Getting good at estimating taxes.
By Mark E. Battersby
It will come as no surprise to anyone that Uncle Sam wants taxes paid in full during the course of the year. Avoiding the penalties associated with guessing wrong about estimated tax payments is easy—with some preparation. Any person, and any business—large or small—can usually avoid penalties by basing estimated tax payments on the previous year’s tax bill.
If the year ahead turns out to be a bad one financially, however, basing estimated tax payments on the previous year can mean that the government, not your business, gets to use those funds (interest free) for as long as a year. And if the coming year turns out to be a good one, basing estimated tax payments on the previous year may eliminate any penalties but result in a whopping tax bill when the tax return is filed—along with the first estimated tax installment for the upcoming tax year.
Estimating the income, and the tax bill, of any type of business can be difficult, especially when compounded by the economy, battling lawmakers and the uncertainty over health care initiatives and tax reform. While most self-employed people and businesses have software programs or a professional to help with estimated tax payments, few people are aware of how to effectively anticipate and deal with changes.
What do you estimate?
Think of estimated taxes as a “pay-as-you-go” tax. Four times a year (quarterly), every business owner is required to send the Internal Revenue Service (IRS) enough revenue to cover income tax as well as self-employment tax (Social Security and Medicare) obligations.
If taxes are underpaid throughout the year, either through payroll withholding or by making estimated tax payments, a business may face a penalty for underpayment of estimated tax. However, the IRS knows that calculating earnings isn’t easy, so it offers a safe harbor rule: If you pay at least as much as the previous year’s liability, or pay within 90 percent of the actual liability, there’s no penalty for underpayment.
Anyone filing as a sole proprietor, partner, S corporation shareholder or a self-employed individual is generally required to make estimated tax payments if they expect to owe tax of $1,000 or more. If payment isn’t made through withholding, then it has to be done by quarterly estimated taxes. If the business is structured as a corporation, estimated tax payments are required if a final tax bill of $500 or more is expected.Â
For estimated tax purposes, the year is divided into four payment periods, with each period having a specific payment due date. If not enough estimated tax is paid at the end of each payment period, a penalty may be charged, even if a refund is due at year’s end.
That underpayment penalty usually consists of a nondeductible interest charge—currently, the federal short-term interest rate plus 3 percent—accruing from the date the payment was due.
Almost inevitable: underpayment
Paying estimated taxes weekly, bi-weekly or monthly is permitted, as long as a sufficient sum has been paid by the end of the quarter. But if not enough estimated tax was paid throughout the year, either through withholding or by making estimated tax payments, a penalty for underpayment of estimated tax is almost inevitable.
If business income is received unevenly during the year, such as for companies doing a lot of seasonal work, penalties can be avoided or lowered by “annualizing” income and making unequal payments. The annualized income installment method annualizes tax at the end of each period based on a reasonable estimate of income, deductions, and other items relating to events that occurred from the beginning of the tax year through the end of the period. The IRS Form 2210, “Underpayment of Estimated Tax by Individuals, Estates, and Trusts,” is used for this payment method.
Those filing as a sole proprietor, partner, S corporation shareholder or as self-employed should use Form 1040-ES, “Estimated Tax for Individuals,” to calculate and pay estimated tax. Incorporated businesses are required to pay their estimated income tax bills in quarterly installments.
When filing as a corporation, Form 1120-W, “Estimated Tax for Corporations” (ETFC) is used to figure the estimated tax. In general, each quarterly federal tax payment is 25 percent of the corporation’s required annual payment, which is the lesser of two amounts:
- Current-year tax liability: 100 percent of federal income tax reported on return for the year of the payment.
- Prior-year safe harbor: 100 percent of a corporation’s federal income tax reported on return for the preceding year.
Corporations with no tax liability in the preceding year obviously cannot use the 100 percent prior-year safe harbor amount to determine their required estimated tax payment. And certain large corporations—those with taxable income of $1 million or more in any of the three preceding tax years—may only use the prior-year safe harbor amount when calculating their first-quarter payment.
If you’ve calculated and deposited estimated tax for your business and then find that your tax liability for the year will be more (or less) than originally estimated, required installments will have to be refigured. An immediate catch-up payment should be made to reduce any penalty resulting from the underpayment of any earlier installments.
All incorporated businesses are generally required to use ETFCs to pay estimated taxes; Form 2220, “Underpayment of Estimated Tax by Corporations,” is used to determine if a corporation is subject to the penalty for underpayment of estimated tax and to figure the amount of the penalty.
Estimated tax refunds
As is generally the case with individuals, if a corporation does not pay a required estimated tax installment by its due date, that company may be subject to a penalty. The penalty is figured separately for each installment due date; a corporation may owe a penalty for an earlier due date, even if it paid enough tax later to make up the underpayment. This is true even if the corporation is due a refund when its tax return is filed.
For some estimated tax overpayments, there is a special “Quick Refunds” solution. An incorporated business that has overpaid its estimated tax for the year may be able to apply for a quick refund by using Form 4466, “Corporation Application for Quick Refund of Overpayment of Estimated Tax.” A corporation may apply for a quick refund if the overpayment is:
- At least 10 percent of its expected tax liability, and
- At least $500.
When a plan comes together
The IRS demands that any business required to pay taxes guess its income for the coming year—and pay an estimated tax bill by making installment payments over the course of the year. Even after an estimated tax payment has been made, changes in income, adjustments, deductions, credits or exemptions may make it necessary to refigure the estimated tax installment.
Any business that does not receive income evenly throughout the year is likely to find that the required estimated tax payments will vary. Failure to make timely payments that accurately reflect the tax liability of the business—or that of its owner—could result in penalties.
Every business owner should give careful consideration to estimated tax payment calculations. Fortunately, the tax rules contain clear guidelines that can help in figuring those estimated tax bills and also provide so-called “safe harbors” to substantially reduce or even avoid those penalties. Professional assistance may be necessary not only when first computing the estimated tax bill for the year ahead, but also when financial circumstances change. People tend to think about taxes once a year, but estimated taxes should be reviewed regularly.