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Plan Estimated Tax Payments to Avoid Penalties

Filed under Federal Taxes. Fact checked on February 13, 2016.

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America's tax system is "pay as you go." Although you may end up owing more on tax day, the taxes you are are supposed to be paid into the system over the course of the year. For wage income, this is done via wage withholding. For other income, this is done through estimated tax payments.

Nearly every small business owner will have to make estimated tax payments because estimated taxes are designed to cover income that is not subject to withholding, such as income from your business.

Warning

If you are a higher income taxpayer, then you may need to pay additional estimated tax as a consequence of the 0.9 percent Medicaid surtax on earnings or the 3.8 percent Net Investment Income Tax.

Because penalties that can be assessed if you don't make these payments on time and in the correct amount, it is important to understand the rules for determining what you owe and when you owe it.

Do I Need to Make Estimated Tax Payments?

As noted above, nearly every small business owner who operates their business as an LLC, an S Corporation, a partnership, or a sole proprietorship will need to make estimated tax payments.

But, because this is tax law, there is always as exception to every rule.

To find out if you are the exception that does not have to make estimated tax payments, take the simple quiz below.

  1. Do you expect to owe $1,000 or more in taxes for this year, after subtracting any income tax withholding and credits from your total tax?
    • If the answer is no, you are not required to pay estimated tax.
    • If the answer is yes, go on to the next question.
  2. Do you expect your income tax withholding and credits to be at least 90 percent of the tax you'll owe for this year?
    • If the answer is no, you are not required to pay estimated tax.
    • If the answer is yes, go on to the next question.
  3. Do you expect your income tax withholding and credits to be at least 100 percent of the tax shown on your last year's return? (If your last year's adjusted gross income was more than $150,000 ($75,000 for married, filing separately), it would be 110 percent.)
    • If the answer is no, you are not required to pay estimated tax.
    • If the answer is yes, you need to pay estimated tax.
Think Ahead

You may be able use withholding from a job or from your spouse's job to avoid owing estimated taxes--or worse yet, an estimated tax penalty.

Because, payroll withholding are treated as being made evenly through the year, regardless of when the withholding is actually done, if you arrange to have sufficient extra tax withheld towards the end of the year, you can avoid estimated tax liability.

To do this, you file a revised Form W-4 with your employer (or your spouse's employer) during the latter part of the year. To avoid penalties, the extra withholding must bring your total tax withholding for the year up to the lesser of (a) 90 percent of the amount you expect to owe minus $1,000, or (b) 100 percent of the amount you owed last year (110 percent for high-income taxpayers) minus $1,000.

Estimated tax for corporations.

If your business is operated as a corporation, the corporation must make estimated tax payments if it expects its tax to be $500 or more for a tax year.

A corporation will generally be subject to an underpayment of tax penalty if the estimated tax payments, required in installments, do not equal the lesser of (1) 100 percent of the tax shown on the return for the preceding year, or (2) 100 percent of the tax shown for the current year (the current year tax may be determined on the basis of actual income or annualized income).

How Much Federal Tax Should I Pay?

If you are a calendar year taxpayer and you have to make estimated tax payments, you have until January 15th following the close of your tax year on December 31st to make sure your estimated tax liability is paid.

Your total tax payments must add up to the lesser of these two amounts:

  • 90 percent of the tax you estimated that you will owe for the current year, or
  • 100 percent of the tax you owed for last year

Total tax payments includes any tax withholding on any paychecks, investment income, pensions, or any other income you receive (or your spouse receives, if filing jointly). If the difference between any withholding during the year, and the amount computed in the paragraph above is $1,000 or more, it must be made up with estimated tax payments.

Tip

You do have the option to file your taxes early if you realize that you have not made sufficient estimated tax payments during the year. This is discussed later in this article.

How Do I Determine How Much to Pay?

Follow these steps to determine how much tax you need to pay.

  1. Look at each major item on each tax form and schedule that you filed this year, and make a guess as to whether that item will change in the coming year.
  2. If you think there will be a change, estimate what the change will be. For example, if the real estate tax bill on your office will rise by 10 percent, that will reduce the amount of net income from your business on Schedule C, and increase the amount of itemized real estate taxes deductible on Schedule A.
  3. Determine how the cumulative changes will affect your tax bill to arrive at a ballpark estimated bill. 
  4. Subtract any withholding that will be done from the expected tax bill.
  5. Subtract $1,000 from the amount remaining. 
This remaining amount is what you will need to pay in estimated taxes.

Work Smart

Business owners should plan to go through this exercise at least twice a year: around April 15th, and then again sometime in the third quarter of the year.

The IRS provides a worksheet on which you can make this calculation, as part of the instructions to Form 1040-ES. You can get a copy by calling 1-800-TAX-FORM or by going to the IRS website.

You Must Determine Quarterly Payment

Knowing the total amount you will owe is not sufficient. The IRS demands that estimated tax payments be made quarterly. As a result, once you know the total amount of estimated tax payments you'll have to make during the year,you need to compute the dollar amount you must pay for each quarter.

Most people will use one of the following two methods to make this computation:

  • the regular installment method or
  • the annualized income installment method.

The regular installment method works by dividing your total amount of estimated payments for the year by four. On each payment due date, you pay one-fourth of the total tax due for the year. The IRS prefers this method, and it's by far the simplest to use.

Annualized income method. If your business is of the type that doesn't receive income evenly throughout the year (for example, you sell surfboards year-round in the Northeast), you may want to use the annualized income installment method to compute your estimated tax payments for each period. Under this method, your required estimated tax payment for one or more periods may be less than the amount figured using the regular installment method.

If you elect to use this method, you'll have to file Form 2210, Underpayment of Estimated Tax by Individuals, Estates and Trusts, with your regular individual income tax return.

Using this method is more complicated than simply determining your net income for each quarter, and figuring the tax on it. For complete instructions on using this method, talk to your tax adviser or get a copy of the IRS's free Publication 505, Tax Withholding and Estimated Tax.

Corporations are generally required to make installment payments equal to 25 percent of the required annual estimated tax.

When Are Estimated Taxes Due?

There are four estimated tax due dates during the year and you are expected to pay one-quarter of your tax liability each time.

Tip

As with all tax due dates, if the estimated tax payment date falls on a Saturday, Sunday, or legal holiday, the payment must be made on the next day that is not a Saturday, Sunday, or legal holiday.

It is also important to monitor whether your income is on track with your projections. If you are going to have a larger tax liability than you anticipated, you will need to increase your estimated tax payments accordingly. If you don't pay enough tax by the due date of each of the payment periods, you may be charged a penalty for underpayment of tax until the underpayment is made up.

Warning

This means that you may be charged a penalty for a particular quarter even if you're due a refund when you file your income tax return for the entire year! Obviously, if you are required to make estimated tax payments, it's important to know the due dates.

Due Dates for Calendar-Year Individuals. If you operate your business on a calendar tax year, your estimated tax payment due dates are:

For the Period Due Date
January 1-March 31 April 15
April 1-May 31 June 15
June 1-August 31 September 15
September 1-December 31 January 15 (of the following year)
If the due date falls on a Saturday, Sunday, federal holiday, or holiday in the District of Columbia, the payment is due on the next business day.

 

Farmers and fishers. If at least two-thirds of your annual income comes from farming or fishing, you have only one payment due date for your estimated taxes - January 15 if your tax year ends on December 31. The first three payment periods don't apply.

Fiscal year filers. If you operate your business on a fiscal year, your estimated tax payment due dates are:

  • the 15th day of the fourth month of your fiscal year
  • the 15th day of the sixth month of your fiscal year
  • the 15th day of the ninth month of your fiscal year
  • the 15th day of the first month after the end of your fiscal year

Corporations. A calendar-year corporation has the same estimated tax payment due dates as individuals for the first three periods. However, its last payment is due on December 15, rather than January 15 of the following year).

For corporations that use a fiscal tax year, the due dates are the also same as individuals for the first three periods of the fiscal year.

However, the last estimated tax payment is due on the 15th day of the 12th month of the corporation's fiscal year.

Paying Your Estimated Tax

Individuals can make estimated tax payments in several ways:

  • by crediting all or part of any overpayment on your annual tax return toward your next year's estimated tax (rather than getting a refund);
  • by paying electronically through the Electronic Federal Tax Payment System (EFTPS);
  • by paying with electronic funds withdrawal (EFW); or
  • by paying with credit card.

Corporations are nearly always required to make estimated tax payments electronically through EFTPS

File Return Early to Avoid Final Estimated Tax Payment

There is a special rule in the tax law that excuses you from filing fourth quarter estimated taxes if you file your annual tax return (Form 1040, etc.), and pay any tax due by January 31.

If you are a fiscal year taxpayer, you don't have to make the last quarter estimated tax payment if you file your income tax return by the last day of the first month after the end of your fiscal year and pay all the tax you owe with your return.

Example

Stella, a self-employed individual with no tax withheld, does not make an estimated tax payment for the fourth quarter of her tax year. However, she files a Form 1040 and pays the tax due as shown on the return on January 20.

Although she did not make a fourth quarter payment of tax, she is excused from doing so because she filed her return on or before January 31 and paid the full estimated tax amount due. Otherwise, she would have had to make a fourth quarter estimated tax payment by January 15.

If you are a farmer or fisherman, you can avoid the fourth quarter estimated tax payment if you file your annual return (Form 1040, etc.), and make your payment of tax due by March 1.

However, there are drawbacks to filing early and most individuals either should not, or can not, take advantage of the option. You must be accurate on your tax return and this could be difficult if you have not received all the Form 1099 information returns and other information you need to fill in the forms. You may not have received documents that must be attached to your final tax return such as a Form W-2, or Schedule K-1s.

Also, as a self-employed individual, you simply may not have had sufficient time to compile the tax information needed to complete your Schedule C, which must be included with your annual return when you file.

Finally, you will have to come up with the balance you owe in tax by January 31, rather than having the luxury of waiting until April 15

Beware of Estimated Tax Penalties

If you underpay your estimated tax you may be assessed a penalty in the form of interest on the underpayment for the period when the underpayment occurred. Unlike most tax penalties that are assessed based on an annual liability, the underpayment of estimated tax penalty is calculated--and assessed--separately for each payment period. This means that you may owe a penalty for an earlier payment period even if you later paid enough to make up the underpayment.

As a matter of fact, if you didn't pay enough tax by the due date of each of the payment periods, you may owe a penalty even if you are due a refund from the IRS when you file your income tax return.

Example

Elizabeth is employed as a teacher and runs her own tutoring business as well. She didn't make any estimated tax payments during 2016 because she thought she had enough tax withheld from her teaching wages. Early in January of 2017, she estimated her total  tax and realized that her withholding was $2,000 less than the amount needed to avoid a penalty for underpayment of estimated tax. So on January 12, Elizabeth made an estimated tax payment of $2,000, the difference between her withholding and her estimate of her total tax.

When she files her final return, Elizabeth's total tax is $50 less than she originally figured, so she is due a refund from the IRS. However, Elizabeth will owe a penalty through January 12 for her underpayments for the first three quarterly payment periods. She won't owe a penalty for the fourth quarter because she made a payment for that quarter by the January 15 due date.

Penalties Waivers Are Rare, But Possible

You can request a waiver of the penalty if the underpayment was caused by a casualty, disaster, or some other unusual circumstance that would make its imposition unfair. The IRS may also waive the penalty for reasonable cause during the first two years after a taxpayer retires upon reaching age 62 or becomes disabled. Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, must be filed to request a waiver.

You can use Form 2210 to calculate your estimated tax penalty. But this form is very complicated, and generally, you aren't required to complete it. When you file your tax return, the IRS will usually figure the penalty for you and send you a bill.

What other situations might require you to file Form 2210? Other than when you request a waiver, you must file Form 2210 when:

  • You use the annualized income installment method.
  • You use your actual withholding for each payment period for estimated tax purposes.
  • You base any of your required installments on the tax shown on the previous year's return and you filed or are filing a joint return for either that previous year or the present year, but not for both years.

Corporations must use Form 2220, Underpayment of Estimated Tax For Corporations, to determine any underpayment of the corporation's estimated tax. Corporations generally don't have to file Form 2220 - the IRS will figure any penalty and bill the corporation. However, corporations must file Form 2220 if:

  • The corporation used the annualizing or recurring seasonal income method to determine any installment required.
  • The corporation is a large corporation computing its first required installment based on the prior year's tax.

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