How Estimated Tax Payments Work

As a business owner, you have a lot of responsibility. On top of running your business, you’re also responsible for paying in federal and state taxes throughout the year. Most people have this taken care of through regular withholding on their paychecks, but not you. You’re special.

You may be wondering how this works, and the thought of needing to take care of this may be creating some anxiety. Fortunately, it doesn’t need to be overly complicated. As a CPA and tax preparation office, assisting business owners with estimates is something we do regularly.

First, let’s understand the general idea behind estimated payments. The government wants their money, and they want it now. They put the responsibility on business owners to pay estimates on what their final taxes will be for the year in the form of four quarterly installments. It’s important to note that they are estimates, and there is zero expectation for you to get it perfect. There are rules for what you need to pay in at a minimum (more on that later) but as long as you meet those requirements, you’ll either get a refund or owe a (hopefully) small amount come tax time and there won’t be any underpayment or late payment penalties. That’s the focus here: avoid penalties at all costs. Whether you pay estimates or not, you’ll still owe the same in taxes. But penalties can hurt, and they’re not necessary. So it’s best to avoid them by being smart with your estimates.

So how do you calculate how much to pay in?

 

There are two options:

 

1. Safe Harbor

Safe Harbor is the easiest to calculate. Under the safe harbor rules, the estimate for the current year is based off the previous year’s tax obligation. To use this option, we first need to know what your previous year’s Adjusted Gross Income was. This is found on line 8b of the form 1040 individual tax return. If this figure is over $150,000 for those who are married filing joint or $75,000 for those who are married filing separate or single, we are going to take 110% of your previous year’s AGI. For everyone else, simply use 100%.

Whatever figure you arrived at divided by four is what you will need to pay in to avoid underpayment penalties. These estimated payments should be made by April 15^th, June 15^th, September 15^th, and January 15^th (If you earn income seasonally, there are adjustements that can be made. There is no need to pay estimated taxes on income that hasn’t been earned yet).

The one drawback to this method is that he calculation has nothing to due with current year earnings. So, if you have a better year than the previous year, you will come up owing in tax when you file your tax return. On the flip side, if you have a worse year, you will get a refund, but will have unneccessarily paid in too much tax throughout the year, and this can create cashflow issues.

For these two reasons, there is a second option.

 

2. 90% Rule.

 

This option requires a little more planning. To avoid underpayment penalties under this option, you must pay in at least 90% of your tax obligation evenly (or weighted for when the income was earned) throughout the year in four installments. This requires having a command of how much you are earning per quarter, so a strong indea of your net earnings by quarter would be ideal. If you don’t meet the safe harbor rules, and also don’t meet the 90% rule, you WILL have an underpayment penalty, so there is more risk with this option.

What’s the upside? If you choose this option, you won’t unneccessarily pay taxes throughout the year that you may not have had too (this mostly applies if your earnings in the current year are less than those of the previous) and you’ll also more likely than not have paid in a figure close to that of what your actual tax obligation is. It requires more planning and strucuture, but it allows for better control of cash flow.

If you need help with planning your quarterly estimates, we can help.