One of most common causes of tax liabilities with the IRS is the failure for self-employed individuals to pay estimated taxes throughout the year. For most Americans, your employer deducts your taxes from each paycheck, both to cover your income tax obligations as well as Medicare / Social Security (FICA) taxes and federal unemployment (FUTA) taxes. Assuming you’ve set your withholding properly, chances are when you go to file your return each year, you’ll be owed a small refund by the IRS. Many taxpayers that make the switch from being a wage-earner to being self-employed are caught off guard at tax filing time because they haven’t paid in estimates to cover not only their income tax obligations, but also the additional tax imposed on self-employment earnings to cover their FICA and FUTA obligations.
The issue compounds when the oversight isn’t uncovered until the following year when they go to file their taxes. Especially if the return is put on extension, a newly self-employed person can find themselves a year and a half behind on their taxes with no practical way to get caught up quickly. This can be especially problematic because the IRS generally requires that you demonstrate that you’re current with your estimated tax payments during the current tax year before they will negotiate with you on a payment plan or Offer in Compromise. Even if you can afford to cover the bill at tax time, the IRS can still subject you to penalties for failure to pay estimated taxes; while these penalties may seem minor in the grand scheme of things, I’ve seen taxpayers get penalized thousands of dollars year after year just for failing to send the IRS estimated tax payments throughout the year.
Below, I’ve endeavored to demystify the payment of estimated taxes to help taxpayers avoid some of the common traps.
Even though taxes are due in April, the IRS expects them to be paid in throughout the year:
The general rule is that your personal income taxes are due in April, and as long as you pay what you owe by the due date, the IRS won’t penalize you for failure to pay. However, §6654 of the IRC requires the payment of estimated taxes in four installments throughout the year, due on the following dates:
1st installment, due April 15th
2nd installment, due June 15th
3rd Installment, due September 15th
4th installment, due January 15th of the following year
*** Note that non-resident aliens who report income on a calendar year basis and do not have wages subject to withholding, are generally not required to make an estimated tax payment until June 15th, the due date for filing the prior year’s return. They are therefore required to submit 50% of their estimated tax obligation by June 15th, 25% by September 15th, and 25% by January 15th of the subsequent year. Non-resident aliens should also submit their estimated tax payments using Form 1040-ES(NR), rather than the standard 1040-ES form.
How to ensure you’re not penalized for failing to pay estimated taxes:
IRC §6654(d) provides that in general, each of the four estimated tax payments must equal 25% of the “required annual payment.” The required annual payment is equal to the lesser of (i) 90% of the tax shown on the return for the taxable year, or (ii) 100% of the tax shown on the return for the preceding taxable year. However, for individuals with an adjusted gross income of greater than $150,000 in the preceding taxable year, the required annual payment under clause ii above becomes 110% of the preceding year’s tax owing. In the case of married individuals choosing to file separate returns, the increase to 110% percent is triggered at an AGI of only $75,000.Therefore, the safest way to ensure that you are not penalized for failure to pay estimated taxes is to pay in 25% of the tax owing on your prior year’s return (or 27.5% if you meet the above income thresholds) in four equal installments on the due dates listed above.
Alternative method for calculating estimated tax obligations:
Many self-employed individuals have income that fluctuates during the year. While the IRS generally requires that estimated tax be paid in in four equal installments throughout the year, the IRS does provide an alternative method for calculating, the “Annualized Income Installment Method” is an alternative means of calculating your quarterly estimated tax obligations to more closely track with the income you receive (and deductions associated with the income) in each quarter.
IRS Publication 505 contains Worksheet 2-7 which can be used to calculate your estimated tax obligations for each quarter under the Annualized Income Installment Method. In essence, the form has you enter in a reasonable estimate of your income at four intervals during the year. The four columns on the worksheet state the intervals to which the income estimates apply, and each subsequent interval includes the period covered by the prior intervals:
1st Quarter: January 1 through March 31,
2nd Quarter: January 1 through May 31,
3rd Quarter: January 1 through August 31,
4th Quarter: January 1 through December 31
The worksheet multiplies these amounts against different annualization factors to adjust the percentage of the annual required payment due for each quarter to track the percentage of the taxpayer’s income earned during that quarter. While the Annualized Estimated Tax Worksheet can be helpful in determining your tax your estimated tax obligations for the forthcoming year based on income projections, it is not just a planning tool. There is no obligation to make the election to utilize the Annualized Income Installment Method at the outset of the tax year, or when sending in estimated tax payments. Rather, when you go to file your tax return, you can file Form 2210 to elect to have your estimated tax obligations calculated under the Annualized Income Installment Method. Even if you did not anticipate electing the Annualized Income Installment Method, the penalty associated with underpaying estimates might be reduced or eliminated by making the election on your return. Therefore, if you’ve prepared a return (or had the return prepared for you), and it shows a penalty for failure to pay estimates, it’s worth working through Form 2210 to see if making the election will reduce or eliminate the penalty.