Small Business Taxes & Accounting: Part I (Estimated Tax Payments)

Someone suggested as a blog post topic "small business taxes and accounting".  So, you mean, like, my entire job?  Let's break that down into smaller chunks, shall we?  I'll start with estimated tax payments.

Everyone is required to pay their taxes during the year (once per quarter) and will pay a penalty if they don't (with some exceptions).  However, people with regular jobs (those who receive a W-2), will generally have their taxes withheld (and paid to the IRS) by their employer throughout the year and so don't have to worry about making estimated tax payments.  Those who are self-employed (or receive investment or other income) will need to make estimated tax payments in order to avoid penalties.

Some exceptions to the requirement to pay estimated taxes include owing less than $1,000 on your tax return and not being required to make estimated payments in the prior year.  Basically, you get a free pass for the first year you're required to make estimates.  Keep in mind, however, if you don't pay estimates, you may end up with a large tax bill next April.

How much to pay?  The requirement for most individuals is either (1) 100% of the prior year's tax or (2) 90% of the current year's tax.  Therein lies the problem, however.  How do you know how much you're going to make this year until the year is over (and sometimes much after the year is over)?  You don't, and that is why they offer the 100% of prior year's tax option.  This is the simplest way to figure estimated taxes.  For example, if on your 2012 tax return you owed $2,000 in taxes, you would be required to pay $500 per quarter in 2013.  Paying this amount would avoid the penalty (generally about 3% per year, calculated on a daily basis), regardless of how much you actually make during 2013.  Alternatively, if you think you're going to make much less in 2013 than you did in 2012, you can guess at your income and pay 90% of the tax due on that.  Say, for example, you make $140,000 in 2012 and owed $50,000 in taxes but you cut way back in 2013 and make a conservative estimate of $10,000 tax due.  You could pay $2,250 each quarter, for a total of $9,000.  This option will avoid penalties only if, in the end, you really do owe less than $10,000.  Of course, you won't know this until the year is over, but often this is a better option if you're fairly certain your income is going to drop dramatically.  Keep in mind that any amount withheld from you or your spouse's paychecks will come off the amount you owe.  Also, if you overpay your estimates, you will get that money back as a refund, just as if your employer had withheld more than you owed from your paycheck.

The estimated tax payments are due in four equal payments on April 15, June 15, September 15, and January 15.  (For 2013 tax returns, that is, 4/15/13, 6/15/13, 9/15/13, and 1/15/14).  Note these are not all three months apart!  If you fail to make a payment on a due date, and you end up owing on your tax return, a complicated computation will take place that figures your penalty from the date you should have made the estimate.  If you forget to make an estimate payment, you can always pay it late to lessen the penalty, or you could pay double on the next date.

A trick to avoiding the estimated tax penalty is available when you have control of your paychecks, such as in an S-corp with an owner/employee situation.  In this case, you could pay yourself in December and withhold the entire amount of taxes owed though the payroll system.  Withholding is treated as being paid equally throughout the year instead of on the date it is actually paid (as is the case with estimated tax payments) so if you forgot to make your estimated payments or made much more money than you thought you would, you can use this option to reduce or eliminate the penalty.

The exception to the 100% prior year tax exists for those making more than $150k.  In this case, the requirement would be 110% prior year tax or 90% current year tax.  Paying 110% of prior year tax is known as a 'protective estimate' because making these payments would protect you from penalty regardless of how much you make.  For example, say you made $140k in 2012 and owed $50k in taxes.  If you pay $55k (110% of $50k) in taxes for 2013, you will be safe from the estimated tax penalty in 2013 even if you make a million dollars.  (You will however, have a large tax bill to contend with next year!)

Lastly, there is another option for business with a cyclical sales cycle.  This is known as the 'annualized income installment method'.  It doesn't seem fair that a business that makes 90% of its income over the Christmas season would have to make payments in April, June and September before it has even started turning a profit.  The annualized method allows it to calculate its estimates based on the percentage of income earned in each quarter.  This is a complicated calculation and I'd recommend getting a professional to assist you with it.

All of this information applies to federal taxes due, but the rules for Colorado income taxes due are quite similar.  This has been a more technical blog post so please ask if you need clarification!

Update: I was asked how a person knows what rate to apply to their income to determine their estimated tax due.

"Something I just thought of that you should add - the actual percentage that people will pay. If they are new and don't know what their taxes were last year, how do they estimate how much to pay?"

The short answer is if they are new they don't need to pay estimates this year and if they aren't new then they just pay the amount they paid last year. The long answer, if you really want to pay estimates in your first year even though you're not technically required to (maybe to avoid a large tax bill in April), is that you would estimate your income and deductions, subtract your exemptions ($3,900 each for you, your spouse, and any dependents) and apply the current tax rates to that. There are different brackets for each filing status. If you are married filing jointly, the tax brackets for 2013 are as follows:

10% on taxable income from $0 to $17,850, plus
15% on taxable income over $17,850 to $72,500, plus
25% on taxable income over $72,500 to $146,400, plus
28% on taxable income over $146,400 to $223,050, plus
33% on taxable income over $223,050 to $398,350, plus
35% on taxable income over $398,350 to $450,000, plus
39.6% on taxable income over $450,000.

Again, this is only for married taxpayers. Please contact me for the other tax brackets.


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