The United States has a “pay as you go” tax system in which tax payments are made to the IRS throughout the year, not as one lump sum when the tax annual return is filed. Employees have their income and Social Security and Medicare taxes withheld by their employers and paid the IRS quarterly or monthly. This includes business owners who have formed corporations to own and operate their businesses. However, most small business owners are not incorporated. Instead, they are sole proprietors (one-person businesses) or partners in partnerships or members of limited liability companies. Such business owners are self-employed for tax purposes.
When you’re a self-employed no taxes will be withheld from your compensation by your clients and customers, or by your business itself. It’s up to you to pay your income and Social Security and Medicare taxes yourself. Ordinarily, this is done by making four annual estimated tax payments to the IRS each year.
You must pay estimated taxes if you expect to owe at least $1,000 in federal tax for the year. However, if you paid no taxes last year—for example, because your business made no profit or you weren’t working—you don’t have to pay any estimated tax this year no matter what your tax tally for the year. But this is true only if you were a U.S. citizen or resident for the year and your tax return for the previous year covered the whole 12 months.
You also don’t have to pay estimated tax if, in addition to running a business, you have an employee job and the amount withheld from your pay by your employer will amount to at least 90% of the total tax you’ll have to pay for the year.
When to Pay Estimated Taxes
You must ordinarily pay your estimated taxes in four installments, with the first one due on April 15, as shown in this chart:
Don’t get confused by the fact that the January 15 payment is the fourth estimated tax payment for the previous year, not the first payment for the current year. The April 15 payment is the first payment for the current year.
You don’t have to start making payments for any given year until you actually earn income. If you don’t receive any income by March 31, you can skip the April 15 payment. In this event, you’d ordinarily make three payments for the year, starting on June 15. If you don’t receive any income by May 31, you can skip the June 15 payment as well and so on.
You can also skip the January 15 payment if you file your tax return and pay all taxes due for the previous year by January 31 of the current year. This is a little reward the IRS gives you for filing your tax return early. However, it’s rarely advantageous to file early because you’ll have to pay any tax due on January 15 instead of waiting until April 15. In other words, you’ll lose three months of interest on your hard-earned money.
How Much do You Have to Pay?
Ideally, the four estimated tax payments you make each year will add up to your tax liability for the year. However, if your income varies substantially from year to year, it can be hard to estimate how much you must pay during the year. If you don’t pay enough estimated tax, the IRS will impose a penalty.
Fortunately, there is a way to avoid having to estimate how much you’ll make this year. No matter what your income for the current year turns out to be, you won’t have to pay any penalties if the estimated tax you pay is at least the smaller of: 90% of your total tax due for the current year, or 100% of the tax you paid the previous year or 110% if you’re a high-income taxpayer (those with adjusted gross incomes of more than $150,000 or $75,000 for married couples filing separate returns).
Note that, if you’re a partner in a partnership or LLC member, you must pay individual estimated tax on your share of the partnership or LLC income whether or not it is actually paid to you. The partnership or LLC itself pays no tax.
Many self-employed people establish separate bank accounts to save up for taxes into which they deposit a portion of each payment they receive from clients. This gives them some assurance that they’ll have enough money to pay their taxes. The amount you should deposit depends on your federal and state income tax brackets and the amount of your tax deductions. Depending on your income, you’ll probably need to deposit 15% to 50% of your pay in the highest tax brackets. If you deposit too much, of course, you can always spend the money later on other things.
How to Pay Estimated Tax
Paying estimated tax is easy: you can do it by check, electronic funds withdrawal, or even by credit card. You should use IRS Form 1040-ES, Estimated Tax for Individuals, to pay your estimated tax. The form includes detailed payment instructions.
What if You’ve Paid too Little?
The IRS imposes a money penalty if you underpay your estimated taxes. Fortunately, the penalty is not very onerous. You have to pay the taxes due plus a percentage penalty for each day your estimated tax payments were unpaid. The percentage is set by the IRS each year. Currently, it’s about 3%. This is the mildest of all IRS interest penalties. Many self-employed people decide to pay the penalty at the end of the tax year rather than take money out of their businesses during the year to pay estimated taxes. If you do this, though, make sure you pay all the taxes you owe for the year by April 15 of the following year. If you don’t, the IRS will tack on additional interest and penalties. The IRS usually adds a penalty of 1/2% to 1% per month to a tax bill that’s not paid when due.
For more details on estimated taxes, refer to IRS Publication 505, Tax Withholding and Estimated Tax.