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5 Traps in Paying Estimated Taxes
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5 Traps in Paying Estimated Taxes
Having business income but being unable to cover anticipated taxes on the income through wage withholding means you’ll have to pay estimated taxes. You’ll have to project what you think you’ll owe for the year and then pay them in four installments to the government. If you underpay, you can be subject to penalties. If you overpay, you’ll effectively have made an interest-free loan to Uncle Sam and will have to file your return after the close of the year to recoup the excess tax payments. Unlike withholding on taxable compensation, which is regimented by IRS tables and up to employers to deposit their withholding, it’s entirely up to you to figure your estimated taxes and pay it to the government. Here are five potential pitfalls that can cause you trouble and money when paying estimated taxes—and what to do to avoid problems.
Failing to have cash on hand
One of the greatest challenges for many small business owners is having the money ready when the dates for estimated taxes roll around. Adopting a payment strategy can help:
- Make monthly payments even though you’re not required to do so this frequently. It may be more manageable to handle smaller payments each month rather than larger payments on the less frequent usual payment due dates.
- Set aside funds in a separate account for estimated taxes. Don’t touch the funds for other purposes, no matter how tempting.
- Explore wage withholding options. For example, if you have an S corporation, you can increase withholding on taxable compensation to cover what you expect to owe on your share of corporate profits (there will, of course, be withholding on your salary and other taxable benefits). Note: When starting a business, it may be worth considering becoming an S corporation rather than a limited liability company because of the ability to use wage withholding for tax payments.
Not covering all tax obligations
In addition to factoring in taxes on net earnings from self-employment, include S corporation owners’ shares of their business profits, taxable compensation from being an employee (although there usually is income tax withholding on this compensation), and other reportable income for accurately estimating taxes. Estimated taxes also cover:
- Self-employment tax to cover Social Security and Medicare taxes on net earnings from self-employment (profits in a sole proprietorship and a partner’s distributive share of partnership profits)
- Additional Medicare tax on earned income (employers must withhold this tax on taxable compensation over $200,000, but self-employed individuals must address this tax themselves)
- Additional Medicare tax on net investment income. Income from businesses in which you materially participate is not subject to this tax, but your business income can boost your modified adjusted gross income, triggering or increasing the tax on your other investment income.
Believing each quarterly payment falls evenly
While estimated taxes are referred to as quarterly payments, they do not fall evenly throughout the year. The due dates for 2014 estimated taxes are:
- April 15, 2014 (for income received from January 1, 2014, through March 31, 2014)
- June 16, 2014 (for income received from April 1, 2014, through May 31, 2014)
- September 15, 2014 (for income received from June 1, 2014, through August 31, 2014)
- January 15, 2015 (for income received from September 1, 2014, through December 31, 2014)
Thus, there are only two months between the first and second required payments. Set aside sufficient funds for each required installment.
Paying too much, too early
It’s not unusual for income of small business owners to vary—sometimes greatly—throughout the year. The IRS gives this example: A shop owner at a marina receives sizable income in the summer but not so much at other times of the year. If you are like this shop owner, you avoid incurring estimated tax penalties by using the annualized income installment method. Under this method, installments in one or more payment period may be less than one-fourth of required annual payments. Details about the annualized income installment method are in IRS Publication 505.
Reporting the payment under the Social Security number of the wrong spouse
If you’re paying estimated taxes under your Social Security number through the Electronic Federal Tax Payment System but your spouse is listed first on your tax return, this can delay a refund or cause greater scrutiny of your tax return. The reason: IRS computers only apply automatically estimated taxes paid under the Social Security number of the first spouse on the return. The IRS must manually look further into estimated tax payments if they don’t match up. You can address this problem in three ways:
- List yourself first on the return; the tax law does not require any special order, such as a male spouse listed before a female spouse.
- Change your EFTPS.gov account to reflect the Social Security number of the first spouse listed on the return, even if this spouse is not the one earning the income or paying the estimated taxes.
- Continue to pay estimated taxes under your Social Security number but ask the IRS to credit your payments to your spouse’s Social Security number; do this before you file your income tax return.
Your best strategy for avoiding estimated tax problems is to work with a knowledgeable tax advisor who can help you craft appropriate installments and ways to handle them.
About the Author:
Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser's Small Business Taxes, J.K. Lasser's Guide to Self-Employment, and Smooth Failing as well as a trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® and host of Build Your Business Radio. She has been included in the List of 100 Small Business Influencers for three years in a row. Follow her on Twitter: @BarbaraWeltman.