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IRS seeks tighter rules to ensure timely tax payments in 2007
Any practice or veterinarian who fails to pay a required installment faces penalties.
Even before the 2006 tax returns of many veterinarians are in the mail, the Internal Revenue Service has proposed new rules governing the way 2007 quarterly installments are made.
The aim is to ensure that it receives taxes due for 2007 on a timely basis.
Under current rules, all self-employed veterinarians, partners and principals in veterinary practices are required to make payments on their estimated yearly tax bill, usually quarterly.
Those installments typically are pro-rated on annual tax liability, but, as an alternative, they can be based on the individual or the practice's so-called "annualized taxable income," the taxable income for a specific number of months, extrapolated into an annual amount. In some cases, the estimated tax bill is based on the individual's, or the practice's, adjusted seasonal taxable income.
Now, the Treasury Department and the IRS proposed new rules to help compute the estimated tax liabilities for every incorporated veterinary practice. Although the IRS and the Treasury requested comments early in 2006, the proposed rules are effective until 30 days after the final regulations are issued.
Estimating new estimates
The new proposals generally affect all incorporated veterinary practices that are required to make estimated tax payments. The new rules reportedly reflect more than 21 changes made to the tax laws in this one area since 1984.
According to the IRS, those 1984 regulations do not provide adequate guidance on how a corporation must determine the amount due with each required installment, nor do they reflect all of the rule changes since 1984.
The IRS and the Treasury have become aware of techniques that have been employed by some incorporated taxpayers — particularly those computing their estimated tax payments using an annualization method — that reduce, if not eliminate, estimated tax payments for one or more installments in a taxable year.
The newly proposed rules provide extensive guidance on how to determine the amount due with each quarterly installment, whether based on the corporation's estimated annual tax liability or on its annualized or adjusted seasonal taxable income.
What is your veterinary practice's tax bill for 2007 going to be? The IRS expects veterinarians and principals in every practice, whether incorporated or not, to know – or at least make a reasonably accurate guess – its final tax bill for the year.
Any practice or self-employed veterinarian who fails to pay a required installment of estimated tax or fails to arrive at a close approximation of their annual tax liability faces penalties.
If, after estimating annual tax liability, a veterinarian later finds that his or her liability will be higher or lower than they estimated, he or she can recalculate the required installments. Failure to adjust can result in an underpayment penalty. An immediate catch-up payment is permitted to reduce any penalty resulting from underpayment of earlier installments.
Underpayment of any of the required installments results in an additional tax on the amount of the underpayment for the entire period of that underpayment. The added tax is based on the underpayment interest rate, which is determined quarterly by the IRS. For underpayments, Form 2220, "Underpayment of Tax by A Corporation" is utilized.
To avoid those underpayment penalties in a calendar-year incorporated veterinary practice, the total installments must equal the lesser of:
- 100 percent of the tax shown on its return for the preceding tax year, or
- 100 percent of the tax shown for the current year (determined on the basis of actual income or annualized income).
As explained, "annualization" means to extend an item to an annual basis. Taxable income for part of the year is ordinarily multiplied by 12 (months) and divided by the number of months involved. If, for example, taxable income for three months is $20,000, it would be annualized as $80,000: $20,000 x 12 or $240,000, divided by 3 = $80,000
The IRS believes the proposed regulations will result in a more accurate reflection of annualized income than the methods that many veterinarians are now employing, which in some cases reduced, or even eliminated, some installment payments.
The proposed rules make it clear that all income and gain must be taken into account when computing the annualized taxable income for any annualization period. This is especially true if the item could be included in the veterinary practice's taxable income on or before the last day of the annualization period.
As for deductions, the proposed rules allow an accrual-method taxpayer to take a deduction only to the extent that the deductible item is incurred on or before the last day of that particular annualization period.
To illustrate: Under the old annualization rules, state property taxes and franchise taxes were deductible from the income of a veterinary practice on the date on which the practice accrued those taxes under its method of accounting. In other words, the entire tax bill could be claimed as a deduction in the annualization period it was received.
The proposed regulations specifically address the so-called "economic performance requirements" of the current tax law.
Thus, the new guidelines prevent an accrual-method taxpayer from taking into account any deduction unless that deduction has been incurred, and is otherwise deductible, in the applicable annualization period. Taxes, while billed annually, are for 12 separate months.
The new rules also cover other annual expenses that might be paid or incurred at the end of the taxable year or, in some cases, even after the end of the taxable year.
Under the new rules, if an accrual-method veterinary practice has a history of incurring an expense (or actually paying that expense, in the case of a cash method taxpayer) then the taxpayer may take into account a proportionate part of that specific expense for each annualization period.
Of course, a veterinarian may take into account a proportionate part of an expense in each annualization period only if the portion of that annual expense can be determined with reasonable accuracy. Obviously, it must also legitimately be deductible in the current taxable year under the taxpayer's method of accounting.
Plain vanilla estimated payments
As with those incorporated businesses targeted by the IRS and all incorporated veterinary practices, the owners, partners and principals in veterinary practices also must pay a portion of their tax currently. The general rule is that at least 90 percent of an individual's federal income tax must have been paid either through withholding or estimated tax payments.
In general, that estimated tax is the amount of income and self-employment tax (as well as any other taxes reported on Form 1040) that an individual estimates will have to be paid for the tax year after subtracting any estimated credits against tax.
Although anyone can use it, according to the IRS, the annualization method is most suitable for those taxpayers who receive or accrue income more heavily at one time of the year.
No penalty for failure to pay estimated tax will apply to an individual whose tax liability for the year, after credit for any taxes withheld, is less than $1,000. In fact, no one need pay estimated tax if he or she had no tax liability for the preceding tax year.
Those veterinary practice partners and principals who do not qualify for any of these exclusions may generally avoid the penalty for failure to pay their individual estimated tax by:
- Paying at least 90 percent of the tax shown on the current year's return;
- Paying 100 percent of the tax shown on the 2005 return; or
- Paying installments on a current basis under an annualized income installment method.
An individual with adjusted gross income in excess of $150,000 ($75,000 for a married individual filing separately) in 2006 or thereafter can avoid the estimated tax penalty only by paying 110 percent of the amount of tax shown on the 2006 tax return.
It should be obvious that the IRS wants what it is due – usually paid in quarterly installments during the year.
The "gray areas" that many incorporated veterinary practices using the annualization method employed to reduce underpayment penalties have been largely curtailed under the IRS's newly released guidelines. However, paying the veterinary practice's estimated tax liability on a timely basis during the year remains an obligation.
The penalties and fines for underpaying that estimated tax bill also remain.
Mr. Battersby is a financial consultant in Ardmore, Pa.