You should consider the items in this section when figuring any underpayment penalty for 2006.

Penalty rate. The penalty for underpayment of 2006 estimated tax is figured at an annual rate of 7% for the number of days the underpayment remained unpaid from April 16, 2006, through June 30, 2006, and 8% from July 1, 2006, through April 15, 2007.

Alternative minimum tax (AMT) exemption amount increased. The AMT exemption amount is increased for 2006 to $42,500 ($62,550 if married filing jointly or a qualifying widow(er); $31,275 if married filing separately).

Additional exemption for housing individuals displaced by Hurricane Katrina. You may be able to claim an additional exemption amount of $500 per person (up to $2,000) if you provided housing to a person who was displaced from his or her main home as a result of Hurricane Katrina.

Personal exemption and itemized deduction phaseouts reduced. The phaseouts of the limitations on personal exemptions and itemized deductions are reduced by 33⅓%.

Earned income credit (EIC). You may be able to take the EIC if:

The maximum investment income you can have and still get the credit has increased to $2,800. For more information, see Publication 596.

Retirement savings plans.  The following paragraphs highlight changes that affect individual retirement arrangements (IRAs) and pension plans. For more information, see Publication 590. Traditional or Roth IRA contribution limits increased. The 2006 contribution limit to a traditional or Roth IRA is increased to $5,000 if you are 50 or older. Traditional IRA deduction limits increased. If you are covered by a retirement plan at work and your filing status is married filing jointly or a qualifying widow(er), your deduction for contributions to a traditional IRA will be reduced (phased out) if your 2006 modified adjusted gross income (AGI) is more than $75,000 but less than $85,000. Additional salary reduction contributions to SIMPLE IRAs. Additional salary reduction contributions can be made to your SIMPLE IRA if you meet certain requirements. For more information, see How Much Can Be Contributed on Your Behalf? in Publication 590, chapter 3.

Standard mileage rates.  The 2006 standard mileage rate for the cost of operating your car is:

Credit for federal telephone excise tax paid. . If you paid the federal excise tax on your long distance or bundled telephone service, you may be able to request a credit. For details, see the instructions for Line 71, Form 1040; Line 42, Form 1040A; Line 9, Form 1040EZ; or Form 8913.

Credit for alternative motor vehicles and refueling property. You may be able to take a credit if you place an energy efficient motor vehicle or alternative fuel vehicle refueling property in service in 2006. You no longer can take a deduction for clean-fuel vehicles or refueling property. For details, see Form 8910 (Form 8911 for alternative fuel vehicle refueling property).

New credits for clean renewable energy bonds or Gulf tax credit bonds. You may be able to take a credit based on the face amount of any clean renewable energy bond or Gulf tax credit bond you hold during 2006. The amount of any credit claimed must be included as interest income. For details, see Form 8912.

Nonconventional source fuel credit. You may be able to claim the nonconventional source fuel credit for facilities producing coke or coke gas. However, the nonconventional source fuel credit is now a general business credit subject to the general business credit tax liability limits. In general, any 2006 unused credit can be carried forward 20 years. For details, see Form 8907.

Residential energy credits. If you make energy saving improvements to your home in 2006, you may be able to take two new credits, the nonbusiness energy property credit and the residential energy efficient property credit. The definition of residential energy efficient property has been clarified to include all property that uses solar energy to generate electricity for use in a dwelling unit as qualifying property. For details, see the Instructions for Form 5695.

Tax on child's income.  The election to report a child's investment income on a parent's return now applies to children under age 18. For details, see Form 8814.

IRA distribution for charitable purposes.  A distribution from your IRA that was made directly by the trustee to a charitable organization may be nontaxable if you were at least age 701/ when the distribution was made. However, you cannot take a charitable deduction on Schedule A of Form 1040.

Waiver of penalty for certain taxpayers abroad. . If you claim the foreign earned income exclusion or housing exclusion on Form 2555 or Form 2555-EZ, the Tax Increase Prevention and Reconciliation Act of 2005 made changes to the tax law that may affect your 2006 tax liability. The IRS will waive the 2006 estimated tax penalty to the extent the underpayment of any installment is attributable to changes made by the new law. For more details, see Notice 2007-16 on page 536 of Internal Revenue Bulletin 2007-8 at www.irs.gov/pub/irs-irbs/irb07-08.pdf.

Tax benefits extended.  The following tax benefits have been extended and will apply in 2006 and 2007.

If you did not pay enough tax, either through withholding or by making estimated tax payments, you will have underpaid your estimated tax and may have to pay a penalty.

You may understand this chapter better if you can refer to copies of your latest federal income tax returns.

In general, you may owe a penalty for 2006 if the total of your withholding and estimated tax payments did not equal at least the smaller of:

Your 2006 tax, for this purpose, is defined under Total tax for 2006 on page 49.

Generally, you do not have to pay an underpayment penalty if either:

Figure your required annual payment in Part I of Form 2210, following the line-by-line instructions. If you rounded the entries on your return to whole dollars, you can round on Form 2210.

You may be able to use the short method in Part III of Form 2210 to figure your penalty for underpayment of estimated tax. If you qualify to use this method, it will result in the same penalty amount as the regular method. However, either the annualized income installment method or the actual withholding method, explained later, may result in a smaller penalty.

You can use the short method only if you meet one of the following requirements.

If you do not meet either requirement, figure your penalty using the regular method in Form 2210, Part IV.

You cannot use the short method if any of the following applies.

You may use the regular method in Part IV of Form 2210 to figure your penalty for underpayment of estimated tax if you paid one or more estimated tax payments earlier than the due date.

You must use the regular method in Part IV of Form 2210 to figure your penalty for underpayment of estimated tax if any of the following apply to you.

If you use the regular method, figure your underpayment for each payment period in Section A, then figure your penalty for each payment period in Section B.

Figuring Your Underpayment (Part IV, Section A)

Figure your underpayment of estimated tax for each payment period in Section A following the line-by-line instructions. Complete lines 20 through 26 of one column before going to line 20 of the next column.

Required installments—line 18.   Your required payment for each payment period (line 18) is usually one-fourth of your required annual payment (Part I, line 9). However, if you are using the annualized income installment method (described on page 51), first complete Schedule AI (Form 2210), and then enter the amounts from line 25 of that schedule on line 18 of Form 2210.

Payments.   On line 19, enter in each column the total of:

• Your estimated tax paid after the due date for the previous column and by the due date shown at the top of the column, and

• One-fourth of your withholding.

For special rules for figuring your payments, see the Instructions for Form 2210.

  If you file Form 1040, your withholding is the amount on line 64, plus any excess social security or tier 1 RRTA tax withholding on line 67. If you file Form 1040A, your withholding is the amount on line 38 plus any excess social security or tier 1 RRTA tax withholding included in line 43.

Actual withholding method.   Instead of using one-fourth of your withholding for each quarter, you can choose to use the amounts actually withheld by each due date. You can make this choice separately for the tax withheld from your wages and for all other withholding. This includes any excess social security and tier 1 RRTA tax withheld.

  Using your actual withholding may result in a smaller penalty if most of your withholding occurred early in the year.

  If you use your actual withholding, you must check box D in Form 2210, Part II. Then complete Form 2210 and file it with your return.

Regular Installment Method

If you received your income evenly throughout the year, use the regular installment method to figure your estimated tax underpayment for the year.

Example.

Ben Brown's 2006 total tax (Form 1040, line 63) is $7,031, the total of his $4,685 income tax and $2,346 self-employment tax. His 2005 AGI was less than $150,000. He does not owe any other taxes or claim any credits other than for withholding. His 2005 tax was $6,116. See Figure 4-B, on page 57, to see Ben's completed Form 2210, Part I.

Ben's employer withheld $3,228 income tax during 2006. Ben paid no estimated tax for either the first or second period, but he paid $1,000 each on September 1, 2006, and January 12, 2007, for the third and fourth periods. Because the total of his withholding and estimated tax payments, $5,228 ($3,228 + $1,000 + $1,000), was less than both 90% of his 2006 tax (90% x $7,031 = $6,328), and 100% of his 2005 tax ($6,116), Ben knows he owes a penalty for underpayment of estimated tax. He decides to figure the penalty on Form 2210 and pay it with his $1,803 tax balance ($7,031 - $5,228) when he files his tax return on April 17, 2007.

Ben's required annual payment (Part I, line 9) is $6,116. Because his income and withholding were distributed evenly throughout the year, Ben enters one-fourth of his required annual payment, $1,529, in each column of line 18 (see Figure 4-B (Continued) on page 58). On line 19, he enters one-fourth of his withholding, $807, in the first two columns and $1,807 ($807 plus $1,000 estimated tax payment) in the last two columns.

Ben has an underpayment (line 25) for each payment period even though his withholding and estimated tax payments for the third and fourth periods were more than his required installments (line 18). This is because the estimated tax payments made in the third and fourth periods are first applied to underpayments for the earlier periods.

Annualized Income Installment Method (Schedule AI)

If you did not receive your income evenly throughout the year (for example, your income from a repair shop you operated was much larger in the summer than it was during the rest of the year), you may be able to lower or eliminate your penalty by figuring your underpayment using the annualized income installment method. Under this method, your required installment (line 18) for one or more payment periods may be less than one-fourth of your required annual payment.

To figure your underpayment using this method, complete Schedule AI of Form 2210 (see Figure 4-C, page 59, for an example). The schedule annualizes your tax at the end of each payment period based on your income, deductions, and other items relating to events that occurred since the beginning of the tax year through the end of the period.

If you use the annualized income installment method, you must check box C in Part II of Form 2210. You also must attach Form 2210 and Schedule AI to your return.

If you use Schedule AI for any payment due date, you must use it for all payment due dates.

Completing Schedule AI.   Follow the Form 2210 instructions to complete Schedule AI. For each period shown on Schedule AI, figure your income and deductions based on your method of accounting. If you use the cash method of accounting (used by most people), include all income actually or constructively received during the period and all deductions actually paid during the period.

Note.

Each period includes amounts from the previous period(s).

• Period (a) includes items for January 1 through March 31.

• Period (b) includes items for January 1 through May 31.

• Period (c) includes items for January 1 through August 31.

• Period (d) includes items for the entire year.

Example.   Laura Maple's 2006 total tax (Form 1040, line 63) is $7,179, the total of her $4,551 income tax and $2,628 self-employment tax. Her 2005 AGI was less than $150,000. She does not owe any other taxes or claim any credits other than for withholding. Her 2005 tax was $6,645. Her required annual payment on Form 2210, Part I, line 9, is $6,461 (the smaller of her $6,645 tax for 2005 or 90% of her $7,179 total tax for 2006).

  Laura's employer withheld $2,868 income tax during 2006. Laura paid no estimated tax for either the first or second period, but she paid $1,400 each on August 15, 2006, and December 1, 2006, for the third and fourth periods.

  Laura did not receive her income evenly throughout the year. Therefore, she decides to figure her required installment for each period (Part IV, line 18) using the annualized income installment method. To use this method, Laura completes Schedule AI before starting Part IV. Figure 4-C, beginning on page 59, shows Laura's filled-in Schedule AI and Part IV, Section A.

  Laura's wages during 2006 were $24,000 ($2,000 a month). Her net earnings from a business she started during the year were $18,600, received as follows.

April through May	$4,600
June through August	6,000
September through December	8,000

  Self-employment tax and deduction. Before Laura can figure her AGI for each period (Schedule AI, line 1), she must figure her deduction for self-employment tax for each period. To do this, she first completes Schedule AI, Part II, (see Figure 4-C on page 59).

  Laura had no self-employment income for the first period, so she leaves the lines in that column blank. Her self-employment income was $4,600 for the second period, $10,600 ($4,600 + $6,000) for the third period, and $18,600 ($10,600 + $8,000) for the fourth period. She multiplies each amount by 92.35% (.9235) to find the amounts to enter on line 26. She then fills out the rest of Part II. See Figure 4-C on page 59.

  Laura figures the deduction for self-employment tax by dividing the amounts on line 34 by the annualization amounts for each period. The annualization amounts are:

• 8 for the first period,

• 4.8 for the second period,

• 3 for the third period, and

• 2 for the fourth period.

Line 1—AGI.   Laura figures the amounts to enter on Schedule AI, line 1, as follows.

Column (a)—1/1/06 to 3/31/06:
$2,000 per month × 3 months			$6,000
Column (b)—1/1/06 to 5/31/06: $2,000 per month × 5 months			$10,000
Plus:	Self-employment income through 5/31/06		4,600
Less:	Self-employment tax deduction ($1,560 ÷ 4.8)		(325)
			$14,275
Column (c)—1/1/06 to 8/31/06: $2,000 per month × 8 months			$16,000
Plus:	Self-employment income through 8/31/06		10,600
Less:	Self-employment tax deduction ($2,247 ÷ 3)		(749)
			$25,851
Column (d)—1/1/06 to 12/31/06:
$2,000 per month × 12 months			$24,000
Plus:	Self-employment income through 12/31/06		18,600
Less:	Self-employment tax deduction ($2,628 ÷ 2)		(1,314)
			$41,286

Line 4—Itemized deductions.    Laura had $6,000 in itemized deductions for 2006—$250 per month withheld for state and local taxes, and $250 per month for mortgage interest—for a total of $500 each month. She divided them by period in the following manner.

• 1st period: $1,500 ($500 × 3 months).

• 2nd period: $2,500 ($500 × 5 months).

• 3rd period: $4,000 ($500 × 8 months).

• 4th period: $6,000 ($500 × 12 months).

She enters each amount on line 4 in the proper column for that period.

  Now that Laura has figured her entries for lines 1 and 4, she can complete the rest of Schedule AI to determine the amounts to put on Form 2210, line 18. Figure 4-C, on page 59, shows her completed Parts I and II.

Underpayment.   Laura then figures her underpayment in Part IV, Section A (see Figure 4-C (Continued) on page 60). She finds that she overpaid her estimated tax for the first payment period, but underpaid her estimated tax for the other three periods.

If you are a farmer or fisherman, the following special rules for underpayment of estimated tax apply to you.

Even if these special rules apply to you, you will not owe the penalty if you meet either of the two conditions discussed on page 49 under Exceptions.

See chapter 2 for the definition of a farmer or fisherman who is eligible for these special rules.

The IRS can waive the penalty for underpayment if any of the following applies.

For more details, see Notice 2007-16 on page 536 of Internal Revenue Bulletin 2007-8 at www.irs.gov/pub/irs-irbs/irb07-08.pdf.