Starting your own business can create significant wealth. But, this opportunity comes with more tax-related complications. With a normal job, your employer withholds your taxes. When you own a business, you need to pay those taxes. Business owners can make this process easier by paying estimated taxes every quarter.
In this article, we’ll explain how estimated taxes work. Specifically, we’ll cover each of the following topics:
- What are estimated taxes?
- Do I have to pay estimated taxes?
- How to calculate estimated taxes
- When are estimated taxes due?
- How to pay estimated taxes
- Final Thoughts
What are Estimated Taxes?
The IRS mandates that people pay taxes as they earn their money. If you have a job, your employer does this for you. They hold back a portion of your paycheck and pay the IRS throughout the year. But, if you make money through A) investments, or B) your own business, you need to pay the IRS. You can pay these taxes with estimated quarterly tax payments.
Estimated taxes let investors and business owners pay taxes every quarter – instead of annually. Then, when you file your annual taxes, the IRS applies these quarterly payments to your total tax bill. Some states also require people in these categories to make estimated payments. But, as every state differs, this article will focus on federal tax payments to the IRS.
What is Self-Employment Tax?
Business owners do not only need to make estimated income taxes. If you own a business, you also need to pay estimated self-employment taxes. These include Social Security and Medicare taxes. As an employee, you pay half of these payments, and your employer pays the other half. However, self-employed workers need to pay all appropriate taxes.
The self-employment rate in 2020 is 15.3% of your business’s net earnings. This includes:
- Social Security: 12.4%
- Medicare: 2.9%
For 2020, you must pay Social Security taxes for the first $137,700 in net earnings. But, you need to pay Medicare taxes on all of your net earnings. As with estimated income taxes, small business owners pay estimated self-employment taxes quarterly.
Withholding and Refundable Credits
Many people have businesses as a side hustle and work full-time, as well. These individuals have taxes withheld by their employer. They also need to pay estimated taxes on business income. But, the IRS doesn’t care who pays your taxes. Instead, you pay taxes based on your total taxable income – wages and business.
For people with side hustles, this presents an opportunity. If you don’t want to pay estimated taxes for your business, you can increase your employer’s withholdings. This means you’ll receive less cash from every paycheck. But, your employer will handle your estimated tax payments instead of you. This can simplify the administration of your side hustle.
And, if you end up paying more in estimated taxes throughout the year, you’ll get a refund. When you file your annual taxes, the IRS returns any estimated payments over your tax bill as a refundable credit.
Do I Have to Pay Estimated Taxes?
All of the following need to pay estimated taxes if they expect to owe $1,000 or more in taxes when they file their annual return:
- Sole proprietors*
- S corporation shareholders*
*The IRS does not recognize LLCs. Single-member LLCs file as sole proprietorships. Multiple-member LLCs file as partnerships or S corporations.
C corporations, on the other hand, need to pay estimated taxes if they expect to owe $500 or more with their return.
How to Calculate Estimated Taxes
The IRS offers taxpayers two methods to calculate estimated taxes.
Method 1: Safe Harbor Rule
This is the simplest method. The IRS will not charge a penalty for underpayment if you make estimated tax payments of at least:
- 90% of your current year taxes; or
- 100% of your taxes from the previous year
As a result, you simply divide your last year’s tax bill by four. Then, pay that amount as an estimated tax every quarter. Of note, while simple, this method can result in an end-of-year tax bill or refund. If you make more money than the prior year, you’ll have a larger bill. If you make less money, you’ll have a larger refund.
Method 2: Detailed
This method is more accurate – but also more time-consuming. At the end of each quarter, calculate your business’s net earnings. Using A) that amount, B) your marginal income tax rate, and C) self-employment tax rates, calculate your total estimated quarterly tax. If you do this each quarter, your estimated payments should equal your annual tax bill on your Form 1040.
What is the Underpayment Penalty for 2020?
If your estimated taxes don’t meet safe harbor amounts, the IRS may assess an underpayment penalty. As a pay-as-you-go system, the IRS uses this penalty to make sure people pay taxes throughout the year. The underpayment penalty for 2020 is 3.398% of your total underpayment.
When are Estimated Taxes Due?
Taxpayers need to file their estimated taxes quarterly. Here are the specific dates:
- 1/1 to 3/31 earnings: Pay no later than April 15.
- 4/1 to 5/31 earnings: Pay no later than June 15.
- 6/1 to 8/31 earnings: Pay no later than September 15.
- 9/1 to 12/31 earnings: Pay no later than January 15 of the next year.
The deadline moves to the next business day if the above dates fall on a weekend or legal holiday.
How to Pay Estimated Taxes
The IRS provides taxpayers four options to make estimated tax payments:
- Mail – Mail your Form 1040-ES with a check enclosed.
- Phone – Call 1-800-829-1040 to pay your estimated tax by phone.
- Online by debit or credit card – Pay online with a card for a fee.
- Online by ACH transfer – This safe and fast option typically has no fee and is the best option for most taxpayers.
Estimated taxes allow business owners to comply with IRS pay-as-you-go requirements. Every quarter, you need to pay estimated income and self-employment taxes to avoid annual underpayment penalties. But, this shouldn’t be a daunting challenge for business owners. At Tax Hack, we live and breathe taxes for business owners, so contact us to set up a tax planning strategy session!