How To Estimate Quarterly Tax Payments for Your Small Business
One of the biggest mindshifts that happens when small business owners open their dream company is the realization that they are in charge of taxes. Where once an employer automatically deducted federal taxes, FICA, FUTA, and even state and local taxes, now, they are in charge. Estimated taxes are used to pay not only income tax, but other taxes such as self-employment tax and alternative minimum tax.
More than once, this has caused the outright failure of a new company and, at the minimum, a lot of discomfort as entrepreneurs try to understand what taxes they owe and when they owe them. With that in mind, let’s take a deeper dive into how Sole Proprietors need to handle their taxes – especially the quarterly payments they’ll owe throughout the year.
Who Pays Quarterly Estimated Taxes?
We’ll paint with a broad brush here and say that, for the most part, any self-employed individual operating under any legal business structure will have to pay quarterly taxes. As a self-employed individual, it’s your responsibility to set aside a portion of your income for taxes, and ensure the money gets to the IRS in a timely fashion. That includes sole proprietors, partners, and S corporation shareholders who will have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed. The IRS, as you can imagine, has clear standards on this and you can read more here. As professionals, our advice is simple – keep abreast of what these payments will be, pay them each quarter, and, in the event of an overpayment, you can still receive a return after filing your annual taxes. While this particular article dives into the most common quarterly tax scenarios for small businesses in general, it is actually the first in a series we’re doing about the various quarterly tax challenges that specific types of businesses will face – so stay tuned and keep reading!
Submitting Quarterly Estimated Tax Payments
There’s a bit of sunshine that pokes through the clouds of quarterly tax payments and that is this: once you know what those payments will be – either based on the previous year’s information or current projections, the IRS has made paying those taxes a lot easier than in years past. As an example, you would simply go to irs.gov/payments, click the “Pay Your Taxes Now” button, and fill in the information. Due to the safety and security measures that the IRS has adopted, you can link directly to your debit or credit card, (but we can’t recommend that!) and simply pay it as you would any other online bill.
When Are Quarterly Estimated Taxes Due?
As silly as it seems, your quarterly taxes are due based on your company’s fiscal year, not the IRS’s. As a result of this bookkeeping, your company will make quarterly tax payments within a given quarter of the traditional fiscal year. If your quarter ends on February 28th instead of March 31st, you still technically have until the end of March to pay. While it is sage advice to hang on to your money as long as possible, our advice as bookkeepers is simple – make the payment when your quarter has ended, no later. You aren’t going to escape payment, so take the time and have the financial discipline to simply pay as you go. Late payments, no matter what the excuse, can and do result in fines and interest assessed on the amount you owe.
You’ll note in the link above that there are some extenuating circumstances that your own business might fall under, but in our experience, these are the exception and not the rule. Pay as you go and your blood pressure will stay lower!
Calculating Your Sole Proprietorship’s Quarterly Taxes
Now, the focus on this article is about truly small businesses – usually sole proprietorship's – but nearly all this information is the same for other business structures. Calculating your tax liabilities will be done with at least a Form 1040ES, but if your sole proprietorship has employees, you’ll also have to use Forms 940 and 941.
This is where a lot of the heartache begins. Small business owners open their doors and in those first few quarters, owe very little and the systems they adopt don’t allow them to easily project quarterly taxes. As the company begins to gain traction, though, they may bring on additional employees and deal with larger amounts of income.
This is usually where a bookkeeper or accounting professional has to step in and help. Of course the IRS has several tools to help sole proprietors understand how to project their quarterly taxes – you can look right here, for example, but it’s been our experience that by the time a small business owner begins to worry about quarterly taxes, they may not have the ability to understand what those numbers will mean of how best to project them. That can lead to real trouble down the road.
Step.1 Estimating your income tax:
Multiply taxable income by the tax rate estimated in your tax bracket.
Step.2 Calculating your self employment tax:
Multiply taxable income by 92.5% then multiply this number by 15.3% (self employment tax rate)
Step.3 Simple Math:
Add the Estimated Income Tax + Estimated Self Employment Tax then take the sum and / divide by 4.
Penalty for Underpayment of Estimated Tax
You guessed it! If you try to keep too much of your money in your pocket, the IRS has plans for you! Not paying enough on your quarterly estimates and trying to make up the difference when you file at the end of the year can result in a penalty. The good news is that penalties are generally not assessed unless that total exceeds $1,000. Those estimates we keep talking about? They are based only on one of two things – 90% of the taxes due for the current year (by quarter) or 100% of the taxes from the previous year’s return – again, broken down quarterly. There are special exceptions made for some businesses – farmers and fishermen, for example – but for the most part, your small business will likely fall under the provisions listed in Publication 505, Tax Withholding and Estimated Tax, If there is one truth for small business, it is that new companies are often feast or famine.
The cyclical nature of a new business can be extremely frustrating and there are bound to be months where cash flow is virtually nonexistent. Surprisingly, the IRS has a provision for these types of problems. The secret is to annualize your total tax liability and make unequal payments by the quarter. As you can imagine, this can be a nerve-wracking experience, since cash flow is sporadic, but there are several ways that sole proprietors and other small business owners can approach this. Remember, unequal payments will result in the IRS assessing a penalty, so you’ll have to file one of several forms and note the issues on your returns. Form 2210 (PDF), Underpayment of Estimated Tax by Individuals, Estates, and Trusts (or Form 2220, Underpayment of Estimated Tax by Corporations) will help you qualify if you owe a penalty for underpaying your estimated tax and, at that point, you can use the Form 1040 Instructions (PDF), Form 1040A Instructions (PDF), or Form 1120 Instructions (PDF), for where to report the estimated tax penalty on your return.
Lets you think this an admission of guilt to the IRS, it isn’t. You have the right to your operating income, just as they do! The secret is to make sure that you meet the criteria for getting the penalty waived. Some examples of when the IRS will waive these fines and penalties are:
- The failure to make estimated payments was caused by a casualty, disaster, or other unusual circumstance and it would be inequitable to impose the penalty, or
- You retired (after reaching age 62) or became disabled during the tax year for which estimated payments were required to be made or in the preceding tax year, and the underpayment was due to reasonable cause and not willful neglect.
As you can imagine, the first option is the most likely one for a small business and, again, this calls for expert help for both forecasting cashflow and a top-notch CPA on your side. You might think these are luxuries that you can’t afford with your new company, but the truth is, you can’t afford not to have professionals in your corner. If the thought of trying to handle quarterly payments and taxes is hard to fathom, then simply reach out to us and let us show you how easy it can be!
By: Chris Groote
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