More and more people are leaving the 9-to-5 for self-employment and small business ownership.
While being your own boss offers freedom and flexibility, it comes with a ton of responsibility. One such responsibility is to Uncle Sam.
As an employee, your income and payroll taxes are withheld from each paycheck by your employers and paid to the IRS for you.
But as a self-employed individual or business owner, you’re required to pay your taxes yourself either annually on your income tax return or estimated quarterly tax payments.
The method you must use depends on your total tax liability.
Do you owe quarterly estimated taxes?
According to the IRS, you must pay estimated quarterly tax if you pass the following 2-part test:
- You will owe at least $1,000 after subtracting your withholding and refundable tax credits.
- Your withholding and refundable credits will be less than the smaller of
- 90% of your 2018 tax liability, or
- 100% of your 2017 tax liability.
This sounds far more complicated than it is, so let’s break it down:
- Withholding is tax that is deducted from your income. If 100% of your income is from self-employment or business ownership, you probably don’t have withholding.
- Refundable tax credits cause a dollar for dollar reduction to your tax liability; these types of credits can even reduce your liability below $0, qualifying you for a refund. The most common refundable tax credits are the Earned Income Tax Credit, the Child Tax Credit, the Additional Child Tax Credit, and the American Opportunity Tax Credit.
- Now for an example:
In this example, you would owe estimated quarterly taxes because you pass both tests.
To simplify this determination, the IRS created an Estimated Tax Worksheet that you can find on page 8 of Form 1040-ES Estimated Tax for Individuals.
To complete the worksheet, you’ll have to estimate your taxable income. As a business owner or self-employed individual, this can be difficult.
Even still, you can make an educated guess by looking at your prior year’s tax return and making adjustments based on your business’s historical performance.
How much do I owe and when do I have to pay?
The Estimated Tax Worksheet will also help you calculate your total tax liability for the year. Once figured, the total is divided into quarterly installments that must be paid according to the following schedule:
- April 15th for income received January 1st to March 31st
- June 15th for income received April 1st to May 31st
- September 15th for income received June 1st to August 31st
- January 15th of the following year for income received September 1st to December 31st
If the 15th falls on a holiday or a weekend, then the payment is due the next business day. You may pay more often than quarterly as long as you’ve paid the total owed by each quarterly due date.
What happens if you don’t pay quarterly estimated taxes but should?
If you should’ve paid estimated taxes but didn’t, you may be subject to a penalty. The IRS will usually calculate the penalty for you, but if you’re curious, you can calculate it yourself with Form 2201 Underpayment of Estimated Tax by Individuals, Estates, and Trusts.
Tax law is complex and the laws surrounding quarterly estimated tax payments are no exception. You can read the IRS’s Publication 505 Tax Withholding and Estimated Tax for additional insight, but it’s a good idea to talk with a tax professional to make sure you and your business are compliant with applicable laws in order to avoid unwanted penalties.