By Dr. James M. Dahle, WCI Founder
Many doctors hired as independent contractors do not understand their obligations to the IRS. As an employee, your employer withholds taxes from your pay and sends that tax money to the IRS. They may withhold more than you owe or less than you owe, but you simply settle up when filing your taxes the next April.
If you had too much withheld, you get a refund. If not enough was withheld, you send in a check with your taxes.
However, as an independent contractor, nobody is withholding taxes on your behalf. Four times a year, you are required to send an estimate for taxes due as a “Quarterly Estimated Payment” on IRS Form 1040-ES.
It's an easy form to fill out and file (you can even schedule payments in advance using EFTPS); you just have to remember to do it. These quarterly estimated taxes are due April 15, June 15, September 15, and January 15. Note that those dates are not all three months apart.
How much to pay? Well, that's complicated, but the bottom line is that you want to be in the “safe harbor.” Being in the safe harbor won't keep you from having to pay more tax in April, but it will avoid any penalties or interest. Most docs simply multiply their prior year's tax bill by 110%, divide by four, and send that amount to the IRS each quarter. That is not the only way to stay in the safe harbor, but it is the easiest way to calculate.
What Happens If You Miss a Quarterly Estimated Tax Payment?
Many new attendings are not aware of this requirement. I always tell all my new partners about this, and it's usually news to them. Many doctors do not get this news until it is too late. What happens to them?
Well, the IRS is not too happy. Theoretically, they end up having to pay the following amounts:
- All of the tax due
- Penalties (0.5% of tax due per month)
- Interest (currently 3% of unpaid tax per year)
The first one is actually the biggest problem. Many of those docs spent the money they should have paid in taxes on a fancy new Tesla. Depending on when they realize their mistake, they may have to dedicate their entire paycheck for several months to their tax bill or, worse, they end up carrying a debt to the IRS for years afterward.
However, most people agree that it is only fair that they pay the tax that they should have originally paid. They don't feel it is too fair to nail them for not knowing about this requirement that is only for business owners. Luckily for them, the IRS agrees. At least the first time.
Penalty Relief Due to First-Time Penalty Abatement
The IRS calls this a “first-time penalty abatement.” Here's the way it works.
First, remember it is optional. The IRS does not HAVE to offer you this.
Second, remember it really only works once and it has to be the first year you were supposed to file 1040-ESs and pay estimated quarterly taxes.
Third, if you qualify, you still have to pay the tax due, but the penalty and interest are likely to be waived.
How Do You Qualify?
All of the following must be true for you to qualify:
- You didn’t previously have to file a return or you have no penalties for the three tax years prior to the tax year in which you received a penalty.
- You filed all currently required returns or filed an extension of time to file.
- You have paid, or arranged to pay, any tax due.
Basically, you pay your taxes and then you plead for mercy to waive the penalties and interest. You are much more likely to receive that penalty abatement if you have actually paid the tax due. Simply call the toll-free number that comes with the notice about the penalties and interest and plead your case. If it's the first time, you'll probably get it. If the penalty is waived, the interest is also generally waived.
Can You Use Penalty Abatement Strategically?
Let's take this to the next level. Let's say you come out of residency on the first of July and will be an independent contractor. You expect to make $200,000 during the rest of the year and owe perhaps $60,000 on that money. What if you used the money you would have paid in taxes for July to December to pay off student loans, max out retirement accounts, or make a down payment on a house? Then, you could save up the tax bill you will owe in April of the next year between January and April. Then, you could plead for penalty abatement and, in essence, enjoy an interest-free loan from the IRS for nine or 10 months. I know of at least one general surgeon who used this technique to pay off her student loans in less than a year. Obviously, she combined it with living like a resident.
Be very careful with this technique. The IRS is considered a “super creditor.” You are far better off owing money to almost anybody else than to the IRS. You need to be very sure you will have the money come April 15. Also, check with your state. It may not offer you penalty abatement if it is a pay-as-you-go state. Some states, such as Utah, are not pay-as-you-go. They have no problem with you paying your entire year's tax bill on April 15. But you will be responsible to make sure you have the money to pay.
First-time penalty abatement is one of the few times that the IRS will give you a mulligan. Take advantage.
What do you think? Have you received a first-time penalty abatement? How did it work out? Comment below!