Every year, thousands of small business owners get a tax refund from the IRS. You might think getting a refund is good. You’re mistaken.
The United States has a pay as you go tax system. In other words, you can’t wait until you file your return to pay all your taxes.
If you’re a business owner, you must pay your income, Social Security and Medicare taxes to the IRS four times during the year. “Estimated taxes” is the term for these payments.
The IRS would pay you a refund only if you overpaid your estimated taxes during the year. In this case, it means you paid to the IRS more in estimated tax than what you end up owing.
Example: Mary, a self-employed salesperson, paid $20,000 to the IRS in estimated taxes during the year. When she prepares her tax return, she finds she owes only $15,000 in taxes. After it processes her return, the IRS sends Mary a $5,000 tax refund.
Mary shouldn’t be happy about getting a $5,000 refund. That was $5,000 she didn’t have to use during the year. And the IRS doesn’t pay Mary interest on the amount of her overpayment. In effect, Mary gave the IRS a $5,000 interest-free loan.
To avoid giving the IRS an interest-free loan, you want to pay no more in estimated taxes than you end up owing. To avoid overpaying, and also avoid underpayment penalties, you need to understand the estimated tax rules.
Who must pay estimated taxes
You must pay estimated taxes if you are a sole proprietor, a partner in a partnership or member of a limited liability company and you expect to owe at least $1,000 in federal tax for the year.
However, if you paid no taxes last year—for example, because your business made no profit or you weren’t working—you don’t have to pay any estimated tax this year, no matter what your tax tally for the year. But this is true only if you were a U.S. citizen or resident for the year and your tax return for the previous year covered the whole twelve months.
How much estimated tax must I pay?
You don’t want to pay any more than you have to. But you don’t want to shell out too little either. The IRS imposes penalties if you don’t pay enough estimated tax. There are different ways to calculate your estimated tax payments.
Payments based on last year’s tax
The easiest and safest way to calculate your estimated taxes is to pay 100% of the total federal taxes you paid last year, or more if you’re a high-income taxpayer as described below. You can base your estimated tax on the amount you paid the prior year, even if you weren’t in business that year, but your return for the year must have been for a full twelve-month period.
Ideally, calculate how much estimated tax to pay for the current year at the same time as you file your tax return for the previous year—no later than April 15. Take the total amount of tax you had to pay for the year and divide it by four. These are the amounts you’ll have to pay in estimated tax.
EXAMPLE: Gary, a self-employed consultant, earned $100,000 last year. He figures his taxes for the prior year on April 1 of this year and determines he owed $25,000 for the year. To calculate his estimated tax for the current year, he divides this amount by four: $25,000 divided by four equals $6,250.
He’ll make four $6,250 estimated tax payments to the IRS. So long as he pays this much, Gary won’t have to pay the penalty even if he ends up owing more than $25,000 in tax to the IRS for the year because his income goes up, his deductions go down or both.
High-income taxpayers must pay more estimated tax to avoid a penalty. You’re a high-income taxpayer if your adjusted gross income is over $150,000 ($75,000 if you’re married and file a separate return). High-income taxpayers must pay 110 percent of their prior year’s tax.
Your adjusted gross income or AGI is your total income minus deductions for:
- IRA, Keogh and SEP-IRA contributions
- The self-employed health insurance deduction
- One-half of your self-employment tax, and
- Alimony, deductible moving expenses
Payments based on estimated taxable income
If you’re certain your net income will be less this year than last year, you’ll pay less estimated tax if you base your tax on your taxable income for the current year instead of basing it on last year’s tax.
The problem with using this method is that you must estimate your total income and deductions for the year to figure out how much to pay. Obviously, this can be difficult or impossible to compute accurately. And there are no magic formulas to look to for guidance. The best way to proceed is to sit down with your tax return for the previous year.
Take comfort in knowing that you need not make an exact estimate of your taxable income. You won’t have to pay a penalty if you cover at least 90 percent of your tax due for the year.
Example: Larry, a self-employed consultant, earned $120,000 last year and paid $30,000 in income and self-employment taxes. Larry expects to make much less this year because a key client has gone out of business.
The lost client accounted for more than one-fourth of Larry’s income last year, so Larry estimates he’ll earn about $80,000 this year. The minimum estimated tax Larry must pay is 90 percent of the tax he will owe on his $80,000 income. He figures this is $22,500.
When do I pay estimated taxes?
You pay your estimated taxes in four installments, with the first one due on April 15, as shown in this chart:
Income received for the period: Estimated tax due: January 1 through March 31 April 15 April 1 through May 31 June 15 June 1 through August 31 September 15 September 1 through December 31 January 15 of the following year
For more details on how to calculate and make estimated tax payments, see IRS Publication 505, Tax Withholding and Estimated Tax.
Be sure to set aside from your compensation the money you’ll need to pay your income and self-employment taxes. If you fail to do this, you could find yourself with a big tax bill and no means to pay it.
