By Jim Forrester, Tax Director of Traders Accounting*
Posted: October 5, 2007

Uncle Sam can be reasonable and, at times, even generous when it comes to its tax rules for traders. However, on one issue it is infamously inflexible: Estimated quarterly taxes. These are the required installment payments you make toward your estimated tax liability.

Underpay on your estimated quarterlies, or fail to pay altogether, and you'll likely receive a penalty for your neglect. That's because the Internal Revenue Service would lose countless millions in potential revenues if it allowed those tax dollars to remain in taxpayer accounts all year, earning interest for you rather than the government.

If your tax due will exceed $1,000, the Internal Revenue Service requires you to make quarterly payments on Form 1040-ES (Estimated Tax for Individuals). Payments are due as follows: First installment: April 15. Second installment: June 15. Third installment: September 15. Fourth installment: January 15.

As a general rule, the payments you make quarterly must add up to at least 90 percent of your final income tax liability to avoid a penalty. But, if you overpay, even if you wildly overpay, don't expect any interest refund; the IRS taketh, but it never giveth away.

Staying Ahead on ES

Because trading income can be extremely erratic, it's important to know the rules where your estimated quarterly payments are concerned. Here's how the IRS guidelines break down based on your income:

If your income requires that you make estimated taxes after March 31 but before June 1, you should pay 50 percent of your estimated tax by June 15 and 25 percent of payments on September 15 and January 15.

If your income requires that you make estimated payments after May 31 but before September 1, you should pay 75 percent of your estimated tax on or before September 15 and 25 percent on January 15.

If your income requires you to make estimated payments after August 31, you should pay 100 percent of your estimated tax by January 15.

As a trader, you face a difficult dance as your earnings ebb and flow: You want to keep as much money as possible in your brokerage account, satisfy the IRS' quarterly payment requirements and have sufficient funds available to pay the balance of your tax bill.

Who Pays Estimated Taxes?

Estimated taxes apply to all U.S. citizens, residents and non-resident aliens who expect to owe in excess of $1,000 on their upcoming federal income taxes. The exception is anyone who did not file a tax return last year or did not incur any tax liability in the last tax year, provided that the year encompassed a 12-month period.

ES payments also apply to C-Corporations. The rules for corporate estimated quarterly payments are the same as for individuals, with these exceptions:

• Corporations make payments with Form 8109 (Estimated Taxes -- Corporations Only and 8109) instead of 1040-ES.
• Fiscal-year corporation payments are due on the 15th day of the 4th, 6th, 9th and 12th months of their tax year.
• If any due date falls on a Saturday, Sunday or a legal holiday, payment is due the next business day.

If a corporation underpays, it should attach Form 2220 (Underpayment of Estimated Tax by Corporations) to its return to show whether the addition to tax applies and, if so, the amount of the penalty.

To avoid penalties, each payment must equal at least 25 percent of the lesser of 100 percent of the tax shown on the current year's return or 100 percent of the tax shown on the preceding year's return, provided the latter showed a positive tax liability and the preceding tax year consisted of 12 months.

"Flow-through" business entities, such as a limited liability companies, limited or general partnerships or S-Corporations, do not pay estimated quarterly tax; this obligation flows through for the individual shareholders or partners to include in calculating their individual estimated tax liability.

Reprieve for Underpayment

The IRS is authorized to waive the mandatory penalty for underpayment if the underpayment was due to casualty, disaster or other unusual circumstances, and the imposition of the penalty would run contrary to equity and good conscience.

It may also waive the penalty for an individual who retired, having attained age of 62, or who became disabled, either during the current or previous tax year. A key test is whether the underpayment was due to a reasonable cause and not to willful neglect.

To petition for dispensation, you must file Form 2210 (Underpayment of Estimated Tax by Individuals, Estates and Trusts).

*Reprinted (and modified) with permission from Online Trading Academy www.onlinetradingacademy.com Jim Forrester is Tax Director of Traders Accounting (http://www.tradersaccounting.com/)