Many business owners get hit with tax surprises when they begin to make a profit. They may not realize that they're required to pay quarterly estimated taxes on their business incomes throughout the year.
Learn how to do a general calculation to find out just how much you might have to pay in estimated taxes and when you're required to pay them.
Key Takeaways
- Estimated taxes are taxes on your business income that must be paid quarterly if you're self-employed.
- Penalties and interest can apply if you're required to pay quarterly estimated taxes and you don't do so.
- You can estimate the taxes you'll need to pay by using forms from the Internal Revenue Service (IRS) and referencing previous years' tax documentation.
Why Estimated Taxes Are Important
Most small business owners must report their business income and pay their business income taxes with their personal tax returns.
You would have payroll tax deductions for income taxes withheld from your pay by your employer if you worked for someone else. But those who work for themselves must take care of this task on their own. The IRS doesn't want to wait for payment of your taxes until you file your tax return in April. It expects you to pay as you earn.
You're also required to pay FICA taxes (Social Security and Medicare) on your business income. This portion of your tax bill is referred to as the self-employment tax. You would pay half and your employer would pay half if you worked for someone else. You must pay both halves if you work for yourself as a small business owner.
Note
Any payments you make to yourself as an owner of your business are considered to be an owner's draw, not a salary or wages. Taxes haven't been withheld the way they would be from an employee's paycheck.
This is where estimated taxes come in.You must pay these amounts quarterly to avoid penalties and interest on late payments.
Who Must Pay Estimated Taxes
The IRS says you don't have to pay estimated taxes if you meet all three of these conditions:
- You had no tax liability for the previous year,
- You were a U.S. citizen or resident for the entire year, and
- Your previous tax year was for a full 12-month period.
Otherwise, you must pay estimated taxes if you owe $1,000 or more for the year over the amount of any withholding from salary or wages you might have earned as an employee and refundable tax credits you qualify for.
How the Underpayment Penalties Work
You may be charged a penalty if you don't pay enough through withholding from a side job if you have one and timely estimated tax payments. You may also be charged a penalty if your estimated tax payments are late, even if you end up not owing anything and receiving a refund when you file your tax return after year's end. Estimated tax payments must be paid in advance.
How and When To Pay Estimated Taxes
Estimate your tax liability by adding up all your income for the tax year, including any capital gains income and/or dividends. You'll owe a percentage of this amount according to your tax bracket.
Payments are due four times a year:
- 1st payment: April 15
- 2nd payment: June 15
- 3rd payment: September 15
- 4th payment: January 15 of the next year.
You can divide what you anticipate owing into four equal installments if your income is steady throughout the year. But you may have to make smaller or larger payments in one or more quarters if your business income is seasonal, or if you experience a change in income and end up underpaying or overpaying in a given quarter.
You can use quarterly vouchers that are included in IRS Form 1040-ES to make these payments. If you use a tax preparer or tax preparation software to file your tax return, they should include an estimated tax calculation and copies of vouchers. You must make the payments yourself in one of three ways:
- Mail in the payment with the voucher.
- Pay online using your credit or debit card through IRS Direct Pay.
- Pay by phone.
It's easiest to make these payments online through one of the IRS-approved payment methods.
Note
You can make additional estimated tax payments to make up for a quarter with more income, and you can also make your estimated payments weekly, bi-weekly, or monthly, as long as you ultimately pay enough by the quarterly due date. Any overage will spill over to the next quarter.
Information You'll Need To Estimate Your Tax
You can calculate your estimated business taxes using IRS Schedule C, which you must submit with your Form 1040 tax return when you file it.
Include all sources of income in addition to your business income and self-employment tax, including:
- Salary
- Tips
- Pension
- Dividends
- Alternative minimum tax
- Winnings, prizes, and awards
- Interest and capital gains
Estimate your business income for the tax year. You can use your income from previous years or take your income up to the current date and estimate the income you anticipate for the rest of the year.
Estimate your business expenses for the year, using previous years as a guideline or using year-to-date expenses and projecting them through the end of the year.
Your estimated taxes will depend on your personal tax situation, so you'll have to include personal income, deductions, credits, exemptions, and any withholding of federal income taxes by an employer. You can use information from prior tax returns or use year-to-date data and project to the end of the year.
You'll also have to calculate your self-employment tax (Social Security and Medicare taxes) and include payment when you determine your estimated taxes due.
Estimated Taxes: Some Calculation Methods
You can calculate your estimated tax payments by asking your tax preparer to run an estimate, or you might get a rough estimate from your previous year's return prepared with tax software. You can use the estimated taxcalculation worksheet provided by the IRS on Form 1040-ES or the worksheets included in Publication 505.
Use tax preparation software to run a rough calculation of your estimated taxes for the next year. You can start with last year's return for information if you use the same software every year. Tax software typically includes calculation of self-employment taxes. It provides a rough estimate for tax planning purposes if your business and personal income are fairly consistent from year to year.
Be sure your tax preparation software is the small business or self-employed version of a program. It should include Schedule C for calculating your business income after expenses, and Schedule SE for self-employment taxes. Business tax return versions are usually designed for a specific business type, like partnerships, corporations, S corporations, or sole proprietorships.
Frequently Asked Questions (FAQs)
What is pass-through taxation and who is subject to it?
Business owners operating as sole proprietors, independent contractors, LLC owners, and partners in a partnership are all pass-through entities subject to this type of taxation. Profits and losses from their businesses trickle down or "pass through" to their business entity to be reported on their personal tax returns.
Does pass-through taxation require paying estimated taxes?
Owners of partnerships, LLCs, and S corporations aren't employees of the business. They receive payments periodically from the business, and these payments are added to their personal tax returns. They're generally not subject to withholding, so estimated taxes may have to be paid.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with anaccountantor anattorney.
Want to read more content like this?Sign upfor The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
