Business Owner Basics: Estimated Tax PaymentsSmall Business
One question I get quite a bit in the CPA office is:
What are quarterly payments, and how do I know what to pay?
First let's deal with the easy part of the question- WHAT are estimated tax payments?
Simply put, the IRS does not want to wait until tax time to get their money, so when you earn money, they require you to pay your taxes for the current year quarterly. Employees often don't have to pay them because they have withholding, but business owners and retirees sometimes have to.
While they are called quarterlies, they are due at strange times:
1st Quarter: April 18th, 2016
2nd Quarter: June 15th, 2016
3rd Quarter: September 15th, 2016
4th Quarter: January 17th, 2017
So keeping that in mind, let's move on to the next part of the question- HOW MUCH do you pay?
It is a good question; the rules are a little confusing. The confusion comes from the IRS guidelines that state there are 2 methods you can use to estimate what needs to be paid each quarter.
I call them: The EASY(prior-year) method, and The HARD(current-year) method.
Most people and accountants use the EASY method, and why wouldn’t you?
It is the EASY way right?
I never do, because it almost always means the taxpayer pays an amount that is a total guess. It is a calculation that has nothing to do with the current year and deals with the past.
In fact, most of the time when we use the EASY method, the taxpayer is “less than” satisfied with the outcome. Let’s dive into estimated payments in detail and I will show you all about it.
THE EASY METHOD
So first up I will show you the easiest and least accurate calculation for estimated tax payments. As I said before, it is based on the previous tax year.
Step 1: Get out your previous year’s tax return. Since I am writing this blog in Feb of 2016 and trying to calculate my estimated payments for the 2016 tax year, I will want to get out my 2015 tax return.
Step 2: Find your Adjusted Gross Income. If it is more than $150K ($75K if you are married filing joint) then make a note that you will use the 110% factor (otherwise you are going to use the 100% factor, I will explain this later)
Step 3: Find the amount of tax you paid last year. This is before any payments. So line 63 of the 1040. If you have any special credits or taxes that you paid in 2015 like excess contributions or refundable credits, then subtract those out. We just want your regular income taxes + self-employment taxes.
Step 4: To calculate your total estimated tax payment, take the tax amount from step 3 and multiply it by either 110% or 100% depending on which factor I told you to use in Step 2.
Step 5: Subtract any withholding or other payments you will pay in this year. Like withholding from wages, etc.…
Step 6: Then divide that amount you calculated in step 5 by 4 (into quarters, that is why some call them “quarterlies”) and that is what you pay each quarter. Here is an example:
In 2015, Mr. Smith had an AGI of $200,000 which means he will use the 110% factor
Mr. Smith is single and on his 2015 tax return (Form 1040) line 63 his total tax is: $47,323
Mr. Smith expects to have withholding this year (2016) of: $(8,000)
So the total amount Mr. Smith needs to base his estimated payments on is: $39,323
Multiply $39,323 x 110% (his factor) and his full estimate is: $43,255
$43,255 divided by 4 (to calculate each quarterly payment) is: $10,814
So there it is, Mr. Smith using the EASY method, should pay $10,814 per quarter in order to conform to the IRS rules for 2016… Most tax software can calculate this easy enough, so that makes it really easy to use.
And I almost never use it.
THE HARD METHOD
Well, before I get into why I never use the easy method, let me show you the hard method first.
The hard method operates from a tax projection for 2016. It is not backward looking, but rather uses information for this year to determine what to pay.
Step 1: Estimate what your income, expenses, deductions, credits, and everything else is going to be for your business for 2016
Step 2: Then estimate what your personal income, deductions, credits, withholding, and AMT will be for 2016.
Step 3: Multiply the amount of tax you calculate in step 2 by 90% (66% if you are a farmer).
Step 4: Divide the amount you calculated in step 3 by 4 and those are your quarterly payments.
I made this only 4 steps, but as you can see there is a ton of work that has to go into the first 2 steps. You basically have to run tax projections for the current year for both your business and your personal tax returns, and keep running them throughout the year so you can make sure they are accurate.
So why would I want to use this method? Why would my clients want me to use it?
Because of the factors… Did you catch it?
THE HARD METHOD IS USUALLY BETTER
The factor in the easy method was either 110% or 100% remember? And in the hard method it was 90%. That makes a huge difference if you are wanting to pay as little tax as possible till tax time.
Let’s see how it would affect Mr. Smith’s situation.
Using the easy method, Mr. Smith would need to pay $10,814/qtr.
And to simulate the hard method, lets imagine that Mr. Smith estimates that he will earn exactly the same amount of income in 2016 that he did in 2015.
In that case, using the hard method, his calculation is: $39,323 x 90% = $35,391
And $35,391 divided by 4 is: $8,848/qtr.
Now which amount would you rather pay? Of course the lower amount. That is the beauty of the hard method. But also know, that Mr. Smith would have to pay some tax at tax time with this method, where with the easy method he gets a refund because he overpaid.
This difference is helping you save money during the year, not changing the outcome of the tax return.
Also, if Mr. Smith was making more money in 2016 than in 2015, the easy method may be better, because the hard method may still be more expensive despite being a 90% factor.
There is another reason that I use the hard method though…
CLIENTS & TAXPAYERS HATE SURPRISES
If there is one thing that I have learned in 15 years of doing taxes for others, it is that taxpayers do not like surprises. Wait, let me modify that… Taxpayers do not like BAD surprises… Like more tax than they thought.
I make them happier when I can accurately show them what they are going to owe, and advise them to pay amounts that are consistent with that calculation.
For instance, if I have a client pay their estimates based on 2015, while their business or personal taxes are going to be less in 2016, they will scold me for making them overpay.
Just the opposite, if their business is doing much better this year, and they pay based on 2015 but come 2016 they owe a ton more tax than they paid or imagined… THEY REALLY SCOLD ME…
I started to say to myself “I don’t want to be scolded anymore” so I went to using the hard method for everyone years ago and it works great.
Even better, with Tax Planner Pro I don’t have to do the calculation. It will show me in real time, on any day, what my taxes are going to be so all I have to do is divide by 4 and pay them. It saves me all the work of the hard method, but provides me and my client all of the benefits!
PAYING THE TAX
So now you know how to answer the question “What are quarterly payments, and how do I know what to pay?”
The bigger question will be, “which method will you use?” And “do you like overpaying the IRS or paying them as little as possible?”
Once you have decided on an amount, you need to use Form 1040-ES to remit your payments. You can also pay them online if you wish. Also keep in mind that most states require estimated tax payments, so be sure to estimate those as well.
Like all things related to taxes, nothing is simple. But estimated taxes are going to be a fact of life for you and your business for years to come. Take the time to learn your options and take control of what you can.
Some links that may help you with estimated taxes: