The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.
The Federal income tax is what is known as a “pay-as-you-go” tax. This means that people and businesses are required to pay taxes as they earn income throughout the year. For anybody who is an employee, this is easy. In fact, it’s done automatically in the form of withholdings from employees’ paychecks. However, things work differently for business owners. When your customers pay you for your products or services, there’s obviously no money withheld to go toward income taxes.
The government’s solution is to require you to make tax payments at approximately quarterly intervals throughout the year. These payments are known as estimated tax payments, because the amounts you pay are based upon an estimate of your total tax liability for the year.
How to Calculate Your Estimated Taxes
Sole proprietors use a worksheet that accompanies Form 1040-ES to calculate their required estimated tax payments. Generally speaking, the amount of estimated tax you are required to pay for the year is the smaller of:
- 90% of your tax for this year, or
- 100% of your tax from last year.
Given the inherent difficulty in predicting what your tax liability is going to be before you know for certain what your business income will be, it’s generally recommended to make estimated tax payments based upon the “100% of last year’s total tax” option. Assuming you use this option, each of your four payments will generally be equal to 25% of the total tax you paid last year.
There is an exception for high-income taxpayers: If your adjusted gross income was $150,000 or more last year, instead of being able to base your estimated payments on 100% of last year’s total tax, you will be required to base your payments on 110% of last year’s total tax.
Due Dates for Estimated Taxes
Self-employed taxpayers are required to make four estimated tax payments each year. The due dates are as follows:
- For the period January 1 – March 31, payment is due April 15.
- For the period April 1 – May 31, payment is due June 15.
- For the period June 1 – August 31, payment is due Sept. 15.
- For the period September 1 – December 31, payment is due January 15 of the following year.
Note that this isn’t every three months exactly. Don’t make the mistake of assuming it’s quarterly, or you’ll end up making your second payment on July 15, and it will be a month late.
Also, please be aware that this means that on April 15, not only is your annual filing for the previous year due, but your first estimated payment for the current year is due as well. For instance, on April 15, 2016, a self-employed taxpayer will be required to file her Form 1040 for 2015 as well as make her first estimated tax payment for 2016.
The one exception to these due dates is for the January 15 payment. A taxpayer can skip the January 15 payment if, by January 31, he files his Form 1040 and pays his remaining taxes for the year just completed.
Consequences of Not Making Estimated Tax Payments
The penalty for underpayment of taxes is calculated as a function of current Treasury Bill rates, so it varies from year to year. The penalty for 2014 was figured at an annual rate of 3%.
- In contrast to employee-taxpayers who have taxes withheld from every paycheck they receive, self-employed taxpayers have nothing withheld when they receive payments from clients. Instead, self-employed taxpayers are required to make four payments of estimated taxes each year.
- Estimated tax payments for each year are due on April 15, June 15, September 15, and January 15 of the following year.
- Generally, the easiest way to avoid penalties for estimated taxes is to make each of your four payments equal to 25% of the total tax you paid last year (or 27.5% for high-income taxpayers). This will ensure that your estimated tax payments will total 100% of last year’s total tax.