A common question I receive from small business owners is “how do I calculate my quarterly tax payments?” At the heart of this question is the fear of ending up like Al Capone. I hope to alleviate those fears and provide you with this ultimate guide to estimated taxes.
First, what are estimated taxes? Estimated taxes are payments of tax on income that is not subject to withholding. The most common types of income that are not subject to withholding are self-employment income, business income, rental income, and investment income.
Am I required to make estimated tax payments? You may be required to make estimated tax payments if you expect to owe over $1,000 in federal taxes after subtracting out federal tax withholding and credits.
Is there a difference between “ES taxes” and “Estimated Taxes”? Nope! They are the same. Sometimes estimated taxes are referred to as “ES” taxes because individuals would send payment with Form 1040-ES.
When are estimated taxes due? Estimated taxes are due in four installments, usually on the following dates:
- 1st Quarter – April 15
- 2nd Quarter – June 15
- 3rd Quarter – September 15
- 4th Quarter – January 15
Does the IRS have to receive my payment by the due date if I mail my check with Form 1040-ES? Nope! The IRS will consider your payment timely if postmarked by the due date.
How do I calculate estimated taxes? I like to break estimated tax calculations into two categories – safe-harbor calculations or actual calculations. The safe harbor provision states that as long as you pay 100% of the prior year tax liability (110%, if your AGI was >$150,000 in the prior year) or 90% of the current year tax, you can likely avoid any penalty on potential under payment. While you may owe additional tax come April 15th, this makes ES calculations much more simple!
Where do I find my prior year Adjusted Gross Income (AGI)? Your adjusted gross income can be found on Form 1040, Line 37 (for 2015).
Where do I find the total tax paid last year? The total tax paid in the previous year can be found on Form 1040, Line 63 (for 2015)
I’m still confused about this safe-harbor non-sense, elaborate! If you expect income (and therefore taxes) to increase year after year, you can simply take last years total tax, subtract out any year-to-date withholding (your spouses withholding from their job as an employee, for instance), and divide by 4.
Here’s an example: Last year, the total tax on Line 63 was $40,000. You work freelance and your spouse works as employee. Your spouse’s federal income tax withholding on their paycheck for the current year is $2,500/month or $30,000 for the year. Your business is growing, and just by looking at your financials on QuickBooks you see that you are on pace to increase net profit by 20% for the year! You know that you will owe more in tax, but you would prefer to hold on to the money for short-term capital needs or an equipment purchase, so you decide to make a safe harbor payment. Since your AGI was greater than $150,000 for the prior year, you will need to have a minimum of $44,000 ($40,000 x 110%) of federal taxes paid in for the current year to avoid penalty. We subtract the amount your spouse will have in withholding, and arrive at $14,000 ($44,000 “safeharbor” tax that needs to be paid in at a minimum, less $30,000 estimated withholding from your spouses paycheck). We divide the $14,000 by 4, to arrive at $3,500. We will make four $3,500 tax deposits by each quarterly due date. Please note, this doesn’t necessarily mean you won’t owe any additional tax at the year of the year, but it does mean you will not owe any interest or penalty for underpayment of taxes.
I know it’s not that easy, do you have any other resources with examples? Okay, maybe your right, maybe estimated taxes are a little more complex than I am making them out to be. The IRS does try to simplify the process and put out instructions and resources on the topic. Estimated tax worksheets and instructions from the IRS website can be found here.
When should I use the safe-harbor provisions and when should I do an actual estimate? I recommend using the prior year tax safe-harbor calculation if you expect taxes to increase from the prior year. The current year safe harbor (90% of the current year tax) is ideal for individuals that may have had a high paying job prior to becoming a consultant or self-employed, and expect their tax liability to decrease significantly. Occasionally, we will calculate an actual tax due amount – if a client has a large unusual transaction, such as a investment property disposal, a large stock transaction, option exercise, or company exit OR if the individual prefers to not owe any tax at the end of the year.
What about Self-Employment taxes? Yikes! The dreaded self-employment tax. If you are subject to the self-employment tax, and want to use the current year safe harbor (paying 90% of the current year tax, as opposed to 100/110% of the prior year tax), refer to the worksheets on the IRS website previously mentioned.
Do you have any other tips? That’s all I have for now – if you have questions, feel free to leave them in the comments!
If this post was helpful, feel free to share it with your friends! Since quarterlies are often overlooked, individuals sometimes end up paying penalties or interest that could have been easily avoided. Why give the IRS any more than you have to?