In the normal taxpayer relationship with the Internal Revenue Service, the taxpayer is an employee and via withholding, taxes are paid the U.S. Government by the employer. Basically the employer pays the tax after each payroll run on behalf of all the employees and the corresponding mandated matching taxes (Social Security and Medicare). But in the small business world, this is not the normal relationship. In most cases, the taxpayer is either self-employed or a partner/shareholder in a pass-through business operation. In these situations, the taxpayer must pay estimated taxes.
Simply stated, each quarter, the taxpayer determines his annual tax liability and pays 1/4th of the required tax obligation. Until recently, these payments were made with a paper document called Form 1040-ES Coupon (estimated tax payment). The taxpayer just writes a check and mails the coupon and the check to the IRS. Today, the taxpayer simply registers with the IRS and makes these payments online.
This article introduces the reader to some history of the tax payment system and then explains the current requirements. The next section explains how to make the payments and finally I finish up with some suggestions and advice.
History of Estimated Tax Payments
The 16th Amendment to the Constitution ushered in a new era of taxation. Basically, Congress was entitled to tax incomes of all the citizens including businesses. The first year of the Form 1040 was in 1913 and in those days the tax was a very progressive. In effect, only the rich paid taxes. If your income exceeded $20,000 you paid a 1% rate. Once you exceeded $50,000, the rate DOUBLED to 2%.
In those days, the tax return was due on March 15th and you paid the entire tax unpaid filing the return. Nobody paid estimated taxes because the reality was that the aggregated amount wasn’t that significant. In 1937 social security kicked in and the employer paid ½ of the total social security tax. From 1937 to 1949, the Social Security rate was a meager 1%. Self-Employed individuals paid ZERO!
Well, the income levels for taxation decreased so by 1940 anyone with income paid income taxes. If you earned $2,000 you paid a 10% income tax.
Just as a side note, during World War II, the highest ever income tax rate existed. For those individuals making more than $200,000 per year, the marginal income tax rate was a whopping 94%! Congress figured that if you were not out fighting the war, you were going to pay more than your share.
Two interesting issues were coming together to force estimated tax payments. The first was the ever increasing obligation of all taxpayers and breath of the number of taxpayers owing tax to the government. The second and actually the greater force for financial need was World War II. To accelerate the dollars needed and into the coffers of the US Treasury, an accountant working for the President suggested that the taxpayers ‘PREPAY’ their taxes as they earned their money. The existing system was a post pay format that required payment upon filing of the Form 1040. The prepay system required the taxpayer to pay his tax throughout the year. Thus because of a war and the increasing tax obligations of all taxpayers, we now have our modern day estimated tax payment program.
Why Are Payments Required?
As the aggregated dollar value increased for tax obligations, Congress mandated estimated tax payments for all individuals that had any knowledge that their total tax obligation would exceed actual deposits into the system of $1,000. Therefore, if you know you will owe at least $1,000 on April 15th, you were required to make estimated tax payments throughout the year.
For corporations and other taxable entities, this threshold is set at $500.
For self-employed individuals and partners or shareholders in pass-through tax entities, you have several forms of tax obligations. First off is the traditional income tax and in most cases some form of self-employment tax. In general, the self-employment tax is often incremental greater than the income tax. It is not uncommon for a self-employed individual netting $70,000 from his business to owe more than $16,000 in taxes to the IRS. Therefore, each quarter, the taxpayer should be depositing no less than $4,000 with the IRS.
The mandated dates of deposits are as follows:
- April 15th for the 1st Quarter
- June 15th for the 2nd Quarter
- September 15th for the 3rd Quarter
- January 15th for the 4th Quarter
It isn’t really clear why the 2nd and 3rd quarter are slightly advanced in the calendar. My understanding is that it relates the timing of local government fiscal years (most end on June 30th) and the September 15th requirement is to accelerate the total revenues of the federal government as their tax year ends on September 30th.
How to Make Payments
Now if you are reading this article, odds are that you most likely need to pay the estimated tax. This is a multi-step process, so I’m going to make it as simple as possible.
First Step – Estimate Your Quarterly Income
As a taxpayer, you need to know this one value in order to properly estimate your federal tax obligation. The quarters end on March 31, June 30, September 30, and December 31. You should have an idea of how much you will make by Mid-March, Mid-June, Mid-September and for the final 4th Quarter you can figure out the actual by the first week of the new year.
Simply add up all your revenues and subtract your expenses. A good source is of course your profit and loss statement (income statement) for your business. Whatever that dollar value is for the Quarter, subtract about $2,500. This value is your tax basis.
Step Two – Figure Your Tax Obligation
Follow this schedule related to the two most common types of taxpayers that pay estimated taxes:
- Self-Employed, Partner, or Active Member (Limited Liability Company) multiply this value by 28% and pay that amount in your estimated tax
- Shareholder that is an employee of his company(1120-S Corporation), Corporation, or Beneficiary of a Trust multiply the value by 15% and pay that amount in your estimated tax
These two formulas are what I refer to as quick and dirty. They are not perfect because everyone’s case is different. You have different family situations, different sources of other income (dividends, interest, gains and K-1 assigned values). But, I will say that this is the fastest method and it will keep you out of trouble.
If your total quarterly net income is greater than $25,000; I strongly encourage you to use a CPA to figure out the tax obligation. If you are netting this much money per quarter, than you can afford to consult with an expert and get a more accurate tax payment.
Step Three – Make the Estimated Payment by the Respective Due Date
The fastest and easiest tool is to write a check made payable to the Internal Revenue Service, insert your Social Security Number in the lower left corner and the corresponding tax year. Print off a Form 1040-ES for your tax year: For Tax Year 2015 Use Form 1040-ES 2015.
The better tool and best for long term ease is to register online for an account with the IRS using their Electronic Federal Tax Payment System (EFTPS). Then you simply go online and pay via a portal. The payment is credited the next business day and the funds are withdrawn from your account within 48 hours. I strongly urge you to use this system as this system logs your payment and you can print reports from your account.
Suggestions and Advice
What is so devastating about all this is the amount of the estimated tax payment. Think about this for a moment, you are self-employed and you net $65,000 per year. This means that based on my schedule above, you’ll need to pay into the system $15,400 or about $3,850 per quarter. That’s a BIG CHECK! This means that you will have $49,600 to live off during the year. Really, you can’t feed a family and live off of $49,600. Seriously, Congress doesn’t get it; these guys have no idea what the small business owner has to endure.
Anyway, here is the simple straight forward math for the $65,000 per year estimated tax obligation:
Self-Employment Tax $9,185 ($65,000 * .9235 * .153)
Adjusted Gross 60,408 (Earnings less ½ SE Tax)
Standard Deduction 12,600 (Married Filing Jointly)
Personal Exemptions 12,000 (Assumes One Child)
Taxable Income 35,808
Income Tax 4,449
Tax Credit 1,000 (One Child)
Net Due 3,449
Total Due $12,634 ($9,185 SE Tax + Income Tax)
Amount Paid In Via Estimated Payments: $15,400
Refund Amount: $2,766
You are safe in regards to your estimated payments. If you expect similar income in the following year, then it may benefit you to reduce your estimated payments around $500 per quarter. But always, pay in slightly more than you calculate in order to be safe.
Failure to pay enough estimated tax generates onerous tax penalties. I mean really significant penalties. I guarantee you, you’ll never underpay again!
Worse, failure to pay at all means the IRS is going to send you a lot of Love Notes. Trust me, I’ve seen these with my clients and honestly, it is less painful to have a tooth removed than to deal with the constant barrage of Love Notes.
Now for some suggestions:
- Use the EFTPS system and pay your taxes monthly. This way, you are never late!
- Don’t forget, most states have income taxes too. Therefore, you’ll need to determine your obligation there and make regular payments.
- Always pay a little more than you anticipate as conditions constantly change.
- On your Form 1040, always leave a balance with the IRS; for those earning less than $100,000 per year, leave $1,500 with them, for those of you over $100,000 per year; leave no less than $4,000 as an ongoing balance (this is accomplished on page 2 of Form 1040 by indicating a partial refund request).
Now for some advice:
I often suggest to new business owners to transfer 33% of all net earnings per month into a savings account or a secondary checking account for the sole purpose of paying federal, state and local income taxes on behalf of the owner. If you are in a partnership situation, the partnership can fund the income taxes on behalf of the partners via a similar system. This is the best tool to prevent a partner from failing to adequately pay sufficient estimated taxes which can create problems for the partnership.
Don’t get behind in your tax obligations. I know this is easier said than actually done. I’m not an idiot; it is tough to fork over that much money to the government especially when we all often disagree with our government’s performance. But that futility with them has a different system to address it, it is called voting.
By the way I have always and will always advocate ‘Vote for the New Guy’ in every election. Seriously, it’s tenure in the government that causes lack of government performance. Serving as a Representative, Senator, or even the President should be more voluntary based than self service via reelection. The focus is not on us, but on self-tenure. I have gotten to the point of I really don’t care which party they belong to; so long as they are not the current official. OK, I digress.
Look at your tax payments that exceed the actual tax obligation as a form of savings. Each year, any refund amount should go straight to some form of retirement investment. Think of your tax obligation as a venue to transfer money to the long term goals of why we work.
In summation, if you are self-employed or a partner/shareholder you will need to make estimated tax payments to ensure adequate tax payments throughout the calendar year. Use the EFTPS site to make your payments and don’t get behind. Act on Knowledge.