Safe Harbor

“Safe Harbor” is a legal term that allows for avoidance of a penalty or fine if certain conditions are met. The term is borrowed from the nautical world whereby a safe harbor or “safe refuge” is a place (usually a port) that a vessel can moor and be safe from tumultuous seas.

As a legal provision you may see the term used in various statutes or regulations.

For wealth managers “safe harbor” will most likely be encountered in the context of income tax planning.

The most commonly availed safe harbor provision will be that of estimated tax prepayment. Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed.

If you didn’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. Generally, most taxpayers will avoid this penalty if:

1) They owe less than $1,000 in tax after subtracting their withholdings and credits
or
2) They paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller.

For higher-earners the rule is modified. If your prior year AGI is over 150,000 USD (75,000 USD for MFS), you must pay 90% of the current year’s return or 110% of the tax paid the prior year. Sticking to these rules gives you “safe harbor” from the stormy seas of the IRS charging you between 5% and 25% of the taxes unpaid, plus interest.

Mr. Client is a MFJ filer with his US national spouse and had a prior year AGI of 720,000 USD.

This year, Mr. Client has an AGI of 940,000 USD with very little tax withheld throughout the year and nominal deductions available.

Mr. Client’s accountant elects to pre-pay an amount that equals 110% of taxes paid in the year prior which is lower than his estimated taxes payable this year, thus keeping extra money in Mr. Clients pocket (or investment account) for longer, and taking advantage of the IRS safe harbor provisions for estimated tax prepayments.