Preliminary Work and Taxpayer Data · Preliminary work to prepare tax returns

Sources of tax payments and refundable credits

A return’s computed liability is only half of the arithmetic. What the taxpayer already paid, and which credits can pay out beyond liability, decide whether the return produces a refund or a balance due — and both are easy to miss, because nothing on the return prompts for them a second time. Payments are also where the year’s penalties are decided: the addition to tax for underpaid estimated tax turns entirely on when money arrived, not on whether the return was right.

The rule

Withholding is a credit. Amounts withheld under chapter 24 are allowed to the recipient of the income as a credit against the tax imposed by subtitle A (IRC § 31(a)(1)), and withholding during a calendar year is credited to the taxable year beginning in that year (IRC § 31(a)(2)). Backup withholding is the same kind of credit, imposed where a payee fails to furnish a taxpayer identification number, the Service notifies the payor that the number is wrong, or there has been notified payee underreporting or a certification failure — at a rate the statute defines by reference rather than by figure, as the fourth lowest rate applicable under § 1(c) (IRC § 3406(a)(1)).

Estimated tax has two safe harbours and a floor. Each required installment is a share of the required annual payment (IRC § 6654(d)(1)(A)), and the required annual payment is the lesser of a percentage of this year’s tax or a percentage of last year’s — the second rising for taxpayers whose prior-year adjusted gross income exceeded a threshold, halved for a married individual filing separately (IRC § 6654(d)(1)(B), (C)). Last year’s tax is unavailable as a safe harbour if the prior year was not a full twelve months or no return was filed for it. A taxpayer who establishes that the annualized income installment is lower may pay that instead, with the reduction recaptured in the next installment (IRC § 6654(d)(2)(A)).

Three exceptions and one shortcut sit in § 6654(e) and (h). No addition applies where the tax shown on the return, reduced by the § 31 withholding credit, is below a small threshold (IRC § 6654(e)(1)); or where the prior year was a full twelve months, the individual had no liability for it, and was a citizen or resident throughout (IRC § 6654(e)(2)). The Secretary may waive the addition for casualty, disaster or other unusual circumstances where imposing it would be against equity and good conscience, and for newly retired or disabled individuals (IRC § 6654(e)(3)). And filing the return and paying in full on or before 31 January removes any underpayment of the fourth installment (IRC § 6654(h)).

Withholding is spread across the year unless you prove otherwise. For § 6654 purposes the § 31 credit is deemed a payment of estimated tax, with an equal part deemed paid on each due date — unless the taxpayer establishes the dates on which the amounts were actually withheld (IRC § 6654(g)(1)). The election can be applied separately to wage withholding and to everything else withheld (IRC § 6654(g)(2)). This is the most useful provision in the section, and the one most often left unused.

The earned income credit. It is a percentage of earned income up to a maximum, then phased out above a threshold measured on adjusted gross income or, if greater, earned income. An individual without a qualifying child qualifies only within an age band, with a United States principal place of abode for more than half the year, and only if not a dependent of another taxpayer (IRC § 32(c)(1)(A)(ii)). Excessive investment income disqualifies entirely (IRC § 32(i)). The identification requirement is a social security number issued on or before the due date for filing the return (IRC § 32(m)) — and a prior improper claim bars the credit for a disallowance period of ten taxable years after a final determination of fraud, or two after a final determination of reckless or intentional disregard (IRC § 32(k)(1)).

Refunds of these credits are held. No credit or refund of an overpayment may be made before the 15th day of the second month following the close of the taxable year where the earned income credit or the refundable portion of the child tax credit is claimed (IRC § 6402(m)). The hold is on the whole refund, not merely on the credit.

Current figures

How it works in practice

Build the payment side from records, not from memory. Wage and pension withholding comes off the statements; backup withholding hides on interest, dividend and broker statements and is genuinely easy to overlook; estimated payments have to be reconciled against the account rather than the client’s recollection, because a payment made in January for the prior year and a payment applied from a prior overpayment are both commonly misremembered. An overpayment applied forward from last year’s return is a payment for this year, and the prior return is where you find it.

Then ask which safe harbour is cheaper. For a client whose income rose, last year’s tax is usually the lower figure and the whole question becomes whether the prior-year percentage is the ordinary one or the higher one — which turns on prior-year adjusted gross income, a number you can read off the prior return. For a client whose income fell, this year’s tax is lower and the annualized method may be lower still, at the cost of a schedule.

The § 6654(g) point deserves a working habit. Because withholding is otherwise deemed spread evenly, a client with heavy late-year withholding is treated as having paid a quarter of it by April — which usually helps. But a client with heavy early withholding who then had a large fourth-quarter liability may do better by establishing the actual dates. It is an election to consider both ways rather than a rule that always favours one side.

For the earned income credit, treat the § 6695(g) due diligence file as part of the engagement, and get identification numbers early: § 32(m) requires the number to have been issued on or before the due date. Where a client claims the credit and expects a February refund, § 6402(m) makes that impossible for the whole refund, and saying so at intake avoids a difficult call later.

How this has changed

The mechanics in this topic have been stable, and that stability is itself worth knowing: the § 6654 safe harbour percentages and the income threshold at which the prior-year percentage rises are statutory and not indexed, so they do not move with the annual revenue procedure the way the earned income credit figures do.

Two changes from earlier legislation still cause errors. The temporary rules for individuals without qualifying children — a lower minimum age, no maximum age, and a larger credit — applied only to taxable years beginning after 31 December 2020 and before 1 January 2022 (IRC § 32(n)). Material written in that window describes an age band that no longer exists. And the investment income limit was raised and made subject to annual adjustment, so any fixed figure for it is good for one year only.

On the payment side the practical change is administrative rather than statutory: the credit figures, the investment income limit and the phase-out thresholds are re-announced every year, while the § 6654 architecture around them does not move. When a client’s facts have not changed but the answer has, the annual revenue procedure is where to look first.

Exam focus

Know the § 6654 safe harbours cold, including that the required annual payment is the lesser of the two, that the prior-year percentage rises above an income threshold, and that the threshold halves for separate returns. Expect a question that supplies both years’ figures and asks for the required annual payment.

Know that withholding is deemed spread across the installment dates unless the taxpayer establishes otherwise, and that this is an election.

For the earned income credit, know the three gating rules for a taxpayer with no qualifying child, the investment income cliff, the social security number timing in § 32(m), and the disallowance periods in § 32(k). Expect the refund hold in § 6402(m) to appear as a question about when a refund can be paid.

Check yourself

1. A taxpayer’s prior-year tax was $18,000 on adjusted gross income of $210,000. This year’s tax will be $30,000. What is the required annual payment?

Answer: $19,800. Under IRC § 6654(d)(1)(B) it is the lesser of 90 percent of this year’s tax ($27,000) and 100 percent of last year’s — but because prior-year adjusted gross income exceeded $150,000, IRC § 6654(d)(1)(C)(i) substitutes 110 percent, giving $19,800. That is the lesser figure and so the required annual payment.

2. A taxpayer had no estimated payments and $12,000 withheld from a bonus paid in December. Is she treated as having paid nothing by the April installment date?

Answer: no. IRC § 6654(g)(1) deems the IRC § 31 credit to be a payment of estimated tax with an equal part paid on each due date, so a quarter of the $12,000 is treated as paid by the April date. She could displace that by establishing the actual withholding dates, but here the default is to her advantage and she would not want to.

3. A single taxpayer aged 22 with no children has earned income well within the phase-out range. Does she qualify for the earned income credit?

Answer: no. IRC § 32(c)(1)(A)(ii)(II) requires an individual with no qualifying child to have attained age 25 but not 65 before the close of the taxable year. The temporary removal of the age floor in IRC § 32(n) applied only to taxable years beginning after 31 December 2020 and before 1 January 2022.

4. A client claiming the earned income credit files electronically on 20 January and asks when the refund will arrive.

Answer: not before 15 February. IRC § 6402(m) bars any credit or refund of an overpayment before the 15th day of the second month following the close of the taxable year where a credit is allowed under § 32 or under § 24 by reason of subsection (d). The bar applies to the whole refund, not just the credit, so the rest of it is held too.