I have a confession to make.
When I first started out in business, having just quit 12 years of full time employment, like many entrepreneurs I was blissfully unaware of my day-to-day business tax obligations.
This changed one day when I sat down for a coffee with a fellow small business owner and was introduced to the facts of life about estimated tax payments.
My personal epiphany aside, one of the biggest mistakes small business owners make during the start-up phase is misunderstanding their tax obligations. And it’s easy to make these mistakes, especially if you have gotten used to working for an employer who took care of the bulk of your income tax withholding and Social Security and Medicare deductions.
So just exactly what are estimated taxes? Who must pay them and how? Below are some facts from the IRS Estimated Tax Guide to help new small business owners understand their estimated tax obligations.
What are Estimated Taxes?
Uncle Sam requires that individuals and businesses pay taxes almost as quickly as they earn income. This means you have to pay taxes over the course of the year instead of waiting until April 15. If your taxes are not withheld by an employer then you will likely need to pay estimated tax payments each quarter.
Estimated tax payments include both your income tax obligations as well as your self-employment tax (Social Security and Medicare) obligations – which, by the way, will increase the total federal taxes you owe.
Who Pays Estimated Taxes?
Generally, if you carry on a trade or business as a sole proprietor, an independent contractor, a member of a partnership, or are otherwise in business for yourself, then you are considered a self-employed individual. According to the IRS, If your tax withholdings don’t cover 90% of your tax liability then you must pay estimated taxes on income that is not withheld (use Form 1040-ES).
If you operate a corporation, you generally have to make estimated tax payments if you expect to owe tax of $500 or more when you file (use Form 1120-W).
You don’t have to make federal estimated tax payments if your tax due, after taking withholdings into account, is less than $1,000 or if your withholding and credits add up to at least as much as your prior year’s tax.
How Much Should You Pay in Estimated Taxes?
The IRS recommends that you calculate your quarterly estimated tax payment using Form 1040-ES (the same form used to pay estimated taxes) which comes with a worksheet that helps you estimate how much you owe for the current year. Corporations can use Form 1120-W to calculate estimated taxes.
You are not obligated to use this calculation method and can instead refer to the estimated tax calculation on your previous year’s tax return (most online tax tools will calculate this figure for you when you complete your return).
If you are an independent contractor, and face fluctuating periods of income, you might prefer to calculate your estimated taxes on a quarterly basis based on the income and deductions for the quarter owed.
If you still feel that you are essentially guessing what your estimated payment should be, take a look at this guide from Fairmark.com which includes pointers on how to best calculate your estimated payments.
When are Payments Due?
For estimated tax purposes, the year is divided into four payment periods. Payments for each year are due on the 15th day of April, June, September and the following January. You should endeavor to pay at least the minimum owed by the due date (with the remainder paid on April 15), or risk incurring penalties from the IRS or your state.
How to Pay Estimated Taxes
Paying your estimated taxes is actually an easy process and the best thing is that you don’t have to explain to the IRS how you reached your estimated sum (any reconciliation is done during tax return season).
If you are filing as a self-employed individual you should use Form 1040-ES which includes quarterly payment vouchers to submit with your payment. Corporations can deposit the payments by using EFTPS for deposit coupons (Forms 8109).
Once you are in the system, the IRS will send you payment vouchers at the end of each tax year so that you don’t have to worry about downloading the latest forms.
What about Estimated State Income Taxes?
You need to pay your estimated state income taxes at the same time as you pay your federal taxes. Find links to your state’s tax office for the appropriate forms here.
Talk to a Tax Specialist
At the end of the day, it’s worth spending an hour with a tax specialist to help you understand what the best calculation methods are, how to appropriately track and deduct expenses, and maintain good records. Many will provide this initial consultation for free – simply because they hope you will return and use them come filing season. So don’t be afraid to shop around for the right kind of advice that your budget can afford.
- Small Business Tax Guide (Business.gov)
- IRS Estimated Tax Guide (IRS.gov)
- IRS.gov Undergoes a Quiet Evolution – Revealing Invaluable Online Tax Tools for Small Business
- When Does a Business Start Paying Taxes? – There are many dependencies that determine when a new small business owner is liable for their first tax payment.
- A Primer in Taxable Business Income – When filing your business income taxes, you must report all income – not just the income from the sale of goods, services, or property.