Quarterly estimated taxes, explained

An employee’s tax is taken out of every paycheque, so by April most of it has already been paid. A self-employed person or a business owner has no employer doing that. The estimated tax system is how the IRS asks for the same thing: pay as the income arrives, not all at once at the end.

Who has to pay

The IRS’s rule for individuals, which includes sole proprietors, partners and S corporation shareholders, is that you generally must make estimated payments if you expect to owe $1,000 or more in tax when you file your return. For corporations the threshold is $500 or more.

There is an exemption for individuals who meet all three of these conditions: you had no tax liability for the prior year, you were a U.S. citizen or resident alien for the whole year, and your prior tax year covered a full twelve months.

The alternative if you also have wages

If you or a spouse receive wages, the IRS points out that you can avoid estimated payments by asking the employer to withhold more, using a new Form W-4. For many owners with a job alongside the business, that is simpler than four separate payments.

How the IRS decides whether you paid enough

You generally avoid an underpayment penalty if, through withholding and estimated payments during the year, you paid at least 90% of the current year’s tax, or 100% of the tax shown on the prior year’s return, whichever is smaller. You also avoid it if you owe less than $1,000 after withholding and credits.

Higher-income taxpayers are subject to special rules, which the IRS sets out in Publication 505. That is the place to check before relying on the prior-year method.

Paying 100% of last year’s tax is the method most owners use when income is uneven, because last year’s figure is known and this year’s is a guess. If this year turns out better, the balance is settled on the return without a penalty, provided the safe-harbour amount was paid on time.

The four payment periods

The tax year is divided into four payment periods, each with its own due date. The dates are not evenly spaced, and they are set out on Form 1040-ES for the year in question, which is the place to confirm them rather than relying on memory. If a due date falls on a weekend or legal holiday, the payment is on time if made on the next business day, and for mailed payments the postmark date counts.

You do not have to pay in four equal lumps. The IRS allows weekly or monthly payments, as long as enough has been paid by the end of each period. Some owners find a monthly transfer easier to live with than a large quarterly one.

How payments are made

Individuals use Form 1040-ES. Payments can be made online, by phone, through the IRS mobile app, through an online account at IRS.gov, or by mail with the payment voucher from the form.

What happens if you underpay

If not enough was paid through the year, there may be a penalty, and the IRS notes this can apply even when a refund is due on the return. Form 2210 is used to work out whether a penalty is owed, and Form 2220 for corporations. If income arrived unevenly during the year, it is sometimes possible to annualise it and make unequal payments, which can reduce or remove the penalty. The IRS can also waive the penalty in some circumstances, such as a casualty or disaster, or retirement or disability during the year, where the underpayment was due to reasonable cause rather than neglect.

The practical approach

1. Decide early in the year whether you are using the prior-year amount or an estimate of this year’s.
2. Set the money aside as income arrives, not when the payment is due.
3. Confirm the current year’s due dates on Form 1040-ES rather than assuming.
4. Revisit the estimate mid-year if the business is clearly ahead of or behind last year.

Estimated tax is not an extra tax. It is the same tax, paid on a schedule. The businesses that find it painful are usually the ones that discover the amount in April rather than planning for it in January.