The Safe Harbor Rule Every Founder Should Know

You filed an extension expecting to owe nothing, then a penalty notice shows up in the mail anyway. If this has happened to you, you are not doing anything wrong on purpose, you are just running into the U.S. estimated tax system.

The core idea is that taxes in America are on a pay-as-you-go system. The government expects that taxes be paid on your income as you earn it rather than in one lump sum the following April. For most employees, these payments are automatically made on their behalf through paycheck withholding. Founders and early-stage executives, however, often earn income that has no tax withheld from it, such as equity compensation, consulting income, and a K-1 from an entity. This leaves a gap between what has been paid in by the taxpayer and what is actually expected to be paid.

The good news is that there is a rule built into the tax code to protect taxpayers in this exact spot. It is called the Safe Harbor Rule, and getting familiar with it can help avoid unpleasant penalty surprises.

What is the Safe Harbor Rule?

The Safe Harbor Rule is a minimum that needs to be paid during the year based on prior year tax liability. If the safe harbor amount is paid, the IRS will not charge you an underpayment penalty regardless of the amount that will be owed in April.

Your income level determines the percentage that you are required to pay in:

The IRS also allows you to pay based on the lesser of safe harbor or 90% of your current year tax liability. This approach can result in less estimated tax payments if income is down in the current year.

Which test should you use? For most taxpayers, the safe harbor approach is the simplest method. It is predictable, and you can work out the estimated tax payments the moment last year’s tax return is finished. However, many founders can face fluctuating income year over year, which can result in overpaying estimated tax payments if you only look at the safe harbor method.

Why do Founders Tend to Underpay?

This is usually a structural issue with a few common situations:

How do Quarterly Estimated Payments Work?

Instead of one annual payment, the pay-as-you-go system requires the taxpayer to make four estimated payments spread across the year. Note that the tax quarters differ from financial quarters. The due dates are as follows:

These payments can be made online through IRS Direct Pay or EFTPS, the Electronic Federal Tax Payment System.

It is important to remember that paying the full balance in April does not undo penalties for missing the quarterly deadlines. Taxpayers should be evaluating their earnings quarterly, to ensure they are paying the correct amount and not over or under paying their estimated taxes.

A Quick Example

If last year a taxpayer’s total tax was $80,000, and AGI was over the $150,000 threshold and the taxpayer’s current year projected tax is $100,000.

Step 1 – Calculate the Prior-Year Safe Harbor

Because AGI exceeds $150,000, the safe harbor is 110% prior-year tax.

$80,000×110%=$88,000 or $22,000 per quarter

Step 2 – Calculate the Current-Year Safe Harbor

$50,000×90%=$45,000 or $11,250 per quarter

The taxpayer can pay based on Current Year Tax since it is the lower estimate due. The taxpayer should evaluate both calculations each quarter.

What About State Taxes?

On top of federal payments, most states have their own estimated payment rules and their own safe harbor thresholds. If a taxpayer is a high earner in a high-tax state such as New York, California, or New Jersey, the combined federal and state exposure can be significant. If there was a move between states partway through the year, the rules would get more tangled.

Cross-reference: State Income Tax Planning Considerations for a Liquidity Event – Withum

The safe harbor rule works in your favor, but only if it is utilized ahead of time rather than after a penalty notice arrives. A little planning turns tax season from a stressful scramble into a routine.

Not sure whether you are on track? Our Withum team can run a quick estimated tax projection, so you know exactly where you stand.