Estimated Taxes: A Quick Guide for Small Business Owners
Estimated taxes can be a rude awakening for many new small business owners.
If you were an employee before starting your own business, your taxes were likely pretty straightforward. Your employer withheld federal and state income taxes, Social Security, and Medicare from your paychecks, and that added up (more or less) to the amount you owed at tax time.
Small business owners and self-employed people don’t have an employer withholding taxes from their paychecks. Instead, they’re responsible for paying their own taxes, and the IRS expects a payment every quarter.
Who needs to make estimated payments?
The IRS requires small business owners to make estimated payments if they expect to owe $1,000 or more when they file their tax return. That includes sole proprietors, partners, LLC members and S corporation shareholders. Estimated taxes cover both income taxes and self-employment tax.
For businesses structured as a C Corporation, the company has to make estimated payments if it expects to owe tax of $500 or more.
If you don’t pay enough estimated tax throughout the year, the IRS can assess an underpayment penalty when you file your return.
When are estimated payments due?
Quarterly estimated payments are generally due on April 15, June 15, September 15, and January 15 of the following year. If one or more of those dates fall on a Saturday, Sunday, or legal holiday, the payment is due on the or business day.
How much do I need to pay?
Figuring out how much you need to pay can be complicated because there’s no hard and fast rule for how much you owe. It depends on your tax bracket, the other types of income you earn, and the deductions and credits for which you might be eligible.
Some experts recommend setting aside 25% to 30% of your business income for taxes, and for many business owners, that rule of thumb works. But if you’re in a higher tax bracket, have a lot of other income, such as interest, dividends and capital gains, and don’t qualify for many tax deductions or credits, you might need to set aside more.
If you’re new to self-employment, you need to come up with an estimate. This can be difficult when your income fluctuates from month to month, and you don’t know what you’ll earn. The worksheets in IRS Form 1040-ES are designed to walk you through the calculation.
If that seems too complicated, the IRS also provides a “safe harbor” method for paying estimated taxes. If you use one of these methods, the IRS won’t charge an underpayment penalty, even if you owe at year-end:
- 90% of the tax you owe for the current year. Estimate what you will owe this year and pay at least 90% of this amount in four equal installments.
- 100% of last year’s taxes. Pay 100% of the tax shown on your prior-year return, before applying any estimated payments, withholding, or refundable tax credits. Note that if your adjusted gross income (Line 7b of Form 1040) is greater than $150,000 (or greater than $75,000 if you are married and file separately from your spouse), the safe harbor is 110% of your prior-year tax.
- Annualized income installment method. This method is best for seasonal businesses. It allows you to annualize your tax for each quarter based on an estimate of income and deductions rather than paying four equal installments. For example, a pool cleaning business might have estimated tax for the year of $20,000, but $15,000 of that comes from income earned during the summer months. The annualized income installment method allows the business to make a larger estimated payment in that quarter.
Just keep in mind, if your income has grown substantially since last year, making safe harbor payments only protects you from owing underpayment penalties – you could still wind up with a big tax bill at year-end, so make sure you’re setting money aside to cover that.
How do I make estimated payments?
You can mail a check for your quarterly estimated payment to the IRS using the vouchers included with Form 1040-ES, pay online using IRS Direct Pay, or use the Electronic Federal Tax Payment System (EFTPS).
Depending on where you live and the states in which your business operates, you may also need to make estimated quarterly payments to one or more states or localities. Each jurisdiction has its own rates, forms, and sometimes different due dates.
Prioritizing estimated tax payments can be tricky, especially if this is your first year being self-employed. But planning for estimated payments and setting the money aside to cover them can take some of the bite out of tax season.
Need help calculating your estimated payments? Feel free to set up a call with me! I can help you.
