Our resident tax-lady Caroline Devoy is back in action today with everything you need to know about estimated taxes- what they are, whether or not you need to pay them, when to pay them (next deadline is coming up on June 15th!) how to pay them and what happens if you don't. Read on for all the info, and thanks Caroline for the great post!
{photo by ShellyS - Be on top of your money!}
What are estimated taxes?
It's not just what you owe the IRS, but also when
you owe it. Estimated tax is the method used to pay tax on income that
is not subject to withholding. It's the difference between having an
employer withhold the taxes for you each payday or you having to make a
federal tax deposit each quarter. For purposes of this discussion, I
am referring to individual estimated taxes, not corporate estimated
taxes. Individual estimated taxes are required on income from a
business that passes through to the individual level which would
include the following entities: sole proprietorship, S-corporation,
partnerships and limited liability companies.
Why does the IRS require the payment of estimated taxes?
The
IRS likes to receive their money throughout the year and will penalize
you if you wait until the due date of your
return to pay the tax you owe. Thus, if you are receiving wages, your
employer is required to withhold a portion of your salary each paycheck
as tax withholding (based on the W-4 form you filled out for them). If
you are earning your income from a non-salary source, you are expected
to pay estimated taxes each quarter.
Do I have to pay estimated taxes?
If you have a small business, possibly. It depends on how much tax you are going to owe and whether you are willing to pay the penalty.
There are two reasons you would not have to pay estimated tax:
1. You had no tax liability for the previous year. Note I said no tax liability, meaning you owed the government no tax. Don't confuse this with showing no tax due on your return.
2. Your tax liability minus withholding is less than $1,000 when you file your return.
If you are employed and don't have significant additional income from other sources, you don't need to mess with estimated taxes. Just make sure the W-4 form you file with your employer is withholding enough to cover your tax liability.
Another caveat about estimated taxes. If you are married, filing jointly, the IRS does not distinguish between your and your spouse's liability. That means that all the limits and exceptions listed here apply to what will appear on your joint return, not just your business portion of the return.
Also, don't forget if you have a state income tax, your state most likely has an estimated tax requirement as well.
When do I have to pay them?
Estimated
taxes are to be paid 15 days after the end of each quarter (three month
period). For individual taxpayers, the due dates for estimated taxes
are April 15, June 15, September 15, and January 15.
How much do I need to pay?
To avoid a penalty, your estimated taxes must equal the lesser of:
1.
100% of the prior year's tax liability (110% if your Adjusted Gross
Income is greater then $150,000. Also, see new rules for small
businesses in Note 1)
2. 90% of this year's tax liability
You may hear your tax adviser throw out the term "safe harbor", which is just fancy talk for that prior year 100% exception. The "safe harbor" rule is great if you are expecting to have a larger tax liability this year because it can prevent you from having to pay your taxes as early. However, if your income will be lower this year, the "safe harbor" rule will just cost your cash that you could use elsewhere.
Note 1: As part of the Economic Recovery Act recently passed by Congress, the safe harbor percentage has changed to 90% (versus 100%) if you have an eligible small business.
You have an eligible small business if you satisfy the following.
-
You certify that more than 50% of your gross income in 2008 was income from a small business.
-
The average number of employees for the 2008 calendar year was less than 500.
-
Your AGI for 2008 was less than $500,000 ($250,000 if you are married filing separate returns in 2009).
How do I pay them?
You
can set up an account with the Electronic Federal Tax Payment System and pay them online. You can also pay
by phone with a credit card, although you will be charged a processing
fee. You may also write a check and mail in with the 1040-ES voucher.
The mail solution is probably the easiest, but your payment must be
postmarked by the due date and you are taking a risk that your payment
won't be received.
What if I don't pay?
Well, if you
don't pay estimated taxes, you will be assessed a penalty for the
amount of money you didn't pay and for how long it was not paid. It is
roughly the equivalent of paying interest on the money that you
"borrowed" from the IRS. In 2008, for example, the penalty was 5
percent for most of the year and 6 percent from October 1 to December
31. You can file Form 2210 when you file your return to compute the
penalty, or you can let the IRS compute it for you and send you a bill.
Okay, now what?
Estimated
taxes cause business owners a lot of stress. Not only are you having
to come up with cash each quarter, but you are also having to estimate
your tax liability. That means you need to have a pretty good handle
on your projected business income, as well as your spouse's
contribution to income and withholding. Here are some things to keep
in mind when approaching estimated taxes.
1. Use a tool such as Tax Caster by Turbo Tax which will give you a rough estimate of your tax liability based on some basic items. Use your last year's tax return as a starting point, adjusting for changes to this year's business income.
2. If you have a working spouse and you can make a pretty good estimate of your business income, you might find it easier to increase your spouse's withholding to compensate. Your spouse can file a new W-4 form with his or her employer indicating the additional withholding desired on Line 6.
3. Another tax planning strategy also involves your wage-earning spouse. If you are coming up on the end of the year and realize that you did not pay enough estimated taxes, you can adjust your spouse's withholding for the last several paychecks of the year. The IRS assumes that withholdings are paid continually throughout the year as opposed to estimated taxes, for which underpayment is computed based on the actual date paid.
4. If you had a wage-earning job last year and started a business this year, you will most likely NOT want to use the "safe harbor" rule (the 100% of last year's tax liability). Of course, I'm assuming your new business will earn less than your wage-earning job, so you don't want to tie up your cash with the IRS. At the end of each quarter, compute your income and multiply by the tax rate from your last year's tax return. Make your estimated tax payment based on this computation, recognizing that it might be slightly high since if your income drops, your rate might drop as well.
5. Remember that you can't get any estimated tax payments back if you overpay until you file your tax return. So if you are anticipating a loss in future quarters, adjust your current estimated tax payment accordingly. The last thing you want to do is give the IRS money that you ultimately won't owe and that you will need in the future for your business.
6. If cash is tight and you are having to borrow to make your estimated tax payments, you might consider not making them and just paying your taxes at year-end when your return is due. I know, that's crazy talk, but if the IRS will loan you the money for between 5 and 6 percent, that's not a bad rate. (And since no financial institutions are loaning money right now...) Just remember that you must pay all taxes due on April 15 or you will be subject to a failure to pay penalty, which is expensive and ugly. Filing an extension of time to file your tax return does NOT extend the time for payment.
7. Most tax preparers will give you a nice schedule of quarterly tax payments to make based on last year's tax return. Just be aware that it is unlikely that this year will match last year. You need to monitor your business income and adjust the tax payments accordingly to make sure you don't give away all your cash or end up with a big surprise at year-end.
8. Don't stress. Remember that they are called estimated taxes. You won't ever get them "spot-on"-- just aim for close. Besides, you don't want to spend more money improving the estimate than you would pay in penalties.
More information than you could ever want can be found on the IRS website:
Publication 505 Estimated Taxes Publication
Form 1040-ES Form for sending in estimated tax payments
Form 2210 Form for computing underpayment penalty
Form 2210 Instructions for computing underpayment penalty
Caroline Devoy graduated with a B.S. in Accountancy some time in the 20th century. She worked as a CPA until
the public accounting firm found her serious demeanor to be a problem
in their fun-filled environment. In pursuit of further initials, she
got her M.B.A. in Entrepreneurism and in her spare time, she runs jcaroline creative!, a website retailing
fabric, ribbon, notions and a questionable hedge fund. Just kidding,
we don't sell notions.
