Figuring out how to manage your taxes is one of the most stressful aspects of running a business. Federal tax law is complicated, and it’s easy for a business owner to make simple mistakes that result in an audit.
You’re probably familiar with the way most non-business owners pay taxes: Employers withhold a small amount from their paychecks to pay the IRS. Employees receive a W-2 in the mail and do their taxes in the Spring.
However, the rules are a little different for non-employees. Generally speaking, business owners and those who are self-employed and earn a certain amount of income each year have to pay Quarterly Estimated Taxes.
The government expects you to pay taxes on your income as you receive it, and if you don’t have an employer to do it for you, then it’s your responsibility. You can’t simply wait until April to file your taxes and pay it all then. While it’s important for most taxpayers, staying on top of paying your estimated taxes is critical for small businesses.
What Are Estimated Taxes?
Business owners and freelancers pay the IRS using estimated taxes instead of withholding. Four times a year, workers or business owners that receive tax forms other than a W-2 are expected to make a tax payment directly to the IRS, which effectively replaces the tax withheld for many individuals by their employers.
Estimated taxes apply to any kind of taxable income that comes to you directly without any tax withheld. That can include interest, stock dividends, capital gains, and anything you earn through self-employment.
If you are starting or already own a business, learning about various tax requirements is essential to understanding your tax burden and avoiding possible legal penalties and fees.
How Do I Calculate Estimated Taxes?
Small business owners use IRS Form 1040-ES to calculate annual estimated taxes. We recommend speaking to an accountant or tax preparer if you’re at all unsure of how to estimate your taxes.
There are three steps to calculating estimated payments.
1. Calculate Total Taxable Income
The first step is to figure out approximately how much you think you’re going to make in a year or your total estimated income. You can use either the full amount you expect to make in the year or the exact amount you make each quarter.
Estimating the full amount is a simple task for entrepreneurs and small business owners who have fairly steady income from year to year. For freelancers who may have more unpredictable cash flow from quarter to quarter, it might make more sense to tally your actual income at the end of each quarter and pay taxes on that exact amount instead.
Either way, be sure to take into account any deductions you plan to claim to calculate your Adjusted Gross Income (AGI). If you don’t take deductions into account, you’ll end up paying much more than you need to.
2. Take Taxes into Account
Once you know your AGI, a crucial step in estimating your tax burden is to ensure you account for income tax and self-employment tax.
Calculate your income tax, by multiplying your AGI by your tax rate, using your income tax bracket. Tax brackets change year-to-year, so be sure you’re using the correct rate.
Those who make more than $400 in a year are also required to pay self-employment taxes. The self-employment tax rate includes 2.9% for Medicare, and 12.4% for Social Security. Multiply your estimated total income (not your AGI) by 92.35% to calculate your taxable income for the self-employment tax. Multiply the result by 15.3% to calculate what you owe for self-employment.
3. Total and Divide
You’ve calculated your estimated income, taken deductions into account, and calculated your income and self-employment taxes. Now it’s time to add everything together, and divide it into payments. If you’re calculating the exact amount each quarter, you can skip the division.
Income Taxes Owed + Self-Employment Taxes Owed = Total Estimated Taxes
Total Estimated Taxes/4 = Quarterly Tax Payment
Note: If you live in a state that levies personal income tax, you’ll need to calculate your state tax burden when estimating your tax payments.
Should You Pay in Equal Amounts?
For most people who pay quarterly estimated taxes, it’s easiest to pay in four equal amounts when using the formula above.
However, there are some situations where you may end up paying more in other quarters than others:
- If you had your previous year’s overpayment credited to your current year’s estimated tax payments
- If you miss paying your first estimated payment until after April 15 when the first one is due
- If you make more than expected in one quarter
What is the Safe Harbor Rule for Estimated Tax Payments?
Due to the difficult nature of estimating quarterly payments, the IRS implements a safe harbor provision that helps people avoid penalties for inaccuracy. In 2020, the safe harbor rule provided a cushion for people that paid at least 90% of their bill for 2020. So if you paid 90% of your final bill in estimated taxes and made your payments on time, you would be exempt from paying a penalty.
When are the Due Dates for Estimated Payments in 2021?
Estimated tax payments are due to the IRS once per quarter of the financial year.
Here are the 2021 deadlines:
- Fourth Quarter 2020: January 15, 2021
- First Quarter: April 15, 2021
- Second Quarter: June 15, 2021
- Third Quarter: September 15, 2021
- Fourth Quarter: January 15, 2022
If your earnings predictions are reliable, you can also pay your estimates early. As long as the payments aren’t late, you can combine them and pay them together at an earlier due date. IRS form 1040-ES explains the estimated tax requirements for individuals.
How Can I Pay Estimated Taxes?
You can file using the voucher that comes with Form 1040-ES and a check, or you can pay online using the IRS website. If you pay online directly from your bank account, there is no fee. If you choose to pay with a credit card, however, there’s a fee of either $2.59 or up to 2% of your payment.
Who Owes Estimated Taxes?
Most self-employed individuals and businesses have to pay estimated taxes. However, it might not be mandatory for you, depending on your circumstances.
The primary determining factor is how much you’re going to owe in total. If you owe $1,000 or more on your tax return, including any estimated payments you’ve already made, then you must continue to make quarterly tax payments.
Exception: Farmers and Fishermen
There is an exception for quarterly estimated tax payments for farmers and fishermen. Calendar year taxpayers with at least two-thirds of their gross income for 2019 or 2020 coming from farming or fishing only have one payment due date for their 2020 estimated tax on January 15, 2021.
According to the IRS, calendar-year taxpayers who file their 2020 Form 1040 by March 1, 2021 don’t need to make an estimated tax payment if they pay all of their owed tax at that time.
Farmers and fishermen who don’t start their tax year on January 1 can either:
- Pay all of their estimated tax by the 15th day after the end of your tax year, or
- File their return and pay all the tax they owe by the 1st day of the 3rd month after the end of their tax year
Is Paying Quarterly Taxes Mandatory?
In some circumstances, an employer might withhold from your main income, but perhaps you’ve made other income as well. You do not have to make estimated tax payments if your estimated tax and tax withholding so far will make up at least 90 percent of the total tax you owe for the year.
You might also use your tax return from the previous year to gauge your liability. If you have already paid as much as the total taxes you owed last year, then you don’t need to pay any more in advance. This is known as the Safe Harbor rule.
However, if your income is higher, you will need to pay slightly more. If your AGI is over $150,000, then you need to have paid 110 percent of your previous year’s tax total in order to not worry about paying estimated taxes. If your filing status is married, but you’re filing separately from your spouse, then your taxable income only needs to be over $75,000 to make the higher barrier necessary.
What Happens if I Miss an Estimated Tax Payment?
If you miss a deadline, make the payment as soon as possible. Don’t wait until the next deadline to pay them at the same time. You could face fines and tax penalties when you file your tax return at the end of the year.
If you don’t make sufficient payments throughout the year or on time, then an extra penalty may be added to what you owe on your tax return. That amount will depend on how much you underpaid and exactly how late you were with your payments.
The IRS isn’t satisfied receiving what you owe all at once at the end of the year instead of at the end of each quarter. Even missing a deadline by a few days can mean an extra fine. Understanding your tax obligations throughout the year can be difficult and stressful, but it’s necessary for avoiding extra fines and unnecessary complications.
How to Make Quarterly Estimated Taxes Easier
Quarterly estimated taxes may seem intimidating at first glance. However, there are some things you can do to make them easier.
If you are married and filing jointly and your adjusted gross income is less than $150,000, you can make a payment equal to 100% of what you paid in income taxes the previous year or 90% of the tax you estimate for the current year and you will not be penalized.
Rather than putting off your quarterly estimated taxes, at the beginning of each year calculate your payments. Then, put together a savings plan so you’re not caught off guard when it comes time to make a payment.
If you’re worried about meeting the requirements, or you don’t have the time to do the work of figuring it out, consider getting help from a professional. Working with an accountant will help your business save money and avoid penalties, and it will leave you with more time to focus on the work your business really needs for getting ahead. Get help now!
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.