer’s total tax liability (after withholdings and credits) is less than $1,000
  • The taxpayer paid a minimum of 90% of the total tax from the current year’s return or paid 100% of their tax liability from the previous year. (*See below for a more detailed note)
  • The taxpayer missed a required payment due to an unforeseen, uncommon, or noteworthy event (such as a casualty or disaster)
  • The taxpayer retired at age 62 or older during the prior or current tax year 
  • Estimated payments were unfulfilled because the taxpayer became disabled during the tax year or the preceding tax year
  • Any other situation in which the underpayment was due to a reasonable cause, not willful neglect. 

(*Note: In this case discussed in this second point, the rule changes a bit if your annual income increases. If your adjusted gross income for the current tax year exceeds $150,000 ($75,000 if married filing separately), you must pay 110% of your previous year’s tax liability.

However, those who don’t qualify for the above exceptions may still qualify for a reduced tax underpayment penalty in certain circumstances. For instance, individuals who change their tax filing status from “single” to “married filing jointly” may be eligible for a reduced penalty because of the higher standard deduction.

What you can do if you received a tax underpayment penalty

Generally, if you fail to pay a sufficient amount of your taxes owed throughout the year, the IRS can issue a tax underpayment penalty. However, suppose you have already paid enough and still receive a tax underpayment penalty. In that case, you may request to have it waived by showing a reasonable cause or proving that you were unable to calculate your estimated income. 

In some cases, you may successfully reduce or eliminate your tax underpayment penalty if the IRS provided you with incorrect information. For example, if you called the IRS to address a question and got the wrong advice from an IRS agent, you might succeed in avoiding a tax underpayment penalty. To be eligible for this, make sure you always note down the date and time of your call to the IRS as well as the name of the person you spoke to. If you encounter an agent who is hesitant to give you a firm answer to your question, try to be patient with them. Many agents are cautious to answer anything that could be regarded as tax advice for fear of misspeaking or giving you wrong information.

How to avoid tax underpayment penalties in the future?

No one likes ending up with a tax underpayment penalty, so here are some steps you can take to avoid this penalty in the future. 

1. Be aware of when your payments are due

For starters, adequately paying quarterly taxes by the dates shown below will help save you from incurring the underpayment penalty: 

  • Apr. 15
  • Jun. 15
  • Sept. 15
  • Jan. 15 of the following year

If a due date falls on a weekend or holiday, the payment is due the next business day.

2. Annualize your income

Generally, you don’t need to wait and pay all your tax liability at the end of the year. Especially if your income is unpredictable or seasonal, you may want to annualize your income, which basically means you will pay your tax payments based on a reasonable estimate of your income during each quarterly period. 

If you own a seasonal business and most of your annual earnings come from three consecutive months, annualizing your income can help you better estimate your tax payment. Calculating your estimated payments and making quarterly estimated payments can help you avoid the tax underpayment penalty. To use this method, you need to complete Form 2210 and attach it to your return.

For example, your business makes $30,000 per year, but all of that money comes in from June through September. When determining your estimated payments, take the $30,000 you expect to make and divide it by 12 months. This way, you can spread the amount of your estimated tax payments evenly across the year and make sure you don’t break the IRS’s pay-as-you-go rule.

3. Adjust your W-4 withholding

Generally, employers must withhold taxes from employees’ paychecks based on their earnings and employees’ information on their W-4s. If your employer isn’t withholding enough tax, you can make up the difference by revising your W-4 and requesting that they withhold more.

You can use the IRS withholding calculator to estimate how much your employer should withhold from your paychecks. Then fill out a new Form W-4, indicate how much you want to be withheld, and submit it to your employer. This can reduce or even eliminate the need for making estimated payments on your own.

The bottom line

To pay the right amount of your taxes owed throughout the years, you can ask your employer to withhold more from your paycheck. Otherwise, you can calculate and make your quarterly estimated tax payments if you’re a freelancer.

Submitting tax payments on time and filing paperwork can seem daunting, but it’s all part of developing a disciplined, well-organized documentation process. The Shoeboxed app can help your business stay efficient and organized!

Shoeboxed is a painless receipt-tracking and expense-managing app that helps get you ready for tax seasons. After scanning your receipts with the Shoeboxed app, you can create clear and comprehensive expense reports that include images of your receipts. You can then export, share or print all of the information you need for easy tax preparation or reimbursement, all within a few clicks. Shoeboxed ensures that the digital versions of your receipts are legibly scanned, clearly categorized, and accepted by both the Internal Revenue Service and the Canada Revenue Service in the event of an audit. 
The Shoeboxed app is available on iOS and Android. Try Shoeboxed for free and get yourself prepared for tax seasons!

How To File Taxes For The First Time: A Complete Guide To All Your Questions

The first time filing taxes is a significant milestone for any young adult or freelance worker. You could count on your parents to handle tax filing in the previous years, but now it’s your turn to be responsible for your finances and file your taxes. This article will give you some quick tips on how to file your taxes for the first time and answer the most common questions. 

When do you need to file your taxes?

First, let’s figure out if you need to file taxes this year. This depends on your age, income, and filing status. For example, if you’re under age 19 (or under age 24 and a full-time student) and your parents cover more than half of your financial expenses, they can likely claim you as a qualifying child, and you won’t need to file taxes in this case. Another example is if you’re not married, younger than 65, and your gross income is less than $12,400, you also don’t need to file tax. 

Otherwise, if your income is from self-employment, this would be considered a “special situation,” and you’d be required to file your tax return. You can take a look at this guide for the minimum income to file taxes. 

how to file taxes for the first time
The IRS’s guide for the minimum income to file taxes

You can always check the IRS Tax Guide and answer a few questions to determine if you need to file.  

Important notice: Before filing your taxes, don’t forget to check with your parents to determine if they’re claiming you as a dependent on their taxes this year. This can happen if you still live with them or they offer substantial financial support. If you have enough income, you’ll still need to file your tax return, but your parents will get certain tax benefits, such as education tax credits and the Credit for Other Dependents. In this case, when preparing your return, you’ll need to indicate that you can be claimed as a dependent on someone else’s return. 

What documents do you need to file taxes? 

1. Personal documentation and income tax forms

To prepare for your taxes, you’ll need to provide your Social Security number, your income (and any freelance work) or unemployment income, and receipts of other income types (from real estate, royalties, trusts). You’ll also need to prepare a copy of last year’s tax return. 

Here is a list of tax documents needed before you begin: 

  • W-2s 
  • 1099s
  • Receipts of other types of income (from real estate, royalties, trusts)
  • Tax forms that report other income types

FYI: Keeping track of all your receipts can be a daunting task — paper receipts can fill up your wallet, desk, and drawers. In this case, consider using a receipt management app to store these papers digitally. See our suggestion for the Top Five Receipt Scanner And Organizer Apps 2021 to choose which one works best for you. 

Keep in mind that the IRS wants to know about all of your income, including your side jobs, bonuses, and interest income (such as from your savings account or investments), which the bank will notify you with a 1099-INT form if you’ve earned more than $10 in interest. So, don’t forget to keep track of your activities in the past year that might impact your taxes, such as: 

  • Changing jobs
  • Opening a new savings account
  • Selling stocks or mutual funds
  • Paying college tuition or student loan interest

2. Deductions

Deductions are factors that can lower your tax bill and can add to your refund. For instance, if you’re a student, you may be eligible for educational deductions. Your school will notify you if you qualify for these deductions by sending you a Form 1098-T. You can also deduct the interest you paid on your student loan. Or, if you’re a freelancer working from home, you might get the home office deduction. 

The most common tax deductions and credits for first-time filers are the following: 

Make sure you’re claiming as many deductions as possible, but remember to keep your deductions honest. 

You can try summing up itemized deductions and see if they’ll turn out to be more than the standard deduction. If not, don’t itemize since the standard deduction will save you more money.

Besides, if you itemize deductions, you need to be able to prove your expenses. This means being organized and keeping track of your receipts so you can prove to the IRS your return is legitimate. 

You can also claim your stimulus check if you missed one (or both). Check out the Recovery Rebate Credit on 2020 to see if it’s possible to claim this and file in Form 1040 or Form 1040-SR when preparing your federal tax return.

How to file taxes? 

After gathering all the necessary information, it’s time to start filing your taxes. But how to file taxes for the first time correctly? There are three options that you can choose from.

1. Filing taxes online

One of the most convenient ways to do your taxes is to file online. If your tax situation is simple, you can file your taxes for free using online tax services like TurboTax, H&R Block or the IRS’s free e-file options. You can also pay for premium packages to get access to extra features. 

These tools are comparatively easy to use. They will guide you through the process by asking you simple questions and filling out your state and federal returns for you. You can even take pictures of your completed forms and upload them to have your information entered automatically. Once you’ve finished, the tool will calculate the possible refund and file your taxes for you. 

2. Filing with a tax professional

It’s a great idea to have a specialist do your taxes if your tax situation is a bit complicated. You’ll have to pay a fee, which varies depending on the complexity of your taxes and the professionalism of the tax preparer. You can hire a certified public accountant, attorney, or enrolled agent. Just make sure the person is qualified by checking their credentials. 

Typically, the price range is between $100 and $300. If you’re looking for a low-cost option, you can look into your local credit unions and see if they may offer low-cost tax preparation services.

3. Filing your taxes manually

If you choose to file your taxes manually, especially when it’s your first time, it can be a bit complicated. You’d have to fill in Form 1040 or Form 1040-SR by hand and calculate all your income and deductions. After that, you’d have to send the form via email and wait from six to eight weeks for the IRS to process your return.

Though this is no longer a common way, especially when you don’t know how to file taxes for the first time, it can still be helpful for those who like to do some “DIY accounting” or simply want to practice the process. Keep in mind that if you choose to print and mail your return to the IRS rather than e-file it, you’ll have to think about the correct postage or stand in line at the post office.

The bottom line

Filing taxes, especially for the first time, is never easy and can lead to endless headaches. However, don’t let it scare you. All you need to do is track and manage your expenses properly, keep all necessary documents, and use a reliable tax service or contact a tax professional. 

The Shoeboxed Receipt Scanning & Expense Tracking app enables users to keep track of their expenses and receipts by turning paper receipts into digital data for tax prep purposes, accounting and bookkeeping. You can clear your wallet, desks, and drawers of paper receipts and have them precisely scanned with our OCR engine and human data verification features. We ensure that all of your paper receipts are legibly scanned, clearly categorized, and accepted by the IRS. 

Shoeboxed saves you a lot of time and hustle preparing for taxes, especially for the first time. Shoeboxed is now available on iOS and Android. Get your free trial now and be ready for the tax season! 

Expense Report Everything To Know For Successful Business

Being in business is all about making a profit. But profit isn’t only about your sales numbers. Effectively controlling and minimizing expenses is just as important as boosting sales to achieve the ultimate goal: generate maximum profit. 

Caught between limited financial resources and the pressure to maintain competitive pricing, small businesses these days need to stay more proactive than ever to stay on top of their expenses. One of the most commonly used practices for managing costs among small businesses is the expense report. 

In this article, we will go through some basic fundamentals of expense reporting. Once you fully understand the nature of an expense report, you’ll be able to make the most of it and improve your business’s productivity and internal control.

What is an expense report?

An expense report is a document filled out by an employee or a partner so they can be reimbursed for professional expenses. They are also used to track company spending.

Expense reports are generally presented as forms, whether in a paper or a digital format. The report can be prepared using accounting software or using a template in Word, Excel, PDF, and so on. 

With the advent of new technologies, several solutions now exist to automate the expense management process. The purpose of these solutions is to free time up for everyone involved in the process, streamline expense reports management, and increase profit. 

What is an expense report used for?

Making reimbursements 

Small businesses sometimes require employees to pay for work-related expenses such as transportation out of their own pocket, which will later be reimbursed by the business owner. This process is documented in an expense report with 3 simple steps: 

  1. The employee lists all the business-related spending such as transportation-related costs, accommodation, or meals in an expense report. Receipts should be attached to the document.  
  2. The employer checks the expense report for accuracy and validity. 
  3. The requested amount is paid back to the employee.

Sometimes, the process can be reversed in which the companies make advance payments to staff. The employee still needs to submit an expense report to detail expenditures. However, there won’t be any reimbursement. Instead, the employer will just deduct the expenses from their advances and have these transactions recorded in the bookkeeping system. 

Tracking expenses

An expense report is also a great tool to help small businesses keep track of their spending periodically (on a monthly, quarterly, or yearly basis). By reviewing expense reports, companies can examine their financial health, determine if they’re spending over or under budget, then analyze the causes and devise immediate solutions to improve expense management. 

Shoeboxed expense report

Filing tax

Regardless of what type of business you run, filing a tax return can be a real headache. Businesses are always searching for ways to minimize their taxable amounts.

Many business expenses are deductible and can be subtracted from a company’s income before it is subject to taxation. Expense reports are the legal documents to prove just that. Creating an expense report allows you to monitor deductible costs that may not yet be shown on your company bank account, making it a lot easier to write such expenses off at tax time.

Auditing purposes 

Expense reports are valuable evidence for both internal and external audit activities. Unnecessary and fraudulent reimbursement claims are not, unfortunately, an uncommon theme in many workplaces. These reports can help with business audits by providing visibility into what funds are coming in and out of the business. By properly processing these expense reports, owners can examine the details and audit their current businesses’ financial and managerial health. 

As we’ve just mentioned above as well, expense reports are vital for deducting tax. They can be requested for submission as supplemental documents, in addition to reporting total applicable costs on tax forms when submitting taxes with the revenue service at any time. 

What does an expense report look like?

Small businesses usually create expense reports using templates in Word, Excel, PDF, etc, or have them automatically prepared by accounting software. No matter how an expense report is made, it typically should contain these elements: 

  • Employee’s information: name, department, position, their manager, or details of who submits the expense
  • Date: when expenditure was incurred (a receipt showing the same date should be attached)
  • Vendor: where a product or service was purchased
  • Description: the nature of the expense such as taxi fee, meal, or hotel
  • Account: where the expense should be charged to 
  • Amount: the total sum of the expense (this amount should also be on the provided receipt) 
  • Subtotal: the amount for each type of expense listed 
  • Subtraction: adjustments when there are any prior advances paid to the employee
  • The grand total: the final amount of reimbursement requested
  • Note: an extra explanation for any unidentified or unclear type of expenses. 

Sometimes, an expense report may also include a brief summary of the company’s policy regarding which kinds of expenses are not reimbursable. It’s a good way to remind employees before they submit their expenses, saving time for employers and also raising awareness of spending policies within the business. 

An expense report may look different among small companies, depending on the nature of its business as well as each company’s own preference. However, it should always tell you how much the expense is and what it was used for. 

Business expense categories 

One of the most important functions of using expense reports is to help small businesses collect data and categorize business expenses, many of which can be written off in a company’s taxes. Some of the most common expense categories include utilities, travel, office supplies, and rental expenses, but there are many more that small businesses, freelancers, and sole proprietors should pay attention to. 

According to the IRS, as long as an expense is “ordinary and necessary” to running a business in your industry, it’s deductible. That’s why we suggest you should follow the categories listed in the Schedule C form  from the IRS for your expense report if you run a sole proprietorship. Developing categories that match your business and a tax return file can make the tax filing process easier, smoother, save you time, and make sure you get all the deductions that you can.  

We’ve listed below 10 most common business tax expenses that you can deduct with brief explanations of what’s covered, what’s allowed, and what’s not.

Advertising

You can fully deduct expenses related to promoting your business, including digital and print advertising, social media advertising, website design and maintenance, and the cost of printing business cards.

Business insurance and professional service

You can deduct the cost of your business insurance on your tax return such as business liability or workers compensation. Fees paid to an attorney, designer, architect, or other professionals directly related to operating your business are also tax-deductible.

Office supplies

You can write off office supplies including stationery, office cleaning service, drinks and snacks in the break room, and work-related software. Shipping and postage charges may also be deducted. Bear in mind that you may only deduct the cost of materials used in the current year.

Home office expenses

If you’re a small business owner working from home, don’t miss out on this deduction! Generally, you’d need a space that is regularly and exclusively used for businesses to be qualified for deduction. You can deduct $5 for every square foot of your home office which meets all the requirements, up to a maximum of 300 square feet.

Travel expenses

First and foremost, before you try to write off your travel expenses, ensure that the purpose of your trip. Here are 3 rules to help you determine whether your trip is qualified or not:

  • The trip must be primarily business-related.
  • The trip must take you away from your tax home, i.e. outside the city or area where your company is located.
  • As well as being away from your tax home, it must be substantially longer than a normal day’s work and require you to sleep or rest prior to returning home.

Business interest

A business interest expense is the cost of interest on business loans required to keep operations running. Your deduction is generally limited to 30% of adjusted taxable income but it was raised to 50% in 2020 due to the pandemic. However, this limitation does not apply to small businesses (with average annual gross receipts of $25 million or less over a trailing three-year period), farms, or real estate investment enterprises.

Cell phone and internet bills 

You can deduct your entire bill if you have a dedicated business cell phone or Internet connection. It’ll be a little bit more complicated if you mix business with personal usage. In this case, you will need to calculate and deduct only the percentage used for work. 

Wages and benefits

If you run a small business and hire people, you may deduct their wages, benefits, and vacation expenses. However, don’t include your own wages because they’re not allowed to be deducted by the IRS. 

Donations 

Tax-deductible donations must meet certain criteria. For example, the receiving organization must be a qualified institution. Recognized institutions may include, but are not limited to, religious organizations, nonprofit educational agencies, museums, and local volunteer groups. There are different guidelines depending on the nature of your donations such as cash, food, and clothing.

Depreciation

When you deduct depreciation, you’re usually writing off the cost of a tangible asset like a vehicle or machinery over the useful lifetime of that item, rather than deducting it all in one go for a single tax year. It’s best to deduct depreciation for costly long-term business investments, so you’re reimbursed for the expense over the entire lifetime of use of the item. 

Medical expenses

You can claim insurance premiums; and if you’re self-employed and pay for your own health insurance, you can deduct your health and dental care insurance premiums. You can also claim medical care expenses, including doctor’s fees, prescription drugs, and home care.

By designing your expense report template based on Schedule C, you’ll find it much quicker and easier when inserting data into tax forms.

So get organized and save time and money!

What is a monthly expense report? 

A monthly expense report details company outlays paid over the course of a given month. These reports are not typically used for employee reimbursement, but rather to track company or department spending, allocate expenses to specific projects or clients and compare expenses to revenue to determine a company’s overall profitability. These reports are typically organized by category, or payee, and can be tremendously helpful for companies to coordinate planning, budgeting, and resourcing requirements. In times of financial difficulty, a monthly expense report can be used to check how costs can be cut or eliminated to improve profit. 

What is considered an expense? 

Not all costs are expenses. An expense is the cost of operations that a business incurs to generate revenue. It can be salary compensations for employees, train tickets fees, or office rent payments. The summary of all expenses is shown on Income Statements (Profit or Loss Statement) as deductions from the total revenue.

While businesses can write off many kinds of expenses, they are not allowed to claim their personal, non-business expenses as business deductions. They also cannot claim bribes, lobbying costs, penalties, fines, and contributions made to political parties or candidates. 

It’s also very common for businesses to make the mistake of writing off“capital expenditure” as an expense. Capital expenditure (CapEx) is used to acquire, upgrade, and maintain tangible assets such as property, buildings, or equipment. Businesses must capitalize those expenses or write them off slowly over time as depreciation. For example, if you acquire a new oven for your bakery business, the oven should be capitalized and recorded as your asset, instead of a business expense. Identifying the nature of an expense will help you do your taxes properly and precisely. 

Essentially, companies should have strict rules regarding what can be considered a business expense. Employees should be informed thoroughly as well before submitting expense reports for reimbursement. 

Conclusion 

Expense reporting and analysis is an indispensable element of an effective cost management process. However, many small businesses struggle with keeping track of documents and receipts manually which ends up being time-consuming and unproductive.

Clear away that pile of documents and go paperless with Shoeboxed!

Shoeboxed creates clear and comprehensive expense reports that include images of your receipts. In just a few clicks, you can export, share or print the information you need for easy tax preparation or reimbursement.