Estimated tax is the method used to pay tax on income that isn’t subject to withholding, most notably earnings from self-employment. Many owners of small business—whether operates as S corporations, partnerships, limited liability companies electing partnership taxation, or sole proprietorships—pay their estimated tax using the same IRS Form 1040-ES that individuals use.
Payments of estimated taxes are spread out over four payments, falling due in April, June, and September of the current year, and January of the following year. Generally a taxpayer must file estimated taxes if he or she owes $1,000 or more in taxes when an annual tax return is filed. An underpayment penalty can be avoided if tax payments for the year, including withholding and any tax credits, cover the ultimate tax bill, or at least are short by less than $1,000. There are special rules for farmers, fisherman, certain household employers, and some higher-income taxpayers.
A taxpayer who also receives salaries and wages may be able to avoid having to make estimated tax payments on other income by asking his or her employer to take out more tax from such earnings. In addition, in a given year a taxpayer does not have to make estimated tax payments until there is income on which income tax will be owed.
Given the difficulty in anticipating the year’s total tax obligation in April, or even June, there are two “safe harbors” for avoiding a penalty for under payment of estimated taxes: Pay either 90 percent of your current tax obligation or 100 percent of the previous year’s tax.
Corporations are subject to similar, but slightly different, rules for paying estimated taxes. A corporation must make equal installment payments on the 15th day of the 4th, 6th, 9th, and 12th months of its tax year if the expected tax for the year is $500 or more. Corporations use IRS Form 1120-W. The safe harbors for corporate taxpayers are each set at 100 percent. Accordingly, to avoid a penalty, a company should make each payment at least 25 percent of the current year’s income tax or 25 percent of the prior year’s income tax, whichever is smaller.
Actual resolution of legal issues depends upon many factors, including variations of facts and state laws. This post is not intended to provide legal advice on specific subjects, but rather to provide insight into legal developments and issues. The reader should always consult with legal counsel before taking action on matters covered by this post.