A question that I get a lot from business owners is “Do I need to make estimated payments?”
Short answer, probably.
Picture this: you’ve been working your business all year, making your coins, and living your life. Your business is booming. You’re signing up new clients, slinging your tees, selling out of your jewelry. It’s great! You made a lot of money, you even retired your husband. I’m proud of you, sis! Then… January comes, and you start to stress out. You haven’t even thought about taxes all year. The mere idea of what your tax bill is going to look like gives you anxiety. You don’t even know how much money you made! February comes and you still haven’t even attempted to gather your documents.
The DIY software that you always use keeps sending you reminder e-mails to file your tax return. Or your tax preparer has called you several times to make an appointment. You’re dodging both like bill collectors. March comes and you know you need to get this done. You start to organize your paperwork, hands shaking, sweating bullets, imagining the damage. It’s April 15, and you’re finally sitting down in front of your computer or your tax preparer and you get the news you’ve been dreading all along. You owe. A lot. And you don’t have the money to pay it right now. Facepalm.
If only there were a way to be proactive and avoid all of that stress. *insert thinking emoji here*
Estimated tax payments are payments that you send to the IRS quarterly to pre-pay your tax. It’s similar to when you work your “W-2 job” and they withhold taxes from your paycheck, except that you have to keep track of and remit these payments yourself. Many small business owners don’t pay anything to the IRS until after they file their return. Unfortunately, a lot of times they have to set up payment plans, which costs them money in the form of interest and penalties.
Why Make Estimated Payments?
You might thinking to yourself, “Why would I send the money to the IRS now, when I can use it to fund my business, flip it, and then pay it all at once?” That’s a great idea, except that’s not how our tax system is set up. Our tax system is considered a “pay as you go” system. This means that we are actually required to pay a certain amount of our current year tax liability throughout the year instead of paying it all at once on April 15.
Typically, we are required to pay the lesser of 1) 90% of our current year’s tax liability or 2) 100% of our prior year’s tax liability (or 110% if our income exceeded $150,000 on the prior year’s tax return). If we don’t pay in enough during the year, the Tax Code allows for the imposition of an underpayment penalty. So, you can be assessed a penalty for not paying enough taxes in throughout the year, AND then you can be assessed a penalty for not paying your balance in full by April 15. Penalties on penalties! As a small business owner, you can start saving money and helping your bottom line simply by paying your taxes when they’re due throughout the year instead of waiting until the end of the year and being assessed penalties for not paying.
How to Calculate Estimated Payments
This is where great recordkeeping comes in. You’ll need to make sure that you’re keeping accurate records of all income and expenses in order to calculate your estimated payments.
Each quarter, you’ll estimate your taxable income for the year. Start by calculating your taxable income year to date and then annualizing it for the year. So, after March 31, you’d add up all of your income and subtract all of your deductible expenses to determine what your taxable income for the year is. Since it’s the first quarter and there are four quarters in the year, you’d multiply that income by 4 to get the estimated taxable income for the whole year.
From there, you’d calculate what your tax liability and required annual minimum payment are. Subtract what you’ve already paid in for the year, or expect to pay in through withholding. Lastly, divide the result by the number of quarters left in the year. This is the amount that you will need to pay each quarter.
Since income can change throughout the year, estimated payments should be revisited each quarter to make sure that you are on track.
Estimated Payments Due Dates
Estimated payments are due on certain dates each quarter. If the payment is made late, you can still get a penalty for being underpaid in that quarter, even if the payment is made up in a later quarter.
- 1st quarter due April 15: January 1 – March 31
- 2nd quarter due June 15: April 1 – May 31
- 3rd quarter due September 15: June 1 – August 31
- 4th quarter due January 15 (of next year: September 1 – December 31
Increased Withholding in Lieu of Estimated Payments
If you’re an employee and a business owner, you can choose to increase your withholding through your job instead of making quarterly estimated payments. You would still need to estimate what your total income and liability would be for the year, and then you could use the IRS Withholding Calculator to determine how you should complete your Form W-4 to avoid having a balance when you file your return.
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