11
ESTIMATED PAYMENTS
I love giving the IRS lots of money. It means I have made a huge fortune!
—TAXMAMA
Estimated Payments Overview
You’re in business now. Cool, isn’t it? But your safety net is gone. If you’re not on payroll, you don’t get any W-2s. For the first time, you have to make your own tax deposits. Your mind is filled with questions.
• When do you make them?
• What forms do you use?
• Where do you send them?
• How much should you pay?
• What’s the big deal if you don’t make the payments?
Not making payments can cost you big-time! That’s one of the two ways to destroy your business and drain your cash flow. (The other way is to skip paying payroll taxes. See Chapter 9 to learn about this important topic.) While it may hurt your wallet a little to make the payments each quarter, it might wipe you out, or worse, to try to pay all the taxes on April 15th.
If you want to succeed in business, set the money aside and pay the tax.
What’s in It for You?
When you have a system to guide you, life is much less stressful. There’s a comfort to knowing how much to budget each month for each of your expenses. Taxes are no different.
If you’re a numbers freak, like me, you like to see a nice, steady monthly cash flow statement, with all the numbers being consistent. Knowing how much you’ll need to pay the IRS each quarter, you can put a fixed-dollar amount aside each month. You won’t have to panic, wondering if you must make up for last quarter and pay a large amount all at once.
Best of all, if you do come up short, the IRS will go out of its way to help you because you’ve established a consistent history with the agency. It’s like a credit history. The IRS is used to dealing with people who are contentious and belligerent. You’ll be a breath of fresh air.
Think how easy it will be to get bank or venture capital financing once people see how responsibly you’ve handled your tax obligations. Lenders and investors get skittish when business owners come to them after having gotten themselves into tax trouble. Naturally, if you’re totally brilliant and have a killer product, the “angels” might overlook your financial failings. Of course, they’ll charge you more for the money.
Then again, not everyone needs to be paying estimated taxes. After all, if you don’t have a profit, you don’t need to pay taxes, estimated or otherwise.
Who Should Be Making Estimated Payments?
There are four categories of people who should be paying estimated payments:
1. People who are self-employed
2. People whose nonwage income is increasing (or expected to increase) in the current year
3. People who have done well on the stock market
4. People who have gotten a healthy inheritance (or other windfall), with assets that produce income
Anyone else? For business owners receiving wages, if you expect to owe extra taxes, simply have your tax professional manipulate your payroll tax withholding before year-end. That way, you never have to make estimated payments.
When Should You Be Making Those Payments?
When we talked about payroll quarterlies in Chapter 9, you learned that “quarterly” means every three months, right? Not when it comes to estimated payments. We’re dealing with the tax code here. Some extremely clever lawmakers decided that quarterly, for tax purposes, breaks down as indicated in Table 11.1. Notice that sometimes you’ve got to pay within two months; other times, the quarter is four months long.
TABLE 11.1 Estimated Payment Schedule
How Much Must You Pay?
Before we get into any payment specifics, let’s start with some fundamental tips about making estimated tax payments. Keep handy the link found at the end of this chapter to the online version of IRS Publication 505, which is about withholding and estimated tax payments. Changes in the rules will appear there.
You will be using Form 1040-ES, and your state’s equivalent. For the current year, look up the instructions to Form 1040-ES—https://www.irs.gov/pub/irs-pdf/f1040es.pdf.
Typically, you must only pay estimates if
1. You expect to owe $1,000 or more beyond any payroll withholding
and
2. Your withholding or other tax credits (education, children, and so on) will be less than 90 percent of the tax you expect to owe on your current year tax return. (If your income falls into the “wealthy” or “high-income” levels for the year, you must pay 100 percent of what you expect to owe.)
or
3. Your withholding or other tax credits (education, children, etc.) will be less than 100 percent of the tax shown on your prior year’s tax return. If you expect to have losses from the business, don’t worry about making estimated tax payments on the business.
Wise heads feel that it is best to pay the minimum required taxes in advance. You can put your money to better uses than the IRS can.
My Short Method
Use this shortcut if your expected taxable income will be the same as or higher than it was last year. It’s so simple. Everyone loves using it.
Start with your last year’s return.
Ta-daaa! That’s how much you should be paying each quarter. That’s it. That’s all there is to it. Read no further.
That Makes You Nervous? You Want to Pay More?
You’d rather pay just enough to owe nothing next April? OK, increase each of those payments by a couple of hundred dollars.
You don’t have to. All you have to do to avoid the penalties is to pay the minimums. Some people prefer to have a small refund. That’s fine. Uncle Sam can surely use your money.
You’re well within your rights to open a savings account or investment account to hold those funds until it’s time to pay. But in today’s economic climate it may not be worth going to all that trouble. Earning less than half of one percent interest on my money doesn’t excite me. On $5,000, that’s less than $25 of interest for the whole year. Of course, when interest rates rise—or if your additional tax due is much larger—you may have an incentive to hold on to that money.
Cash Flow Strategy: Yes or No?
Some businesses feel they can make better use of this money to grow their operations, so not making estimated payments is part of their strategy. This is not a good idea.
Take the example of the Klaus Company (not the real name), which had a steady stream of work. Klaus’s bids were generally accepted for large-ticket jobs. He was able to subcontract some of the work, so he didn’t need a payroll. He worked more than 15-hour days on the jobs, usually hundreds or thousands of miles from home. He’d be gone for months at a time. It’s not that he didn’t want to make the estimated payments. He wasn’t home long enough to take care of bookkeeping or administration or to cut the checks. Besides, every time he’d get a job, little disasters beyond his control would occur, wiping out most of the profit on the job. (In one case, he and his crew were not permitted to work during office hours. No one mentioned that when he bid the job.) Often, he’d be working for nothing. While he felt there was no profit at all, he actually made enough of a profit so the rent and family expenses were being paid. That means he always had lots of self-employment taxes due. Since he didn’t set any money aside each quarter, in April there’d be no money. And so he didn’t pay the estimates, and he didn’t get the bookkeeping done—and he hasn’t filed tax returns. He’s been behind for the last three years, and the IRS is about to attach his bank accounts.
In another example, Matt and Jamie Garrison of Aluria Software LLC, considering what it would cost them to borrow money, decided to hold back much of the money from their estimated taxes as their business grew. That money could be better used for payroll, payroll taxes, or advertising. As part of their strategy, they knew at the end of each year they had to save money, quickly, to cover the tax debt by April. They didn’t always make it. By filing an extension, the Garrisons were able to keep the late-payment penalties to 0.5 percent per month. With IRS interest rates at the lowest in my lifetime, the penalties and interest paid to the IRS were lower than interest rates charged by traditional lenders.
I bring you the story of Aluria Software LLC because Matt and Jamie successfully built it into a million-dollar business. Their strategy did not get them into big trouble. Aluria is one of the few companies that managed its funds successfully using this strategy, until it got bought out—for millions of dollars.
Generally, when companies start tapping into the tax coffers, they’re signing the death knell for their business. They end up like Klaus, whose business and marriage are both in jeopardy.
Worst-Case Scenario
Did I forget to tell you? Getting behind on your estimated taxes may destroy your marriage.
There’s this whole snowball effect. First last year’s estimates. Then this year’s taxes. Then the IRS is attaching your bank account or levying your spouse’s wages. Then your children start noticing that you’re afraid to answer the phone or get the mail. You start losing sleep. Then you start quarreling with your spouse—usually over nothing. I cringe when I get calls from certain clients. I know they’re into this loop. They’re depressed. They can’t work through their problem. They won’t follow my advice, and their business starts going down the tubes. Then the spouse calls.
While people are most afraid of going to jail over their tax troubles, that’s not the worst thing that can happen to you. After all, in jail you get room and board, plenty of exercise, and a library to use. You won’t work any harder than you do now—probably fewer hours, even. The worst thing isn’t going to jail. No, the worst thing is staying home—watching your home, family, and reputation fall apart.
Am I scaring you? Well, I’m trying to.
Sorry, my friends, but I’ve been doing this for a long time, working with people who think the rules don’t apply to them. Your tax professional probably isn’t dealing with this—he or she is sending those failures to people like me. There are a few of us in each town who work with taxpayers in trouble. We’re not the ones running those ads on the radio or television, collecting huge fees. But the pros know who we are. People only come to us by word of mouth. It’s a gut-wrenching business. I hate this part of my practice, and all of us in it want to do less of it. The only way for that to happen is to convince you not to get into trouble. So . . . don’t monkey with your tax obligations.
If you can’t afford your estimated payments now, what makes you think you’ll be able to pay them in April? It’s time to look at your budget and see what’s wrong.
The only solid reason to delay those payments is when your business is cyclical. If much of your income comes in over the Christmas shopping season, for instance, or during the first quarter—you know you’ll have the money in time.
Computing Your Estimated Installment Payments
Ideally, at this point in the book, you should sit down with the tax advisor on your team (see Chapter 1 to review). Figure out your payments, project your income, and estimate your profits, from all sources. Prepare for the meeting by making a list of your investments and how much income you expect. Do a realistic projection of your business profits. Your business plan from Chapter 2 and your accounting records from Chapter 4 should come in handy now. Run those numbers through one of the free handy online income tax estimator tools. Use the tax estimator calculators at TurboTax.com, H&R Block, or 1040.com.
Have your tax professional review the results to determine whether to revise your tax projections.
The main reason to use electronic brains like the online calculators is to compute self-employment taxes, Schedule SE (which you learned about in Chapter 9), and alternative minimum taxes, Form 6251. Whenever I see people guesstimating their tax liability, those are the two big surprises they get on April 15th. You think you have no taxable income because your mortgage, property taxes, and child tax credit swallowed up your taxes. Then these two taxes rear their ugly heads.
Self-employment taxes amount to 15.3 percent of your business profits from Schedule C or your Schedule 1065 K-1.
The alternative minimum tax limits and rules have changed several times during each presidential administration, and Congress is always talking about changing them. All you need to know is that if your itemized deductions are too high or your income reaches certain levels, you will owe taxes you didn’t anticipate. You can easily look up the alternative minimum tax levels by scrolling down this page on the Small Business Taxes and Management website—http://www.smbiz.com/sbrl001.html.
The original concept of the alternative minimum tax was to ensure rich people didn’t get away without paying taxes. Instead, it’s hitting the folks struggling to make ends meet.
There is one bright note about the alternative minimum tax. If you pay it this year, next year it generates an alternative minimum tax credit (Form 8801). That might reduce next year’s tax—unless you have another alternative minimum tax. Chapter 32 of IRS Publication 17 can tell you more.
These are the kinds of questions and issues to submit to the National Taxpayer Advocate. If you have a solution or a viable suggestion, Nina Olsen, the advocate, is open to your input. She writes an annual report to Congress, outlining problems taxpayers have had with the IRS and the tax system. She proposes fixes, which sometimes become legislation. The submission form is on the IRS website at https://apps.irs.gov/app/samsnet/IssueQualification.jsp.
Paying the Tax
Naturally, if you have the money, make the payment. Always put the form number, the tax year, and your Social Security number (and your spouse’s) on each check. (See the section on FYTIN in Chapter 13.)
The IRS is pushing its electronic federal tax payment system (EFTPS). Once registered, you can make all your estimated payments online. It’s actually a great idea. You can make your payment at the last minute, and you’ll get proof that you paid it. The input form asks you all the pertinent questions. You’re likely to get the payment applied for the correct tax year and to the correct account.
Is that important? You bet. If you don’t put the correct information on the check, the IRS doesn’t know to which form or year to credit the payment. This comes back to haunt you. It’s such fun having the IRS locate your payment and apply it to the right account and year. You’ll learn the IRS coded it wrong when you get a CP23 notice of underpayment (discussed in Chapter 13) for a year you thought you’d paid. So, yes, if you have access—pay online.
If you didn’t set up an EFTPS, you may pay by credit card. Chapter 13 tells you how. Since the information about how and where to pay changes so rapidly, it needs to be maintained online.
Tips to Reduce Penalties for Underpayment of Estimated Tax
The IRS bases its penalty computation on the date and amount of your payments. Here’s a way to make a December payment look like it was paid on time. Change it from an estimated payment to withholding.
Withholding
Did you know that when your taxes are taken out of your paycheck, the IRS treats all the withholding as if it had been paid in evenly throughout the year? Even if you had a total of $1,000 withheld from January through November and then paid in $20,000 in December, the IRS doesn’t blink. This is something doctors and lawyers have been doing for decades. But it’s not the greatest idea. It means scrambling during the most expensive gift-giving time of the year to come up with big chunks of cash to cover taxes.
While I really don’t recommend that you handle your payments that way, it does give you a way to avoid late-payment penalties when you get behind in your estimated payment schedule. After all, if you’re reading this book late in the year, there’s a chance you haven’t kept up with estimated payments until now. You didn’t realize how important they were. Now you want to catch up and avoid the penalties.
How does this help when you’re in business? If you have a spouse with a job, arrange to increase the withholding for his or her last paychecks of the year. You may even need to deduct everything except $1, so your spouse still gets a check. Will he or she be angry? Not if you hand over the money you would have mailed in for withholding.
When your spouse has a job, it’s much easier just to increase his or her withholding all year long. We did that with my husband’s paycheck when I operated as a partnership. I didn’t need to pay as much each quarter. Now that I am an S corporation, I am on payroll—and taking withholding out.
Another Withholding Option
When being paid as an independent contractor by your own company or a customer’s, you have the option of requesting withholding from your fee. There’s even a box on the Form 1099-MISC to allow for this. (See Chapter 9.) Take advantage of this option and deduct withholding from each remittance, if it can make your life easier.
Note: Beware! If you have a tendency to be behind on your tax payments, the IRS can mandate that your clients and customers take withholding from your fees and checks.
Annualized Payments Method
When you file your tax return, use the worksheet on page 4 of Form 2210, Underpayment of Estimated Taxes by Individuals. With good bookkeeping software, getting the information you need is easy. You must be able to compute your net profits from January through the end of these months: April, June, September, and December. Armed with this information, you or your tax pro will have to allocate your deductions to each period. You’ll need to know when you paid big medical bills, made large charitable donations, or bought the expensive employee tool. Apply all the deductions to the appropriate time frame. Then follow the computations. Better yet, have a computer do it.
I’ll tell you right now, unless you owe tens of thousands of dollars’ worth of tax, the time investment to fill in this page is prohibitive. Remember, you might save $100 in penalties and pay your tax pro $150 to work out the numbers. (It’s not that bad, but it should be.)
This is only worth doing if the substantial part of your income was received in the last three months of the year—or your big expenses happened in the beginning of the year. Otherwise, it won’t save you much.
Don’t Overpay Your Estimates If You’re in Trouble
Perhaps in the past you got into trouble with the IRS or a state. Perhaps you have a former spouse chasing after you for support. Or suppose you’ve defaulted on your student loan or ignored traffic tickets. Until you clear up those problems, the IRS will be grabbing your refunds. (These are called “offsets.”) In your case, you’re better off owing a little bit, rather than shooting for a big refund. You won’t get it.
The best idea, however, is to clear up those old debts or get on a payment plan (which we’ll discuss in Chapter 13) so the IRS doesn’t embarrass you in your business. The last thing you need is for your employees or vendors to get wind of your tax woes.
Basically, though, if you just follow the guidelines at the beginning of this chapter, the whole process is easy.
Estimated Payment Resources
• Form 1040-ES, Estimated Tax for Individuals. https://www.irs.gov/pub/irs-pdf/f1040es.pdf.
• Form 2210, Underpayment of Estimated Taxes by Individuals. https://www.irs.gov/pub/irs-pdf/f2210.pdf.
• Form 6251, Alternative Minimum Tax—Individuals, Estates, and Trusts. https://www.irs.gov/pub/irs-pdf/f6251.pdf.
• Form 8801, Credit for Prior Year Alternative Minimum Tax—Individuals. https://www.irs.gov/pub/irs-pdf/f8801.pdf.
• IRS Publication 17, Chapter 32. https://www.irs.gov/publications/p17/ch32.html.
• IRS Publication 505, Withholding and Estimated Payments. https://www.irs.gov/publications/p505/ch02.html.
• Links to all states’ tax forms. http://www.taxadmin.org/state-tax-forms.
• TaxMama’s payment and installment agreement information. http://taxmama.com/category/installment-agreement/. Scroll down to see the articles and posts.
• The Taxpayer Advocate’s Suggestion Page. http://taxpayeradvocate.irs.gov/submit-a-suggestion.
• Thomas, the Library of Congress’s searchable legislation database. https://www.congress.gov/.
• TurboTax Income Tax Liability Estimator and other tools. https://turbotax.intuit.com/tax-tools.
• H&R Block Tax Liability Estimator and other calculators and tools. https://www.hrblock.com/get-answers/tax-calculators.html#/en/te/aboutYou.
• Small Business Taxes & Management website quick look-up for AMT, and other annual limits. http://www.smbiz.com/sbrl001.html.
• TaxMama’s Quick Look-Ups. http://iTaxMama.com/TM_QuickLookUp. You will find all kinds of useful reference materials, webinars you can replay, e-books, and more.
• Your Business Bible. http://www.yourbusinessbible.com. Look for worksheets, printable checklists, and other goodies and resources.