Estimated taxes. Every entrepreneur, small business owner, and creatives worst nightmare. Here are 6 steps to simplify the estimated tax payment process.
Quarterlies. Estimated Taxes. 1040-ES. Huhhhh. All you want to do is comply with the IRS and pay your share of taxes. You can’t help but hear the horror stories told by fellow entrepreneurs. A six-figure tax bill… Five figure penalty… An audit… You don’t want to tell your own horror story so you set out on a quest (because it’s no small task to figure this stuff out) to do the right thing.
There’s so much misinformation… confusing tax jargon… forms and worksheets…
What a headache!
Let me simplify things for you.
When to Pay Estimated Taxes
If you’re making money in your business, you should set aside money for taxes and remit it to the IRS (and state if applicable) every quarter.
The IRS says,
“Taxes must be paid as you earn or receive income during the year, either through withholding or estimated tax payments. If the amount of income tax withheld from your salary or pension is not enough, or if you receive income such as interest, dividends, alimony, self-employment income, capital gains, prizes, and awards, you may have to make estimated tax payments. If you are in business for yourself, you generally need to make estimated tax payments. Estimated tax is used to pay not only income tax but other taxes such as self-employment tax and alternative minimum tax.”
In plain English, that means you must pay taxes, and if you are self-employed, you do not have anyone to withhold taxes on your behalf (like an employer), so you have to send the taxes in yourself.
Easy-peasy, right? Let’s keep going.
What Does Self-employment Tax Go Towards?
When you pay self-employment taxes, you are paying into Social Security and Medicare. You are paying the same taxes as if you were an employee except you are paying the employee and employer portions.
The self-employment tax is broken down like so:
12.4% for Social Security (only the first $118,500 of earnings is subject to social security)
2.9% for Medicare
15.3% tax rate
The self-employment tax is in addition to ordinary taxable income, so you may have a situation where your regular tax is $1,000 then you would owe an additional $153 in self-employment tax. Lucky for you, the IRS decided to be a little helpful. You can take half (50%) of the self-employment tax as a deduction against your income.
Entity Choice Matters
I would totally not be serving you if I did not bring up entities and how they play a huge role with your taxes.
There are three primary business structures that the majority of small business owners, creatives, and entrepreneurs use:
- Sole Proprietor
- LLC (Single-member/Multi-member)
Sole Proprietors include independent contractors, freelancers, and any business you are operating yourself and haven’t created a separate entity. Sole proprietors file business income on their personal return by adding a Schedule C with their Form 1040. Self-employment tax is calculated from the net profit (income – expenses) shown on Schedule C. Information from the Schedule C is used to populate Schedule SE which will show your self-employment tax due.
Single Member LLCs are classified as a sole proprietor according to the IRS. The same rules apply as above.
Multi-member LLCs are taxed as a partnership by the IRS. They are required to file a Form 1065. Each member will receive a Schedule K-1 with the individual member’s share of profit/loss and amount subject to self-employment tax.
S-Corporation is a corporation with S status approved by the IRS. The S-Corp will file Form 1120S and is required to provide each shareholder and board member a Schedule K-1 showing their basis (how much money they have invested in the business) and any amounts subject to self-employment tax.
Why You Should Pay Attention to Estimated Taxes
- If you fail to send estimated tax payments and your balance due at tax time is greater than or equal to $1,000 then you will be penalized. Of course, the calculation is a long unnecessarily complicated formula. The majority of DIY tax prep, big box, and professional tax software will automatically calculate the penalty.
- You are forced to stay on top of your books. You do not want to send the IRS way more money than what they are entitled too. So unless you are ok with that, you will be forced to check-in with your books at least quarterly to see if you need to make any adjustments to your estimates.
Putting it All Together (Step-by-Step)
Here are the steps to go about calculating your taxes. If you would rather outsource this task to your accountant (kudos to you), you should still have a basic understanding of what’s involved in case the need to make any last minute adjustments arises– such as you landing an important contract worth major bucks, for example.
- At the very least, review your books quarterly. Make sure everything reconciles and is up-to-date. With your accounting system in place, this should not take you longer than an hour.
- Run a profit and loss report for your business(s)
- Plug your numbers into the Estimated Tax Calculator and print (or save to Evernote or the cloud or wherever) the results.
- Add the quarterly payments in your accounting system (QuickBooks, Xero, Wave, etc) as a bill with a due date matching the quarterly due dates.
- When the time comes you can send your payments online via irs.gov/payments, pay by phone, mail, or direct debit using EFTPS. Visit irs.gov/payments for all the details.
- Update your accounting system after payment with a copy of the receipt and transaction details. You could also use a handy dandy spreadsheet to capture all the deets.
I hope you learned a thing or two about estimating your taxes. My final two tips are;
- Be proactive! If you fail to plan, plan to fail, or pay the IRS more money than you should.
- Always. Always. Always mind your numbers. Even if you outsource your accounting, bookkeeping, and taxes you should still know, understand, and love your numbers.
Now go forth and prosper! You awesome entrepreneur.
How have you handled estimated taxes? Let me know in the comments.
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