Estimated taxes are hard to pay at the best of times – none of us enjoys handing over one third of our hard-earned income to Uncle Sam each tax quarter – but what do you do if you can’t pay your estimated taxes?
If your small business has cash flow problems, cash management issues (i.e. you don’t have the right controls in place), or you simply weren’t aware that estimated tax payments are required (it happens, especially for freelancers) – then you have a problem.
Before we take a look at some options for addressing a crisis like this, let’s take a look at the IRS requirements for estimated business income tax payments.
Who Must Pay Estimated Taxes?
As a business owner you don’t withhold taxes on your own pay check in the same way you would as a W2-based employee. However, since the U.S. has a pay-as-you-go tax system, you’re still required to pay taxes on any income that you haven’t already had tax withheld on. Now, since you don’t have a fixed annual income (unlike salaried employees), you’re required to estimate your taxes on a quarterly basis.
As a rule of thumb, if you operate any kind of business and expect to owe more than $1,000 in taxes during the year then you’ll need to make estimated tax payments to both the IRS and your state revenue office (who you’ll need to contact to get estimated tax forms and information).
How do You Calculate Estimated Taxes
There are two ways to calculate your estimated taxes.
1) Based on last year’s income – Using this option, you’ll pay 100% of the tax shown on last year’s return, 110% if you made over $150,000. If you have a steady income with little overall growth, this is the best way to go.
2) Based on your current year’s income – Using this option the IRS requires that you pay at least 90% of the tax owed for the year, spread over the course of each tax quarter. Many business owners prefer this method because it means you’re literally paying-as-you-go based on realized income and expenses for that quarter. It’s also a good option for seasonal businesses and those who experience inconsistent income. But be careful, if your total estimated taxes paid for the year add up to less than 90% of what you owe, you may incur a penalty.
If you use tax preparation software it will calculate the amount owed for you. The IRS also provides information on how to calculate your estimated taxes.
If you go with option two, make sure you keep good records both of income and expenses (profit and losses) this will ensure you only pay what you owe!
The IRS installment payments are due on April 15, June 15, September 15 and January 15 of the following year. You can skip the final payment if you file your return and pay all the tax due by February 1. Although most states follow the same due dates, some do vary slightly, be sure to check the protocol where you live.
What if You Can’t Make your Estimated Tax Payments?
As a business owner, skipping your taxes is never a good idea.
If you owe taxes, but fail to pay or think you can delay your payment until the next quarter, you will be assessed a penalty in the form of interest on the underpayment for the period. You’ll also be left with a potentially huge tax bill come April 15. Now, before you start breaking out in a sweat, the penalty isn’t quite as bad as it sounds, for example, if your underpayment is small, the penalty of course will be less. Also if you make higher payments in subsequent quarters the period during which you’ll be charged interest is reduced.
That being said, many small business owners often opt to pay the penalty at the end of the year rather than losing income during the business year to estimated tax payments. This is ok, but be sure to pay all taxes owed by the end of the tax year (April 15) to avoid additional interest and penalties.
If you find yourself consistently unable to make your estimated tax payments then it’s time to take a look at your financial management practices and see if there are things you can do to better prepare for the inevitable. Here are a six things you might consider:
- If you’re new to business ownership or have struggled to manage cash in the past, plan on putting aside at least 30% of any income into a separate bank or savings account – somewhere you won’t be tempted to touch it and where it will reside until you need to make that payment.
- If you’re a freelancer and are employed full or part-time by someone else, consider increasing your withholdings there to offset or eliminate the need to pay estimated taxes.
- Do everything you can to maximize and track your deductions, these will offset the estimated taxes you need to pay each quarter.
- Develop a cash flow estimate (aka cash flow statement). This will help you predict future cash flow and help you predict any dry periods that may compromise your ability to pay your estimated taxes, and give you time to plan accordingly.
- Try to find the money. Whether it’s chasing clients to pay ahead of time, seeking out new work quickly, falling back on your credit card (only if you can pay it off quickly), or solving short-term cash flow issues with services like those offered by Fundbox, look for sources of potential money.
- Pay as much as you can as soon as possible. The IRS won’t come after you immediately if you pay less than you owe and no special permission is required (in fact the IRS can be quite lenient in this regard). As mentioned above, paying the underpayment penalty can be less costly for some business owners than dipping into their valuable cash assets during the year. And it’s always best to show some payment activity, if you owe taxes, than none at all.
The Bottom Line
The quarterly estimated tax system can make it easy to forget about your obligations, but don’t sweep your tax responsibilities under the carpet until it’s too late. With proper budgeting, record keeping and cash flow management those payments needn’t be a headache and can be keep you on the IRS’s good side!
Disclaimer: The information in this blog doesn’t replace the advice of a tax or financial expert. If you have any questions about your small business tax situation, talk to a professional.
About the author:
Fundbox is a technology company that is fixing the small business economy. Fundbox is helping SMBs, freelancers and home offices grow by managing their cash flow better and by overcoming short term cash flow gaps.