Paying taxes and doing so on time is the less exciting part of doing business, albeit a necessary one. If you are a first-time business owner, then you have to “play nice in this sandbox” or face fines and penalties. So, you need to know the rules, when and how to file your taxes, and, most important, learn when and if you need to pay quarterly estimated tax payments and how to estimate what you owe. Hopefully, what follows will give you the basic information you need to figure all of this out.
What are Estimated Tax Payments?
Estimated tax is a way of paying tax on income that is not subject to withholding – self-employment, dividends, interest, rent etc.
The whole point of estimated tax payments for a business is to “soften the blow” at the end of the tax year. If you have estimated reasonably well and you have made quarterly payments, then the reconciliation that occurs at the end of the tax year is not so bad, because you have been paying all along.
While it seems like a hassle, it will payoff in the long run. You won’t face a “whammy” at the end of the tax year, and that’s a good thing.
Basically, you will need to estimate what your net income will be during the current year, and divide it up in 4 monthly payments.
The due dates for estimated tax payments are:
- an. 1 – to March 31 – Payment due on April 15
- April 1 – May 31 – payment due on June 17
- June 1 – August 31 – Payment due September, 16
- September 1 – December 31 – Payment due January 15 of the next year
Do You Need to Make Estimated Tax Payments?
Your business may be one of many possible types, according to your situation and to the IRS. If you are a freelancer, you may be a sole proprietorship or you may have formed an LLC. But the bottom line is this: any money made that comes in must be accounted for and reported in some way. So this will take some tax planning.
So, let’s look at the “rules” of whether you will have to pay estimated taxes or not.
If you register and file as a sole proprietor (many freelancers and very small businesses do this), or any other type of business entity, you will have to pay quarterly taxes if you believe that you will owe $1,000 or more in a quarter. And if you are registered as a corporation, and you expect to owe more than $500 in the tax year, you will also need to file quarterly estimated.
You will not need to file quarterly taxes, obviously, if you are an employee. But when you have your business, any income you take from it is personally taxable. So, you have two things to worry about – business income that may be taxable and personal income from that business that will also be taxable.
If you are self-employed as any type of business, any personal income you take from the company is also subject to self-employment tax (the equivalent of social security payments that are deducted from employee paychecks). The income you take will be reported on a K-1 form and will then need to be reported on your personal income tax return.
The whole process may sound a bit complex, especially when you are figuring thing out for the first time. And you may be well-advised to contract with a tax consultant at first to help you with the tax planning. Your other option is to use some business accounting software that will categorize everything and even calculate your estimated tax payments for each quarter. You do not have to be hanging out there all on your own.
How to Calculate Your Estimated Taxes
If you are a brand new business of any kind, you have a bit of a reprieve – unless, that is, you expect to earn a lot in your first year. But once you reach your second year of business, there are no exceptions. So, how do you calculate your quarterly tax payments?
Look at Your Previous Year’s Income
This is probably the best way. You will need to use your gross income, your deductions, credits, etc., and look at the net income figure from your previous tax year. It is then a matter of some simple calculations to figure out how much you should pay. The IRS even provides a worksheet for this – Form 1040-ES for individuals (e.g. self-proprietorships) of Form 1120-W for corporations.
Once you have your previous year’s net income, you figure your taxes on that income and divide it by four.
If Your Business Has Taken Off
If you are experiencing a significant increase in business and revenue, then using last year’s figures will not work. But here is a “non-scientific” but at least generally decent way to figure this out. Begin with your first quarter earnings, deduct your expenses, and get a net figure. Figure your taxes on that and write that check to the IRS, along with the voucher that they have either provided (they do sometimes send vouchers) or found on the IRS website.
If you think your income will continue to increase in future quarters, then you may want to write that check for a bit more. Each quarter you can go through this process. By the end of the tax year, your final reconciliation should not hit you too hard.
Example of Estimated Tax Payments
Suppose you have begun as a sole proprietor. Many startups launch like this and then change their organizational structure later on. Others remain as sole proprietors indefinitely.
As a sole proprietor, you and your business are one and the same. But unlike a status as just an individual, you are now responsible for following the IRS rules.
So, let’s say you are a freelance writer. And you estimate that your income will be about $65,000 this year. Working with this estimate, here are the steps you must take.
Estimating Your Taxable Income
Begin with your gross income of $60,000. Subtract your deductions (standard or itemized) and business expenses. Let’s say those total $15,000.
Now you are down to $45,000. This is your adjusted gross income (also, your taxable income).
Calculate Your Tax
Use the current tax tables to figure your tax.
Note: if your structure is as a corporation, your corporate taxes will have to be done separately from your personal taxes. But the money you take for income is your personal responsibility, and if it more than $1,000 in a quarter, then it must be filed every quarter.
Calculation of Self-Employment Tax
This is the amount you owe that replaces social security and Medicare. If you make more than $400 a year from your business, you have to figure this into your total tax bill. You do this by estimating your total annual income and multiplying that by 92.35%. When you get that number, you multiply it by 15.3%.
So, your total liability is the tax due on your personal income, plus the 15.3% in self-employment tax.
Figuring How Much to Pay Quarterly
This is now a simple calculation. You take your total estimated annual tax bill (personal income plus self-employment tax) and just divide it by four. This is how much you will pay each quarter.
Be careful here, though. The IRS demands that the amount you pay quarterly, when all added up, must be equal to at least 90% of what the final figures are once everything is reconciled at the end of the tax year. If it is not, then you can face penalties.
How to Make an Estimated Taxes
You will find a voucher on the IRS website – Form 1040V. You complete it and send it in with your check. This can also be done electronically, directly from the IRS site or via your business accounting software. And you don’t have to actually send a check. Just provide you bank information, debit or credit card, and you’re good to go.
Do be mindful that business tax returns and payments must be sent to the appropriate address, and they will not be the same address as personal income taxes, unless you are a sole proprietorship. The IRS provides these addresses on its site.
If You are Still Confused about Estimated Taxes
With luck, this short synopsis has given you the basics. But if you are confused, and if you have any questions at all, do not try to do this by yourself. The IRS can be pretty unforgiving. Get some professional advice, or at least get the right software tool that will provide all of the information and calculations you need to get it right. Penalties can be painful, and will be imposed under the following conditions:
- Failure to pay on time
- Not paying enough estimated tax during the quarters
- Even paying too much estimated tax
Here is a good general rule. Pay either 90% of what your true estimate is for the current year (divided by four) or pay 100% of the taxes you owed last year. This is known as the Safe Harbor Rule, and will relieve you of penalties, even if the end-of-year reconciliation means you have to pay more.
You may be used to a tax season that comes once a year. And paying taxes four times a year may not be your idea of fun. But if you prepare yourself and keep your finances organized, it won’t be the nightmare you envision!
Photo by TheAngryTeddy