How to avoid tax penalty on bonus, restricted stock
William Koopman and wife Lisa encountered a tax problem that confronts many employees who receive bonuses, stock compensation and other types of one-time income.
On Sept. 30, Lisa received a bonus from her employer. Then in December, a portion of her restricted stock units vested. When restricted stock vests, the value of the stock on that date generally becomes income subject to tax that year.
The bonus and restricted stock are two types of “supplemental income.” Employers are required to withhold federal tax at a flat rate of 25 percent on the first $1 million in supplemental income and 39.6 percent on amounts over $1 million — regardless of the employee’s withholding rate on regular income. For many employees, 25 percent is not enough to cover their actual federal tax liability. They need to make estimated tax payments to cover the difference. That’s what the Koopmans did.
“Within a week after Lisa’s bonus posted to our account, we made an estimated tax payment that more than covered the withholding shortfall for both the bonus and the stock vesting,” WiIliam Koopman said.
But in early June, the Palo Alto couple got a notice from the IRS saying they owed a penalty for failing to pay proper estimated tax.
“The IRS isn’t claiming we paid too little estimated tax — it is claiming we should have paid estimated tax in equal quarterly installments earlier in the year. I find it hard to believe that taxpayers are required to anticipate un-
certain events, like a bonus which, in Lisa’s case, was not in any way guaranteed,” Koopman said in an email. “As for the stock vesting, we knew the date on which it would vest, but had no way of knowing what the stock would be worth on the vesting date. Is the IRS right?”
Fortunately, the IRS does not expect you to predict the future when it comes to bonuses and future stock prices. It does expect you to pay taxes on income as it’s earned. But unless you let the IRS know that part of your income came in a chunk, it will assume it was earned evenly — and expect you to pay tax on that income evenly throughout the year, said Mark Luscombe, principal federal tax analyst at Wolters Kluwer Tax & Accounting.
The IRS explains this on its website: “If you didn’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax.
“Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and estimated tax payments, or if they paid at least 90 percent of the tax for the current year or 100 percent of the tax shown on the return for the prior year, whichever is smaller. (If your adjusted gross income is more than $150,000, substitute 110 percent for 100 percent of the prioryear amount.)
“Because the penalty is figured separately for each payment period, you may owe a penalty for an earlier payment period even if you later paid enough to make up the underpayment. This is true even if you are due a refund when you file your income tax return.”
The way you let the IRS know you received one-time income is by filing Form 2210, including the schedule labeled “Annualized Income Installment Method,” with your tax return. This form lets you break down your income and deductions for each quarter. “That’s how you support you don’t owe a penalty,” Luscombe said.
Koopman said, “We used TurboTax, and it didn’t prompt us to file this form.”
A spokeswoman for TurboTax said in an email that its software “will automatically calculate the penalty for underpayment of estimated taxes and generate Form 2210: Underpayment of Estimated Taxes. The guidance to annualize your income can be found in the ‘Other Tax Situations’ section of the TurboTax federal return.”
She added that before starting their return, “customers are asked if they would like TurboTax to ‘Guide Me’ or ‘Explore on my Own.’ Customers that choose ‘Guide Me’ and follow the screens sequentially will land on the ‘Other Tax Situations’ landing table which includes ‘Underpayment Penalties’ and the annualized income method.”
Users that chose to explore on their own, which is what Koopman did, may not see this. “I certainly didn’t,” he said.
Another way to avoid an underpayment penalty on lumpy income is to bump up your payroll tax withholding to cover the shortfall. The IRS considers payroll withholding to come in evenly throughout the year, even if a big chunk of it came in December.
To reduce or eliminate the penalty, the Koopmans should file an amended 2016 return with the “annualization form,” Luscombe said.
For California income tax, the withholding rate on supplemental income varies depending on when it’s paid and the type of income. In the Koopmans’ case, the amount withheld came close to the couple’s actual tax liability, so they did not incur a state tax penalty.
Parcel-tax question: After reading my May 27 column entitled “Seniors won’t have to reapply for parcel-tax exemptions each year,” reader Phyllis Pacin wondered why she got a notice from the Oakland Unified School District that said she had to renew her exemption for this year by July 17.
Thanks to a new law that took effect Jan. 1, California school districts that offer parceltax exemptions to seniors, low-income or disabled homeowners cannot require them to renew or reapply for the exemption each year as long as they still qualify. Oakland Unified offers exemptions to seniors 65 and older from two parcel taxes ($120 each). Low-income homeowners can seek an exemption to those taxes and a third ($195).
So why did Pacin receive an April 28 letter that said, “Homeowners who were already approved for an exemption in previous years must renew your exemption by completing the Parcel Tax Form enclosed with this letter,” with required documentation, by July 17? After multiple calls to the school district over two weeks, I got the following response:
“The exemption application from (the district) was created from an outdated template,” district spokesman John Sasaki said in an email. After it became aware of the problem, the district began “reaching out to individual exempted taxpayers to let them know they don’t have to reapply.” The district is “in the process of updating our website and we are planning to put out a public notice.”