One of the greatest parts about being an entrepreneur is the tax advantages it offers. As an employee, the IRS gets first crack at your paycheck. Even before you see a dime of the money you earned, your employer is required to send a certain percentage to Uncle Sam as prepayment for your income taxes. As a business owner, you get paid first and the IRS gets paid last. Not only does this mean you get more money up front, it usually means you keep more money and pay less in taxes.
The downside to this model of tax payment is that you are now responsible for paying the taxes that your employer used to take care of for you. Instead of having your taxes withheld from paychecks, as a business owner you will likely pay your taxes through quarterly estimated payments. For new entrepreneurs, this is a very confusing concept and figuring out if they need to make estimated payments and how much to make is a huge headache. In an attempt to alleviate some of that pain, here are some simple guidelines to figure out if you need to make estimated payments and if so, how much.
Do You Need to Make Estimated Payments
The rule for determining whether or not you need to make estimated tax payments is surprisingly very simple. If your year end tax liability is $1,000 or more, you must make estimated payments. If your tax liability at the end of the year is less than $1,000 you are in the clear, no estimated payments necessary.
Unfortunately, determining if you will owe $1,000 or more at the end of the year isn’t quite as simple. My best advice here is to work with a CPA to reasonably estimate your year end tax liability. If you want to do this yourself, there are a few free online tools that will help you estimate your tax liability.
How Much Do I Have to Pay
In order to avoid underpayment penalties on your tax return, you must pay in enough taxes during the year to meet what the IRS calls “safe harbor”. There are two ways to meet the safe harbor and avoid underpayment penalties.
1. Pay 100 percent of last years tax liability (110 percent if you made over $150k)- The first option, and the easiest to accomplish, is to pay 100 percent – 110 percent if last years AGI was over $150k – of last years tax liability. To accomplish this, simply take last years tax return, look at line 61 of form 1040, and divide that number by four. For example, if line 61 of last years 1040 showed your total tax liability of $16,000, to meet the safe harbor requirement you would need to make four estimated payments of $4,000 each.
2. Pay 90 percent of the current years tax liability- This option is a bit more tricky as it requires you to know very early on exactly how much money you will owe in taxes at the end of the year. Again, I would recommend hiring a CPA if you go this route (have I mentioned we do this?), but there are also online tools to help. Like option one, after you figure out what your total liability is you must pay that amount in four quarterly payments.
When to Pay and Penalties for not Paying
For both options, the payments will be due on the 15th of April, June, September and January. To prevent people from just making one lump sum payment at the end of the year, the IRS wants these payments to come in four equal amounts quarterly. There are exceptions made to this rule for those who make significantly more income in certain quarters than others.
If you are required to pay estimated payments and you do not make them, you will be hit with penalties and interest come tax time. The amount of the penalties will vary based on how much you owe and how much you paid.
Having to make quarterly tax payments may seem like a hassle, but it is a huge benefit over the employee method of paying with every paycheck. With a little bit of work up front, you can easily figure out your required quarterly payments and avoid penalties come tax time.