Sole Proprietor Taxes
Copyright 2010 by Morris Rosenthal - - contact info
Copyright 2010 by Morris Rosenthal
All Rights Reserved
Estimating Business Taxes, Paying Estimated Taxes and Underpayment Penalty
Warning: These pages are not intended as professional advice. They are presented "as is", reader beware!
As a sole proprietor of a small business, you are required to estimate your taxes for the year and make quarterly estimated payments. It's a good new bad news scenario, so let's look at the good news first. By forcing us to make estimated payments, the government is essentially taking care of tax planning for us, it's not something you can simply procrastinate or say, "I'll save for that later." And it's not a small thing, since you can easily end up owing 40% or more of your gross income in taxes if you don't have many Schedule C deductions and live in a state with income tax. There's not much you can do to lower your tax burden if you get past the end of the year and find that you've underpaid, other than making the maximum contribution to a retirement account, and that will only help with Federal Income tax, not self employment tax or state income tax. If you get to December and find that you've underpaid, you may be able to make it up in your final estimated payment on January 15th without owing a penalty , but it depends on the amount and the system you use to file (regular payments or annualized). Don't try to buy a bunch of junk you don't need in December just to lower your tax burden. It's money you'll never see again.
It pays to check updated publications the IRS releases every year because they sometimes make changes in tax rules to accommodate economic conditions. For example, I was surprised to see that for 2009 the safe harbor amount for paying estimated taxes was decreased for most home businesses. The conditions are that you must have less than 500 employees, derive at least 50% of your income from your small business, and have a 2008 AGI (Adjusted Gross Income) of less than $500,000. If your business meets those conditions, you only need to pre-pay 90% of your previous year (2008) taxes, or 90% of your current year (2009) expected taxes, to avoid owing any penalties. This doesn't change the amount you'll be paying in the end, but it makes tax planning a little easier because you have more flexibility in holding onto cash to during the down-turn, at least until the next April 15th rolls around.
There are a few exceptions to the requirement to pay estimated taxes, the easiest of which to meet is if you had no income (filed no taxes) the previous year, despite it being a 12 month tax year for you. This often applies to recent graduates starting their first business, if they didn't work or file taxes while in school. The other major exception is if you expect your total tax liability will be less than $1000 for the year. Since this includes self employment tax (Social Security and Medicare), you aren't going to qualify unless your only income is from your business and you just aren't making much more than $7,000, unless you are expecting some serious tax credits from buying a new home or low income to offset the money you did earn. It would require pretty careful tax planning to estimate an eventual liability of under $1,000 based on credits, but the estimated tax forms and examples in IRS Pub 505 do cover those eventualities.
If it's your first year in business, your experience in estimating taxes will be understandably limited. If paid over $1000 in income taxes in 2008 and are filing Schedule C for the first time in 2009, the easiest approach is to make the four regular payments based on 90% of your 2008 taxes. But if you made really good money as an employee the previous year and expect relatively little income your first year in business, it's probably worth going through the whole 1040-ES estimation process to get a lower payment and conserve cash. But read through pages linked in the sidebar for a basic understanding of the factors that will go into the estimate.
I've run a home business as a sole proprietor for the last 17 years running and have never been penalized for underpaying, despite the fact that I don't remember the last time I actually went through the 1040-ES estimate. In fact, I often guess my Federal tax liability within a couple tens of dollars (within one tenth of one percent), and the other safe harbor provision is that you won't face a penalty as long as your underpayment is less than 10% of the total. I suspect the standard 10% error band is where they got the 2009 safe harbor amount of 90% of the previous year or actual year taxes. In previous years, the safe harbor provision was that if you made estimated tax payments of 110% of the previous year taxes, you couldn't be penalized, so the drop to 90% is a pretty big deal. The key to properly estimating your taxes is having been in business the prior year and being aware of what's changed. It's not as simple as saying, "Well, I grossed $25,000 last year and it looks like I'm going to gross $50,000 this year, so I'll double my estimated payments," because your marginal tax rate will have jumped from 10% or 15% to 25% on a chunk of that income. But by doing your taxes yourself, you'll become reflexively aware of the factors involved and find you can estimate your taxes in your head with a high degree of accuracy.
You'll never master tax planning for your home business unless you file your own taxes at least once, and preferably, for several years. And it's far more educational to file your taxes by hand, using the paper forms, than to utilize an interview-style computer program. If you are filing for the first time and terrified of making mistakes, then first take the time to fill out the forms and complete the worksheets on paper, then use a computer program. You'll be amazed how much you learn, and when you talk to friends who have businesses of their own, you'll be even more amazed to find out how little they understand about tax planning themselves. Most small businessmen I know don't really have a clue how taxes work, just a foggy idea that the more they spend on the business, the less they'll pay in taxes. There's simply no relation between building a small business for income or sale, and spending money on business toys to lower your tax rate. You could do worse than to skim through the whole collection of tax pages on this site just to get an overview.
The first estimated tax payment is due on April 15th, after which there's just a two month break to the second payment on June 15th, three months to the third payment on September 15th, and then four months to the final payment on January 15th. If you don't have any income before April 1st, you can skip the April 15th payment, and the same two week buffer holds through the year, ie, nothing before June 1st, no June 15th payment, etc. Otherwise, an individual starting a business in the middle of the summer would be liable for quarterly payments from before the business existed, which would be an impossible tax planning challenge:-)
The bad news is that there are penalties for underpaying are based on the number of days during which the amount that should have been paid remained unpaid, at a fixed interest rate. Of course, to make it interesting, the IRS switches that fixed rate between 5% and 6% depending on the quarter of the year. You can also just check off that you want the IRS to figure your penalty and send you a bill if you work out that you're going to owe a penalty. The moment of truth doesn't come until you finish your 1040 filing, at which point you can compare the total amount you owe with the the amount you prepaid in estimated taxes, and if it's within 10% (there's no penalty for overpayment that I know of) or is at least 90% of the amount you owed the previous year, you should be OK as long as you made regular payments (four even payments based on the estimate for the year). If you pay annualized income installments, like I used to do when my income was less regular, it's conceivable that you could still be penalized for not paying enough for the income during an early quarter of the year even though caught up by the end.
If you get to the end of the quarter, say it's the 15th on which a payment is due and you haven't mailed it yet, you can avoid a late payment penalty by paying directly rather than mailing a check. The EFTPS (Electronic Federal Tax Payment System) is set up for direct withdrawals from your bank account (something I'm not enthusiastic about signing up for), wire transfers, and payment by credit card. The credit card option will include fees, there are currently two companies handling credit card estimated tax payments, I'm including their phone numbers without having used either myself: 1-800-272-9829 or 1-888-729-1040.
If you find you have underpaid your estimated taxes and face a penalty, you can always try filing Form 2210, which you have to fill out anyway if you're going to compute the amount of the penalty, but the IRS strongly advises against trying to figure out the penalty yourself. You have to attach a statement of why you believe you deserve a waiver to Form 2210, but you don't need to fill out the whole form (ie, compute the penalty you are asking to be waived), the IRS will do that for you. If you are asking for a waiver, the main out is be located in a disaster area, but the IRS leaves the door wide open by suggesting you can request a waiver as long as the penalty would be inequitable. The main reasons they mention are casualty, ie, if you can show that your business was destroyed by an earthquake or you were hit by a car and couldn't function, disaster, and "unusual circumstances." They don't offer an examples of unusual circumstances, but I'm guessing if you've been in business for years and something unexpected happens this year to really mess up your finances, it would be worth asking.
Planning A New Business | Estimating Business Taxes | Schedule C Deductions | Car Expenses | Freelancer and Contractor Payments | Section 179 Depreciation and Form 4562 | Employee Benefits and Pension Costs | Professional Services, Business Taxes and Fees | Hotel and Travel Expenses | Deducting Food and Entertainment | Inventory and Cost of Goods Sold | Sole Proprietor Statistics | Home Office Deductions | Self Employment Tax | The Self Employed Sole Proprietor