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Avoiding penalties by making timely estimated tax payments.

The Tax Adviser August 1, 1996 | Ellentuck, Albert B.

Editor’s note: This case study has been adapted from “PPC Tax Planning Guide – S Corporations,” 10^th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 1996.

Facts: Payton Corp., a calender-year C corporation, elects to become an S corporation on Jan. 1, 1997. * On Mar. 15, 1997, it sells an asset and recognizes $14,286 of built-in gain, which results in a built-in gains tax of $5,000. For the year ended Dec. 31, 1997, it has no other transactions that generate tax at the corporate level. * In January 1998, the corporation sells a business asset resulting in built-in gain of $8,743, which causes a built-in gains tax of $3,060. The corporation also receives passive investment income in 1998 and incurs tax on excess net passive income of $4,000. Issue: What are the corporation’s required estimated tax payments for 1997 and 1998?

Analysis An S corporation is subject to the estimated tax requirements of Sec. 6655 if the total corporate-level tax for the year is $500 or more. However, the S corporation rules vary from those that apply to C corporations. this web site estimated tax payments

The taxes subject to the estimated tax provisions for S corporations are:

1. The tax on built-in gains under Sec. 1374.

2. The tax on excess net passive income under Sec. 1375.

3. Business credit recapture under Sec. 1371(d)(2).

An S corporation may also be making required payments because of the Sec. 444 election, or may be making payments because of the LIFO recapture tax, but these payments are not considered to be in the nature of a “corporate income tax” and estimated tax payments are not necessary.

S corporations, like C corporations, generally are required to pay the estimated tax in four equal installments. Each required installment is 25% of the “required annual payment.” (Corporations, including S corporations, can also use the annualization and adjusted seasonal installment methods, which may result in unequal payments; see Variation 1.) An S corporation’s required annual estimated tax payment is the lesser of:

1. 100% of the tax shown on the return for the tax year, or 2. the sum of the following:

a. 100% of the tax owed for the tax year, if the only taxes taken into account for that year are the taxes on built-in gains and recapture of business credit; and b. 100% of the tax on excess net passive income shown on the S corporation’s return for the preceding tax year.

With regard to the tax on excess net passive income, the general estimated tax payment rule, which prevents a corporation from basing payments on the prior year’s tax unless there was prior year tax liability, does not apply to S corporations, including S corporations with $1 million or more in taxable income. In other words, the estimated payments for the tax on excess net passive income can be based on 100% of the amount of that tax shown on the prior year’s return, even if there was no tax liability in that prior year. The rule prohibiting “large corporations” with taxable income of $1 million or more from using the prior year’s tax does not apply to S corporations.

However, last year’s tax cannot be used as a basis for estimating the built-in gains tax and business credit recapture. An S corporation cannot use “safe” estimates based on the prior year’s tax for any tax other than the tax on excess net passive income. It is very important to review the tax situation for built-in gains and business credit recapture at each estimated tax payment due date.

For a calendar-year S corporation, quarterly installments are due by April 15, June 15, September 15 and December 15. For a fiscal-year S corporation, quarterly installments are due by the fifteenth day of the fourth, sixth, ninth and twelfth months of the fiscal year.

Estimated tax payments are made by depositing the amount due in a federal depository with Form 8109, Federal Tax Deposit Coupon.

Conclusion In 1997, Payton Corp. must make quarterly estimated payments of at least $5,000 (100% of $5,000) to avoid the penalty for underpayment of estimated tax. Estimated tax payments for the built-in gains tax cannot be avoided by reference to the prior year’s tax. Payton’s $1,250 estimated tax payment (one-fourth of $5,000) is due on Apr. 15, 1997, the regular due date of the first quarter estimated tax payment, because the tax liability is incurred for the quarter in which the sale occurs. Installment payments of $1,250 are also due on June 15, August 15 and December 15. In 1998, Payton Corp.‘s required annual estimated tax payment is $3,060, computed as follows: go to web site estimated tax payments

100% of current year’s built-in gains tax ($3,060) $3,060 100% of last year’s passive income tax — Required annual estimated tax payment $3,060 Payton Corp. will not be subject to the underestimation penalty if it makes four estimated tax payments of $765 (one-fourth of $3,060). Payton Corp. does not have to make estimated tax payments with respect to the tax on excess net passive income because its prior year liability for such tax was zero.

Variation 1 Assume the same facts, except that the asset is sold in August 1997, rather than in March 1997.

Payton Corp. did not have net recognized built-in gain for purposes of making estimated tax payments until the third quarter, so it can use the annualized income method (described in the following paragraph) and make estimated payments in the following amounts in 1997:

April 15 $ — June 15 — September 15 ($5,000 X 75%) 3,750 December 15 ($5,000 X 100% — $3,750) 1,250 Total payments required $5,000 The corporation can use the annualized income method of Sec. 6655(g)(4)(E) to compute estimated tax installments if that method results in lower estimated payments. Corporations using the annualization method are required to compute their annualized income using a standard set of monthly periods unless they elect to use one of two optional sets of monthly periods. The standard and optional periods are as follows:

Standard Option 1 Option 2

First installment 1^st 3 mos. 1^st 2 mos. 1^st 3 mos.

Second installment 1^st 3 mos. 1^st 4 mos. 1^st 5 mos.

Third installment 1^st 6 mos. 1^st 7 mos. 1^st 8 mos.

Fourth installment 1^st 9 mos. 1^st 10 mos. 1^st 11 mos.

An election to use one of the optional periods is applicable only for the year in which it is made and must be made by the fifteenth day of the fourth month of the tax year. The election is made by filing Form 8842, Election to Use Different Annualization Periods for Corporate Estimated Tax.

Under the annualized income method, the tax adviser determines the taxable income through the applicable month shown in the chart above. In Payton’s case, the corporation did not elect to use one of the optional monthly periods, so March, June and September, respectively, must be used when determining the first, second, third and fourth estimated installments. The income for each period is annualized, and the tax is computed. For the first estimated tax installment (based on income through March 31), the payment is 25% of the tax. For the second estimated tax installment (also based on income through March 31), the payment is 50% of the tax minus the payment made in April. For the third estimated tax installment (based on income through June 30), the payment is 75% of the tax minus the previous installment payments. The fourth estimated tax installment (based on income through September 30), is 100% of the tax minus the previous installment payments.

If Payton had recognized the built-in gain in October rather than August, no estimated tax payments would be due under the annualized income method; only income through September 30 must be considered when making the fourth estimated tax payment. However, all of the tax would still be payable by the due date of the return.

Variation 2 Assume that in 1997, the first S year, Payton Corp. incurs tax on excess net passive income of $5,000. If the corporation can base its estimated tax payments on the prior (C corporation) year, the corporation’s required annual payment would be zero, because there was no passive income tax in the previous year. Otherwise, the corporation’s annual required payment is $5,000 (100% of the current year’s tax). It is not clear what the required annual payment is in this situation, but the S corporation may be able to base its estimated tax payments on the previous year’s tax on excess net passive income (which would be zero) if the previous tax year covered a 12-month period, even if the corporation was a C corporation in that previous year.

Ellentuck, Albert B.