Vlad Rusz is a CPA at Centaur Digital Corp, helping busy business owners efficiently manage their accounting system.
If you own a business, unlike a W-2 employee, taxes aren’t deducted from your income with each payment you receive. This means you inevitably must address the questions of estimated taxes. However, unlike yearly tax returns and payments, you are unlikely to receive letters from the IRS or any tax authority regarding estimated tax payments. Unfortunately, whether letters are received or not, there are penalties for neglecting these payments.
A person can estimate their federal tax liability by either paying as much as last year or paying at least 90% of their tax for this year. The difficulty for small-business owners is the unreliability of estimating their income for the current year. Fortunately, there are creative ways that business owners can make these estimated tax payments work for them.
1. Make timely estimated tax payments.
If penalty avoidance is paramount, estimated tax payments must be made each quarter, which for most people is April 15, June 15, September 15 and January 15. If you are unsure of the current year’s projected tax liability, use last year’s. This ensures you won’t have penalties to pay when you file taxes.
2. Withhold additional taxes.
For businesses that operate as a corporation for tax purposes (S corp or C corp), the owner must be on a W-2. This allows the business owner to increase the amount of federal and state tax withholdings to cover any additional taxes owed and forgo the need to make separate estimated tax payments.
A creative way to use this strategy is to significantly increase withholdings toward the end of the year, since any taxes withheld on a W-2 are treated as being withheld at the beginning of the year. For example, if you neglected to make any estimated tax payments but have a large bonus payout planned for December, you can withhold additional funds from the bonus payout and avoid estimated tax penalties even though you already missed three of the deadlines.
3. Utilize the pass-through entity tax.
If you live in a state with a state income tax or a business franchise tax, there are state estimated payments that must be made along with federal tax payments. If you own a business, you might have the option to pay the tax on your business income as a business tax rather than personal, which can make it deductible for federal tax purposes.
However, to execute this strategy, some states require payments in advance. Thus, it’s likely insufficient to only address this at the end of the year. Here, a proactive tax plan is best. In states with high income tax rates, such as California, this can mean a tax saving of over 3%, meaning if you make $200,000 this strategy can save you over $6,000.
4. Optimize cash usage.
Making estimated tax payments should be part of a broader cash management strategy for your business. For example, if you are paying 30% interest on a business loan, it may make sense to forgo estimated tax payments, which might only be a small percentage penalty in favor of paying off the higher-interest business loan. (Please note: It’s important to consult an expert before implementing this strategy.) Conversely, if you have cash in a savings account earning 3%, it makes sense to pay the estimated taxes on time to avoid penalties. Similarly, in a year when income will be significantly higher than last year, you can use the prior year amounts while saving the difference so they can earn some interest until you need to pay the IRS.
Estimated taxes, and the cost of forgoing payments, are issues every small-business owner should understand and address. There are multiple ways to pay and estimate these tax amounts. Whichever strategy you employ should be encompassed in your business’s overall cash management strategy while striving to reduce costs and ensure that all tax obligations are met.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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