For more than 50 years, IRS has collected estimated taxes on income not subject to withholding, which is known as nonwage income. Nonwage income generally includes income from pensions, interest, self-employment, capital gains, dividends, and partnerships. In 1994, these six categories accounted for 91 percent of all nonwage income. Nonwage income has represented a growing proportion of total U.S. income in recent years, increasing from 16.7 percent to 23.3 percent between 1970 and 1994. The percentage of tax returns reporting only nonwage income has likewise increased from 10 percent to 14 percent over the same period. The ES process requires taxpayers to make four payments to IRS at regular intervals during the tax year. At the beginning of the tax year, taxpayers are to estimate their annual income, determine their potential tax liability, and compute their ES payments. For tax years beginning on January 1, ES payments are due on April 15, June 15, September 15, and January 15 of the following year. If taxpayers underpay their ES payments, they may be liable for ES penalties. Taxpayers who underpay can choose either to have IRS calculate any penalty they owe or to self-assess their own penalty using a Form 2210. Taxpayers using the form to self-assess their ES penalties can use either the short or regular method to calculate their ES penalty amounts. The ES penalty equals the interest on the underpaid amount for the number of days it is outstanding. The interest rate used to compute the penalty is based on the federal short-term interest rate, which is subject to change the first day of each quarter, that is, January 1, April 1, July 1, and October 1. IRS updates the Form 2210 annually to account for changes in the federal short-term interest rate. (See app. I for a copy of a Form 2210.) In 1994, about 4 million taxpayers self-assessed their ES penalties. We could not determine how many of them used the short or regular method because IRS does not collect the data necessary to make that determination. However, to provide a rough approximation of how many taxpayers used the regular method, we examined 100 tax returns from the 1994 Statistics of Income database—the latest information available. The 100 returns were selected to represent taxpayers who either paid ES penalties or were otherwise affected by the ES process. Of the 75 taxpayers who self-assessed their ES penalties, we found that over half used the regular method. Our objectives were to identify causes for the complexity in the ES penalty process and to determine whether changes could be made to simplify the process for taxpayers who use the regular method to calculate their ES penalties. To achieve our objectives, we reviewed IRS reports on the estimated tax process; analyzed the instructions for preparing the Form 2210 and discussed the ES process with IRS officials; and reviewed a random sample of 100 taxpayer returns subject to the ES process to obtain a rough approximation of how many taxpayers used the regular method. The sample, which was too small to reliably project to the universe, was extracted from IRS’ tax year 1994 Statistics of Income database. We did our audit work in Washington, D.C., and San Francisco between September 1997 and March 1998 in accordance with generally accepted government auditing standards. We requested comments on a draft of this report from the Commissioner of Internal Revenue. The comments we received are in appendix II and are evaluated at the end of this letter. The Form 2210 includes three requirements that complicate the ES penalty process and result in additional calculations that need to be made by taxpayers who use the regular method. Simplifying the underpayment schedule, changing the effective dates of the ES penalty interest rates, and using a 365-day year for all ES penalty calculations would make the form easier to understand and reduce the number of ES penalty calculations taxpayers have to make. The changes to the underpayment schedule and the ES penalty calculations could be made administratively by IRS, while changing the effective dates of the ES penalty interest rates would require legislative action. These changes would have either little or no effect on ES penalty amounts. The Form 2210 underpayment schedule is used to determine taxpayers’ underpayments in each of the four ES payment periods. The underpayment calculation first requires taxpayers to apportion the required annual payment amount—the amount of taxes that should have been paid during the year—to each of the four ES payment periods. The apportioned amounts are the required ES installments—the taxes that should have been paid in each of the ES payment periods. Conceptually, the basis for the underpayment calculation is relatively straightforward. To determine the underpayment amount, taxpayers essentially compare the ES installment with the ES payments made and any withholding during the payment period. When the installment amount is greater than the combined amounts of ES payments and withholding, taxpayers have an underpayment and are liable for ES penalties. However, in actual practice, taxpayers must follow a more complicated procedure to calculate their underpayments. This procedure entails additional calculations to account for underpayment balances that may remain from previous payment periods. These additional calculations are necessary to comply with the definition of the term “underpayment” in section 6654(b)(1) of the Internal Revenue Code. The definition precludes existing underpayment balances from being used in underpayment calculations for succeeding ES payment periods. To illustrate the complexity of this procedure, a completed Form 2210 for a hypothetical taxpayer is shown in figure III.1 in appendix III. The underpayment schedule would be simplified by changing the form so as to allow taxpayers to carry forward underpayment balances to succeeding ES payment periods. To calculate their underpayments using this simplified approach, taxpayers would subtract the combined amount of their ES payment and withholding from the total of their current ES installment and their underpayment balance from the previous payment period. This change would reduce the number of calculations taxpayers have to make on the underpayment schedule but would, in some cases, make the computed underpayment amounts different. Figure III.2 in appendix III shows our revised underpayment schedule for a hypothetical taxpayer. To avoid a difference in the ES penalty amounts calculated using the different underpayment amounts, a corresponding change to the ES penalty underpayment period would be needed. The change would further simplify the process for taxpayers by eliminating additional ES penalty calculations, while ensuring that ES penalty amounts are not affected. Appendix IV shows a comparison of ES penalty calculations required under the current and simplified approaches. Although simplifying the Form 2210 underpayment schedule and changing the underpayment period in the ES penalty calculation schedule would reduce the number of calculations taxpayers need to make, it would require that taxpayers and tax preparers adjust to a revised Form 2210, which has not changed since 1986. However, we believe the recurring advantages of simplifying the form outweigh this one-time adjustment. To determine their ES penalties, taxpayers must calculate the interest on the underpayment amount for the number of days it was outstanding, that is, the number of days between when the taxpayer should have made the ES payment and the earlier of (1) when the payment was actually made, or (2) the 15th day of the 4th month following the close of the taxable year (April 15 for a taxpayer using a calendar-year basis). The interest rate used in the calculation is based on the federal short-term interest rate, which is subject to change on the first day of each quarter. Under the current approach, if interest rates change while an underpayment is outstanding, taxpayers are required to make separate calculations for the periods before and after the interest rate change. Typically, in such instances, the separate calculations are necessary to cover only 15-day periods because the applicable ES payment dates occur either 15 days immediately before or after the effective dates of interest rate changes. For example, the July 1 interest rate change occurs 15 days after the June 15 payment date. This use of different dates for ES payment dates and interest rate effective dates has the effect of increasing the number of penalty calculations taxpayers must make. Table 1 illustrates the calculations that would have to be made by a hypothetical taxpayer with underpayments in three ES payment periods. To compute the ES penalty for the June 15 underpayment, the taxpayer would need to make two calculations, numbers 1 and 2, because the April 1 interest rate was in effect during the first period the underpayment was outstanding and the July 1 interest rate was in effect for the second period the underpayment was outstanding. Similarly, three calculations, numbers 3, 4, and 5 would be necessary to compute the taxpayer’s ES penalty for the September 15 underpayment because three different interest rates were in effect during the period the underpayment was outstanding. Unlike the ES penalty calculations previously discussed, penalty calculation number 6 is different. For that penalty, only one calculation at the January 1 interest rate would be required for the entire period the underpayment was outstanding because of a special rule in section 6621(b)(2)(B) of the Internal Revenue Code. The special rule, in essence, changes the effective date of the April 1 interest rate change to April 15, thereby allowing IRS to use the January 1 interest rate for the 15-day period between April 1 and April 15. Expansion of the special rule to cover all ES payment dates and interest rate dates would reduce the number of calculations taxpayers would have to make. Specifically, aligning the July 1, October 1, and January 1 interest rate effective dates with the June 15, September 15, and January 15 ES payment dates, respectively, would eliminate the 15-day ES penalty calculations. Instead, taxpayers would make only one calculation at the interest rate, which becomes effective at the end of the affected 15-day period. To illustrate the effect of the change, we used the hypothetical taxpayer case shown in table 1. Under an expanded special rule, the taxpayer would be required to make only three calculations rather than six, as shown in table 2.