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Estimated Taxes for The Ant & The Grasshopper

Every year I see & hear horror stories about estimated tax payment gone wrong. I’m not sure which is worse, the person who didn’t have any idea they needed to make tax payments for both income and self-employment taxes or the person who set aside the money then used it as a down payment on a house, boat or to buy shares in some shady investment scheme.

The problem with estimated payments is not only are they confusing, but the “right” way to make estimated payments depends entirely on your personality and your financial situation.

For instance, if you’re hit with a whopper of a tax bill come April 15th, will you be able to blithely write out a check or will you be in a frozen panic? Does it gall you to get a big refund knowing the US Treasury has had the free use of your money throughout the year? Or is that new sports car irresistible, knowing there’s stash of cash in your savings account, never mind that it’s for your upcoming tax bill?

You’ve probably never considered Aesop’s fable The Ant and the Grasshopper in the context of tax payments before. :) But if you’re a Grasshopper, you’ll probably succumb to the sports car temptation or not have the cash to fork over for a big tax bill in April. But if you’re an Ant, you can probably either write that check if necessary because you either have it anyway or were able to save for it.

So you when you’re deciding how to approach your estimated taxes, first consider if you’re an Ant or a Grasshopper!

Estimated Tax Payments for the Ant

The Ant will want to pay the minimum amount necessary to avoid the underpayment penalty. You may still have a big tax bill at the end of the year, so you may need to put some aside for that too.

The rules for avoiding underpayment penalty are pretty straight forward. If you meet any of the following requirements you won’t be subject to the underpayment penalty.

  1. The amount due on your tax return is less than $1000.
  2. You had no tax liability the previous year.
  3. Your estimated payments were 90% of the current year’s tax liability.
  4. Your estimated payments were 100% of last year’s tax liability (or 110% if your current year AGI is over $150,000 if married, $75,000 single).

So the easiest way to avoid the penalty is to pay 100% of last year’s tax liability. If you think your AGI will be anywhere close to the $150,000/$75,000 limit, pay 110%. Reduce the prior year’s tax liability by any amounts that will be withheld for federal income tax on your W-2 paycheck, and then pay 25% of that number on April 15th, 17% on June 15th, 25% on September 15th, and 33% on January 15th. Or if you like to keep thing simple, each payment can be 25% of the prior year’s tax liability.

Remember you could still have a large tax liability in April even though you’ve avoided the underpayment penalty.

If you’re prior year’s tax liability was abnormally high you’ll want to meet the 90% requirement. That requires attempting to figure out what your actual tax liability will by for the upcoming year. This is nearly impossible! You’ll never be exactly correct, except by chance. This is what the poor Grasshopper is going to have to attempt so read on…

Estimated Tax Payments for the Grasshopper

If you’re a Grasshopper, then you’re going to want to pay as much of your tax liability through out the year as possible to avoid a big payment come April 15th. You also may not mind a bit of refund, because that will give just you some extra spending money. Am I right? :)

So you’re going to set aside a portion of any income that you make that doesn’t have some withholding for taxes. For instance, if you’re just getting a W-2 paycheck, you shouldn’t worry about that income. But if you’re getting IRA distributions, interest income or alimony that doesn’t have withholdings on it, or if you have income from a sole-proprietorship, partnership, LLC or S-Corp that will end up on your 1040, then you’ll need to set aside something for Uncle Sam.

As a Grasshopper, it might be easier for to send payments to the IRS on a more frequent basis than quarterly. For example, it might make sense for you send payments to the IRS monthly. There’s nothing that says it has to be done quarterly. With EFTPS, you can have payments sent directly from your bank account to the IRS. You can make them as frequently as necessary. It might be an easy thing for you to review your income once a month and then make a payment to the IRS by the 15th of the following month.

But how much to pay? If you expect this year to be pretty much like last year, your total estimated payments should be 100% or 110% of last year’s tax liability. If not, here’s a simplified calculation that I’ve found works well. It’s not exact, but it will probably keep you out of trouble. First, you need to separate your income into three buckets:

  1. Income that is only subject to ordinary income tax but isn’t subject to tax withholding like
    • Interest Income
    • Short-term Capital Gains
    • S-Corp Business Income
    • IRA Distributions
    • State Income Tax Refunds
    • Non-Qualified Dividends
    • Alimony Received
    • Subtract: any alimony paid, IRA/Retirement Plan contributions
  2. Income that is subject to ordinary income and self-employment tax, like
    • Sole-Proprietorship Net Income (Schedule C)
    • Partnership Net Income
    • LLC Net Income
    • Income that is subject to long-term capital gains rates, like
      • Qualified Dividends
      • Long-term Capital Gains

If your annualized income is less than $200,000 married, $100,000 single multiply the total in Bucket #1 by 20%, multiply the total in Bucket #2 by 35% and multiply the total in Bucket #3 by 15%. If your income is over that, then add 5% to the percentage applied to Buckets 1 & 2.

These percentages are estimates but they’re based on experience. These percentages might also be too high if you lots of tax credits. They might be too low if your income is significantly over $350,000.

The 25% on ordinary income will make sure that you’re making the necessary payment if your income is over $200,000 (married) and you caught in 26% flat AMT. There’s an exemption that will keep the actual percentage in the 25% range.

The 35% on self-employment income covers the 20% of ordinary income above plus 15% for self-employment taxes.

The 15% for long-term capital gains & qualified dividend is actually what you’ll owe if you’re in the 25% tax bracket or above.

Keep in mind these are very rough estimates and they’re likely to over estimate your tax. Remember we’re trying to avoid a big payment and a refund will be acceptable. But no matter what you’ll never be able to exactly estimate your actual tax liability unless you have a very fixed income. Remember to use last year’s tax return to help you fine tune the applicable percentages in future years.

Whether you’re an Ant or a Grasshopper, you may be interested in IRS Publication 505, Tax Withholding and Estimated Taxes which goes into the gory details of trying to make a more accurate estimate of your tax liability and goes over the rules and exceptions for making estimated payments.

Remember we have a pay-as-you-go tax system. Pay your taxes on time and keep the IRS happy and out of your life… as much as possible anyway.

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Maybe I missed something

Maybe I missed something but you stated:

"First, you need to separate your income into three buckets"

I only see two (2) headings listed, what is the third bucket?

Bill
....

Quarterly Taxes for S Corp.

What form does one use when paying quarterly taxes for an S-Corp?

Does the taxes paid go toward one's Social Security Taxes or Federal taxes?

--Scott

www.24hourapartments.com
www.roommatesville.com

No Tax for S-Corp

The S-Corp does not pay federal income taxes directly. Rather the income passes to the shareholders and they must make the estimated taxes. Usually this is through form 1040-ES or Electronic Federal Tax Payment System (EFTPS http://www.eftps.com)

Shareholder-officers are employees of the S-Corp, by law. They must receive a "reasonable salary". Those wages are subject to Social Security, Medicare & Unemployment taxes. The S-corp income that flows to the personal return is not subject to the SE-Tax.

Does that help?
L:)

Estimate Tax for S-Corp and Owner/Employee (Difference?)

Linda - thank you for the all the information you have provided. It's very helpful!

I started an one member/owner LLC (me) in CA in March 08 with election to be treated as an S Corp. I have made only $2,500 in April and will be making about 10,000 each in the 2nd and 3rd calendar quarters. I may be contracting for more later but not sure at this point. I will be paying myself on an as needed basis (not consistent every month). Here are my questions:

1) I did not have any tax liability (did not owe taxes) for 2006, do I have to pay estimate tax for 2007?

Even if I don't have to pay for 2007, it would help if I could get information on what to do next year:

2) When making estimated tax payments, do I do it using the S-Corp EIN or the separate individual EIN issued to me by the IRS?

3) Assuming the S-Corp will make $40,000 gross this year with $20,000 paid to me as employee and another $10,000 in deduction/expenses, how do I calculate how much estimated tax I owe? What percentage do I apply? Does the S-corp or the employee pay these?

4) Is the quarterly estimated tax the same as the SS and Medicare tax paid on the employee wages? If not, can I pay the SS/medicare wages every time I pay myself? How do I calculate that? Does the S-corp or the employee pay these?

5) Do I have to pay something every quarter? What if the S-Corps doesn't make any money for that quarter and/or they don't pay the employee? Will this be penalized by the IRS?

Thank you in advance!

S Corp Taxes & Estimated Payments

Hi

Congrats on your new company! I'm glad this site is helpful. :)

1) No, for you personally. If your individual tax liability for the previous year was $0, then you are not required to pay estimated payments. However, for your S-Corp, CA requires you to pay the $800 minimum tax by April 15th (except for the first year). However, you may want to make payments to soften the tax bill for next year.

2) The LLC/S-Corps net taxable income will flow to your personal return. An S-Corp only pays federal income tax in very rare circumstances. So, you pay the federal estimated personally on Form 1040-ES (or EFTPS) using your SSN. I'm not sure what you mean about the other EIN issued by the IRS.

3) FICA taxes (social security & medicare) are paid by both the employer (your S-Corp) and the employee (you). When the S-Corp pays you as an employee it's required to withhold some federal income tax and medicare & social security (FICA) taxes and remit those withholdings and its part of the FICA tax to the IRS throughout the year.

So if the company pays you $20K in salary it will pay an additional $1530 in FICA tax. The net income of the company will be $8740. This will flow to your 1040 via Schedule K-1. In addition you'll have $20K in wages you report on line 7. So your total income from the SCorp will be $28,740. How much tax you'll pay on that depends greatly on your personal situation: What's your filing status, How many dependents do you support, What other income do you have, Do you itemize your deductions.

If you're single, taking the standard deduction, and this is the only income you're reporting your taxable income would be < $20K and your tax would be about $2500 or about 13%. But you just can't use a flat percentage. You have to keep in mind that we have marginal tax rates.

4) No. the quarterly estimated payments are payments toward your total tax liability at the end of the year. The FICA (SS & MC) are paid through payroll. The employer & employee each pay half.

5) You have to make payroll tax deposits on a monthly basis. That is to say you have to pay the payroll taxes the corp withheld from your paycheck and that it is responsible for by the 15th of the following month. You don't have to have a payroll every month but when you do cut yourself a paycheck don't forget about the deposits. The IRS & EDD take these fiduciary payments very seriously.

Actually, the IRS & EDD have a free seminar that gives a good overview of payroll responsibilities. Dates & locations so sign up are here:
http://www.edd.ca.gov/taxsem/txsemv.asp?TitleID=2.
It might be worth going to one of these to give you an idea of how the payroll part works. (I'm teaching the seminar in Capitola on May 8th with the EDD representative.)

I hope this helps.

L:)

Estimated Payments for LLC

Hello Linda,
I have two questions and would appreciate if you could answer them

Last year I was an employee but this year started independent consulting.
I have a LLC and doing consulting since beginning of this year 2007. Do I have to send estimated payments to IRS every quarter? I was searching the EFTPS site and it mentioned that if your revenue is more than 200K then you need to start doing the estimated payments the following year. Is this applicable to me? In case, if I have to make the EFTPS then I have missed it for the first quarter, is there any penalty? How do I catch up?

My second question
My LLC is registered in Pennsylvania but currently I am travelling to California for a project. Do I have to register my LLC in CA too?

Thank you for a wonderful site.
Please write a book or e-book for Independent consultants and small businesses.
-NJ

EFTPS & CA NonResident Income

Hi NJ,

Thanks for the kind words. I'll think about the book idea. There are lots out there, already. I think most people don't think about this stuff proactively, but rather wait until they have a problem or question. ;)

You may or may not be required to make estimated tax deposits. But it would probably be a good idea if you're not having withholdings from some other source. To avoid further interest & penalties, if you missed the 4/17 due date it's better to pay late than not at all. (Remember to include SE tax when calculating your estimated taxes.)

I think you may be a bit confused about the EFTPS. EFTPS is the Electronic Federal Tax Payment System. You're only required to used EFTPS if your tax deposits for all taxes (not your income) exceed $200,000 in a calendar year. Even if they did, you aren't required to use EFTPS until two years after that date. For example , your tax deposits were over $200,000 in 2007 you wouldn't be required to used EFTPS until 2009. So you don't have to use EFTPS for 2007, but I would, because it's so easy and you have an immediate record that the IRS received your payment. (Tax deposits are basically your required payments to the IRS for all types of taxes but usually income & employment taxes & withholdings.)

Regarding your NJ LLC in CA, I'm not sure if you need to register or not if you're only going to be in CA for a short time. You should contact the CA Secretary of State's office to find out for sure. If you're not planning to return to NJ. Then I would definitely register.

Keep in mind there is a $800 minimum annual fee in CA and the franchise tax on LLCs is based on gross receipts, not net income. Regardless of registration with the CA SoS office, based on recent court rulings your LLC will probably be subject to CA LLC tax on the income while you are in CA.

You will probably need to pay CA personal income tax on your income while you are here and file at least Form 540NR for income you earned while in California. See this Do I have to file? PDF document from the FTB to see if you need to file. (Note this is for 2006 and 2007 figures are not yet available on their website).

Hope this helps.
L:)

single owner LLC

I'm a single owner LLC. The LLC has it's own EIN. Do I file estimated taxes under the LLC EIN or use my personal SSN. IF LLC is to file estimated taxes do I still use 1040-ES
RTT

Estimated Payments for LLC

Hi,

Actually, your LLC is treated as a disregarded entity (IRS speak for sole-proprietor). So you do need to use Form 1040-ES to pay your estimated taxes. Either the EIN or your personal SSN will work because the IRS links the two numbers.

I'd use the EIN because the IRS wants you to put your tax payer ID number on the check you send them. Using your EIN limits the possibility of someone getting hold of your SSN.

Or better yet, use the IRS's free service, EFTPS, to pay your estimated payments electronically.

Good Luck!
L:)

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