When you have your own business (and are not taking traditional payroll), there is nothing worse than getting to the end of the year, preparing your taxes, and realizing that you owe WAY more than you anticipated. The government is not taking out taxes from your pay like they would be if you were an employee receiving a standard paycheck. You are in charge! Now what? It can be a struggle to come up with all that money in a short timeframe and can be a huge stressor on a business. Enter Estimated Taxes.
What Are Estimated Taxes?
Estimated Taxes are a periodic advance pre-payment of expected taxes due, based on the amount of income that is earned. This allows business owners to pre-pay a certain amount of income tax based on their income received before the year is complete. Most often, on a quarterly basis. It can greatly help smooth the income tax payment situation, so there is no surprise lump sum due at tax filing.
Generally, anyone who is self-employed, investors who receive dividend income and generate capital gains and landlords who earn rental income must work on estimating their tax liability and make these quarterly payments. Corporations are expected to pay estimated taxes if they will have at least $500 in tax liability, while individuals (including sole proprietors, partners and S Corporation shareholders) will have to make estimated tax payments if they expect to owe $1,000 or more when their tax return is filed.
It is also important to note that when estimating your expected tax liability, you will want to make it equal to at least 90% to 110% of the prior year’s liability, depending on the level of adjusted gross income. Otherwise, you will face possible interest and penalties on amounts that were not paid on time or were too low. Paying 100% of the taxes you owed in the previous year is referred to as the Safe Harbor Rule. This means that even if your income grew this year, you will avoid penalties if you match the payments that you owed in the previous year, you would just make up the difference of what is owed if any. Know, however, that if your income is more than $150,000 per year, then you will be required to pay 110% of what you paid in taxes the prior year.
What Will You Owe?
So how can you figure out what you would owe? The IRS Form 1040-ES is used to calculate and pay estimated taxes for a given year. You will need to figure out your expected adjusted gross income, taxable income, taxes, deductions, and credits for the year. This is why it can be helpful to use the prior year as a starting point. Just remember, you will want to estimate your income as accurately as possible to avoid those nasty penalties.
Tips and Tricks
Want to make things as easy as possible? Take a look at these tips and tricks to get a jump on any tax liability you may owe:
- Consider paying with your refund – did you overpay last year, and you are getting a refund back from the government? Apply the overpayment to your estimated taxes. It is a painless way to take care of some of what you may owe in the coming year.
- Find out if your state also has income tax (there are only 7 states that do not). If so, you will need to set up quarterly state tax payments, as well.
- Are you married and your spouse has a regular job (where taxes are withheld by their employer)? In that instance, they may have enough taxes withheld to cover the two of you. Or you can change their tax withholding amount from their regular paychecks to ensure that it will cover what you owe in a much easier way than dealing with quarterly estimated tax payments.
Additional Taxpayer Resources
- IRS.gov/payments has information on all payment options.
- More information about tax withholding and estimated tax is at the Pay As You Go page and IRS.gov.
- Publication 505, Tax Withholding and Estimated Tax, is another resource for taxpayers. This has worksheets and examples, to help determine whether you should pay estimated tax.
Ultimately, paying taxes four times a year is not fun. It is one of the many unglamorous parts of owning your own business and being an entrepreneur. But, with a little preparation and organized record keeping, it can be a relatively painless task that you can handle with ease. And know that we’re here to help!