Have you ever had an argument about the smartest person who ever lived? The discussion usually revolves around Einstein, Stephen Hawking, Leonardo da Vinci, Newton, among others. One person always throws out William James Sidis because he has the highest IQ ever recorded…show off. The argument then divulges into whether IQ is the sole marker for intelligence and so on and so forth. Being the smart aleck that I am, I always like to say it was Milton Friedman because he is the main person credited for coming up with the US Income Tax Withholding system which forever changed how we view taxes. But, I’m only half kidding.
Many people view their tax liability based on the amount they were refunded or owed in the prior year. “I got $1,200 back last year” or “I had to pay in $2,000.” They forget one big thing. Each paycheck that they receive takes money out to pay for federal and state taxes, among other things. They usually don’t realize that they may have paid in $10,000 throughout the year. All they think about is how much they paid/received in April. There is one exception to this general rule…small business owners.
Small business owners always know how much they pay in taxes. Here’s why. They must make payments every quarter! The average small business owner is paying 20-30% of their net income in federal and state taxes. Those checks do not go unnoticed. Owners must calculate their tax payment each quarter based on their net income projections for the year.
What happens if you don’t make estimated payments? I see this a lot with new businesses. Aside from the big tax bill you will pay in April, you will also be penalized for underpaying during the year. This creates a major burden for owners trying to grow their business. It becomes an ongoing issue because they end up getting behind each year trying to pay off the previous year’s taxes.
Here are some tips to help all you small business owners take care of your estimated payments throughout the year.
1) Keep good records – You must be able to estimate your Net Income each time that a payment is due.
2) Figure out your tax rate – Remember, this will be your personal tax rate for almost all of you. There are many online calculators that can help with this. You can also ask your tax preparer.
3) Don’t forget Self-Employment Tax – Small business owners must pay the employer and employee portion of payroll taxes (Social Security, Medicare, etc.). This tax is 15.3% of your self-employment income. That is in addition to your regular income tax rate.
4) Compare to last year – Does this payment make sense based on your prior year return and the amount of income tax you paid?
5) Set aside money – Now that you are keeping good records, set aside money each month for your quarterly tax payments. Some people prefer to keep this money in a separate savings account.
6) Withhold extra from paychecks – If you or your spouse still earns a paycheck, you can withhold extra instead of paying the full quarterly amount. Your business is taxed on your personal return so these withholdings will be included in your estimated payments.
7) Ask for advice – Don’t be afraid to contact a tax professional to help estimate your quarterly payments. They can make sure you won’t be in for a surprise in April.
Estimated payments are extremely important. This post is meant to help you understand why they are important and how to develop a routine to make the payments. Small business owners can get into a big mess if they don’t make estimated payments. Luckily, for those of working as an employee, Friedman took care of this years ago.
Do me one favor after reading this. Find your last tax return and look at Line 63 on page 2. That is how much tax you paid. Split that into quarterly payments and imagine having to write those checks. Yes, you are still in the same situation financially, but we all know it is easier to take a little out of each paycheck. Just try to keep that in mind when you listen to small business owners discuss taxes. The calculation may be the same, but the process is very different. A process that can invoke strong emotions.
Mike Zeiter, CPA/PFS