Estimated income tax payments remain a fact of life for most of us who run our own businesses.
Those who are employed receive paychecks where the employer withholds taxes. But most business owners and the self-employed must to periodically send an amount called “estimated tax payments” to the IRS. You may also need to pay estimated taxes to your state taxing authority.
For new small business owners, meeting these tax obligations becomes a big adjustment. It seems particularly stressful when you’ve been used to having an employer take out income tax withholdings with each paycheck.
Learn more about the ins and outs of estimated tax payments. Small Business Trends spoke with Michael Hanley. Hanley works as Managing Partner of the Smithtown, N.Y. CPA Firm Merl & Hanley, LLP. He also authored three small business books. They include Effective Tax Planning for the MicroBusiness, Choosing the Right Structure for Your Business, and Why You Should Incorporate Your Real Estate Business.
We asked him to answer estimated tax-related questions that would be on the minds of many small business owners and self-employed persons.
What are Estimated Tax Payments?
The law requires individuals and businesses to pay taxes over the year, not just at “tax time.” Do you work for an employer? Them your employer most likely withholds these taxes for you throughout the year. If you own a business or employee yourself, things are different. You need to make these tax payments to the IRS and state on your own.
Most small business owners must pay estimated taxes quarterly and do not wait until April 15 or when other taxpayers file their returns. Those quarterly installments are for the amount we “estimate” we will owe.
Who Should Make Quarterly Estimated Tax Payments?
The rules for estimated tax payments vary based on the business type.
For sole proprietors, partnerships, S Corporation shareholders, single-member LLCs who elect to be taxed as a sole prop or an S corporation, or multi-member LLCs who elect to be taxed as a partnership or an S corporation: If you expect to owe $1,000 or more in taxes when you file your income tax return, most likely you will need to make estimated tax payments to the federal government (and, potentially, to the state government, too).
This group includes the self-employed, independent contractors, freelancers, and people with side gigs because no tax is automatically withheld on their income. People with rental or investment income may also need to make quarterly estimated tax payments as that is also taxable income.
There’s one exception to this rule: If your withholdings and tax credits add up to as least as much as your prior year’s tax, you do not need to make a federal estimated tax payment.
What About C Corporations and Multi-member LLCs?
For C Corporations and multi-member LLCs who elect to be taxed as a C Corporation: If you own a Corporation, you will need to make estimated tax payments if you expect to owe $500 or more with your tax filing.
Keep in mind that for most small businesses, it’s typically the owner, not the business entity itself, who is required to make estimated tax payments. That’s because most small business entities, such as LLCs, are what is known as “pass-through entities” for tax purposes and are taxed under the individual income tax.
“Small businesses typically do not make estimated quarterly payments because most small businesses are set up as flow-through or pass-through entities, which means that all taxes are paid at the personal level,” according to Hanley. “This means that the vast majority of all estimated payments would be paid by the business owners, not by the businesses themselves.”
Tax Tip: Remember that some business entities (example: non-pass-through entities) are, in fact, required to pay estimated taxes on behalf of the business entity itself. These include C Corporations, S Corporations that conduct business in New York City, and S Corporations that do business in Washington, D.C.
Who Doesn’t have to Make Estimated Tax Payments?
A small business need not pay estimated tax for the current year if it meets all three of the following conditions, says the IRS:
- Your business had no tax liability for the prior year;
- You were a U.S. citizen or resident for the whole year;
- The previous tax year covered 12 months.
What Taxes Do Self-employed People Pay?
Quarterly taxes typically fall into two categories:
- The self-employment tax (Social Security and Medicare);
- Income tax on the profits that your business made along with any other income.
For 2020, self-employment tax equals 15.3 percent. These business people pay net earnings up to $137,700 at 12.4 percent. For the Social Security portion you pay 2.9 percent on all net earnings for the Medicare portion).
Individuals with net earnings of $200,000 or married couples with incomes of $250,000 are subject to an additional Medicare Tax of 0.9 percent, Intuit says.
When are Estimated Tax Payments Due?
Estimated tax payments are divided into four payment periods throughout the year:
- April 15th
- June 15th
- September 15th
- January 15th
If your business is a Corporation, your estimated taxes are due on the fifteenth day of the 4th, 6th, 9th, and 12th month after the end of your company’s fiscal year.
Once you’re in the system, the IRS will send you estimated payment vouchers at the end of each tax year. However, whether you receive these payment vouchers or not, it is your responsibility to make payments for both the Federal and State taxes.
Also, notice that the January 15 quarterly payment is due, not in the tax year itself, but early the following year (but before your tax return is due). Note also that if the date falls on a weekend or holiday, it may be extended to the next business day.
Because these dates don’t align with the regular quarters — March, June, September, December — you’ll need to mark them on your calendar and plan accordingly. Also, keep in mind you won’t need to make the January 15th payment so long as you file your 2019 tax return and pay what you owe by month’s end.
Tax Tip: If you are in a state where you are required to make state income tax estimated payments, pay your state estimated tax by December 31st. That way, you can claim a deduction for the tax payment in the current tax year.
How Do I File Estimated Taxes?
The IRS and most states allow for electronic payments of estimated taxes, in addition to paper filing.
If you can file electronically, Hanley says, it’s a good choice because you have better proof of payment. “Online payment confirmation is always more concrete than any proof of mailing or proof of delivery that the post office can provide.”
If you’re filing as a self-employed individual or disregarded entity (i.e., single-member LLC, partnership, or S Corp shareholder), you should complete Form 1040-ES (PDF), Estimated Tax for Individuals.
This form is a worksheet similar to Form 1040 that takes you through the calculation to help you determine your taxable income and payments contain blank vouchers for mailing your estimated tax payments. (You will need your prior year’s annual tax return to fill out Form 1040-ES.)
The Electronic Federal Tax Payment System
You can also make payments using the Electronic Federal Tax Payment System (EFTPS). For your state payment, you have to search online for the appropriate form, complete it, and send it in with your payment.
Corporations must submit their payments using EFTPS or can arrange for a tax professional, financial institution, payroll service, or other trusted third party to make deposits on their behalf.
Consider this in your first year being self-employed. The IRS says you will need to estimate the amount of income you expect to earn for the year. Did you estimated your earnings too high? Complete another Form 1040-ES worksheet to refigure your estimated tax for the next quarter. If you estimated your earnings too low, again complete another Form 1040-ES worksheet to recalculate your estimated taxes for the next quarter.
Tax Tip: In most cases, electronic filing also gives you the ability to schedule future payments. Avoid the need to remember or set calendar reminders throughout the year by scheduling all four estimated payments at once, electronically.
What about Making Estimated Tax Payments to the State?
If your state has an income tax, most likely, you are required to pay estimated tax payments toward your state income tax, also.
Nine states do not have a personal income tax on wage income. States that do not have personal income tax include Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire and Tennessee do not tax wage income but do tax interest and dividend income. However, be sure to check for any other business tax filing requirements.
Tax Tip: Go here to find a list of state tax offices you can contact to find out if your state is one where estimated income tax payments are required. You can also find other information and appropriate forms or electronic filing links for each state.
How much Should You Pay?
As mentioned previously, the IRS recommends using Form 1040-ES to calculate your individual estimated tax payments. Corporations should use the Worksheet on Form 1120-W (PDF) to calculate estimated tax payments.
Alternatively, if you expect the current year’s earnings to be relatively similar to last year, you can use the previous year’s tax return to calculate your estimated payments. Or, if you experience fluctuating income, you can choose to calculate your estimated taxes based on the actual amount you made that quarter.
You don’t need to show the IRS how you arrived at your estimated sum. However, it’s in your best interest to reach as accurate a figure as possible. Paying too little can result in an unfortunate surprise when it’s time to file your annual taxes, in addition to potential penalties for underpayment. Conversely, by paying too much, you’ve essentially taken money out of your business, and you could have invested that money for a higher return.
Looking at The Big Picture
Since individuals make estimated payments, you have to look at the big picture, not just your business liability. For example, you may not owe estimated taxes if your spouse is employed. You also may find he or she has enough taxes withheld.
The same goes if you are also employed and have sufficient taxes withheld from your own paycheck. Request that your employer or your spouse’s employer withhold more, to withhold enough to avoid having to file estimated payments. Simply complete a new Form W4 (PDF) for the employer. Also, if you had a refund due from the prior tax year, you can choose to apply that to the upcoming year.
If you’re unsure about your estimated tax obligations, it’s wise to consult a tax specialist who can advise you on the best calculation method for your business and how to accurately track and record your earnings and deductions. Just remember the more time you invest in your estimated tax payments, the easier your life will be at tax time.
Tax Tip: Use a CPA to help you prepare your taxes. Have the CPA generate an estimated tax payment schedule with amounts each year. Do this for the upcoming tax year, at the time you file your taxes for the previous year. Then follow that payment schedule exactly, unless your income or deductions change significantly.
Do I have to Pay Quarterly, or can I Make Monthly Installments?
It’s customary to pay estimated tax payments in four equal installments, but the IRS doesn’t restrict you to making payments quarterly; you can opt to pay more often if you prefer.
Some people choose monthly increments because it’s less strenuous on the pocketbook. Let’s say your business does well, and you owe $6,000 for the year. It’s likely easier to pay $500 per month than $1,500 four times per year.
What Happens if I Fail to Make Estimated Tax Payments?
The IRS charges a penalty if you fail to pay enough in estimated taxes throughout the year. They also levy a penalty for late or insufficient payments. It doesn’t even matter if you’re owed a refund when you file your tax return.
The estimated tax penalty amounts essentially to an interest charge. You pay for not paying taxes throughout the year. The interest rate for underpayments by individual taxpayers ads up to 6 percent for the 2019 tax year. The IRS sets this rate each quarter.
You avoid the penalty if you pay at least 90 percent of the tax for the current year. Or pay 100 percent of the tax you owed for the prior year, whichever is smaller.
According to NerdWallet, the IRS might give you a break on penalties if you fall into one of two categories:
- You were a victim of a casualty, disaster or another unusual circumstance;
- You’re at least 62, retired or became disabled this year or last year, and your underpayment was due to “reasonable cause” rather than “willful neglect.”
Are you “qualified” as a farmer or fisherman? Then pay less in taxes. The IRS considers you to be qualified if you earn more than two-thirds of your taxable gross income from farming or commercial fishing.
The bottom line: Stay out of hot water by knowing your responsibilities for estimated tax payments at the state and federal level and make payments in a timely manner. Just as important as knowing the rules and requirements, get yourself organized so you don’t inadvertently forget and slip up accidentally.
Tax Tip: Like any tax rule, the penalties have various exceptions. See IRS instructions on Form 1040-ES for more. Publication 505 (Tax Withholding and Estimated Tax) also has more information.
Myths and Errors to Avoid
Think about this when calculating your quarterly or end of the year tax liability. Always consider your business’s whole financial picture.
As Hanley explains: “Too many small business owners get caught up in the myth that ‘whatever my business bank account balance is on December 31 is what I will have to pay tax on.’”
Yes, the December 31 bank account balance remains be an instrumental figure when performing a quick cash flow calculation. But it tends to be VERY misleading. It doesn’t determine the profitability of a business.
Think about items like paying down debt, borrowing money, carrying credit card balances and paying personal expenses. Also consider repaying shareholder loans, distributing profits to the owners and more. These all impact how much money is in the bank at the end of the year. But they don’t affect your business’s profit.
Tax Tip: When figuring your estimated quarterly tax amounts, always calculate based on profit. This means income minus expenses.
Want to learn more about making estimated tax payments? See the IRS web page on estimated taxes for small businesses.
Note: Consider the information provided in this article for general background purposes only. Don’t think of this as tax advice. Always check available IRS materials. And contact your tax advisor to ensure you are informed properly.