April 1 may be April Fool’s Day, but April 15 might be considered April’s cruel day. Not only do you have to pay any income tax due for the previous year, you also may have to make an estimated tax payment for the current year. A poor estimate might result in either an underpayment that triggers a penalty or an overpayment that deprives you of valuable cash flow.
Paying as an individual
Many business owners will pay estimated tax on the same IRS Form 1040-ES that individuals use for estimated tax. That’s the case if you run your business as an S corporation, a partnership, an LLC electing partnership taxation, or a sole proprietorship.
Business owners filing estimated taxes on Form 1040-ES must pay in four installments. The first payment is due on April 15 each year; the next payment is due only two months later, on June 15, so there may be a cash crunch. Subsequent deadlines give you more time; payments are due on September 15 and January 15 of the following year. Use IRS Form 1040-ES for these payments.
You generally have to file estimated tax on Form 1040-ES if you owe $1,000 or more in tax when you file your return for the year. Thus, estimated tax won’t be a concern for businesses that will show a loss on their annual tax return.
You can avoid an underpayment penalty if all of your tax payments for the year—including withholding and tax credits—cover your ultimate tax bill, or at least go far enough that you come up short by less than $1,000. However, few business owners can accurately predict their 2014 tax obligation on April 15 or even June 15.
Thus, there are two safe harbors for those required to pay estimated tax. If you pay either (a) 90% of your current year’s tax obligation, or (b) 100% of the prior year’s tax, you won’t owe any penalty.
Pam Owens has an interior design practice, set up as a sole proprietorship. When Pam prepares her tax return for 2013, it shows a $60,000 tax obligation for the year. Pam has no overpayment to put towards her 2014 tax obligation and she does not plan to have tax withheld during the year.
If Pam were confident of owing another $60,000 in tax this year, she could pay $54,000 (90% of $60,000) in estimated tax this year: $13,500 in each of four scheduled installments. That would avoid any risk of owing a penalty.
However, Pam does not know how much business income she’ll earn in 2014. If Pam’s income is much greater than in 2013, and she follows that $54,000 schedule, she could underpay her estimated tax and owe a penalty.
As an alternative, Pam could make four $15,000 estimated tax payments for 2014. That would total $60,000 in estimated tax—100% of her 2013 tax bill—and exempt Pam from a penalty.
However, if Pam’s adjusted gross income (AGI) in 2013 exceeded $150,000, she must pay more estimated tax under the safe harbor. Above that threshold, the safe harbor requires paying 110% of the prior year’s taxable income, rather than 100%. Thus, Pam decides to pay estimated tax this year in four $16,500 installments. This will bring Pam’s estimated tax total to $66,000—110% of the $60,000 in tax that she owed for 2013—so she won’t owe a penalty.
Note that this example assumes that Pam expects an increase in business this year, and a larger tax obligation. If there is some reason to expect a smaller tax obligation, Pam can reduce her obligation accordingly to meet the 90% safe harbor requirement.
The estimated tax rules for regular C corporations are similar but slightly different than those for individuals. Corporations must make installment payments on IRS Form 1120-W if the expected estimated tax for the year is $500 or more. Equal payments are due on the 15th day of the company’s 4th, 6th, 9th, and 12th months of the corporation’s tax year. A corporation with a tax year ending June 30, for example, would make payments by October 15, December 15, March 15, and June 15. (As is the case with individual estimated tax payments, the deadline is postponed to the next business day if the 15th is on a weekend or a legal holiday.)
The safe harbors for corporate estimated tax are both 100%. Thus, each installment should be at least 25% of the company’s current year income tax or 25% of the prior year’s income tax, whichever is smaller, in order to avoid an underpayment penalty.
Some businesses are seasonal, and estimated installment payments may be revised in keeping with two alternate methods. Our office can help you with seasonal estimated payments, if that’s an issue with your company.
A matter of interest
Some IRS penalties are fixed, such as the 10% penalty for early withdrawals from retirement accounts. That’s not the case with underpayments of estimated tax. For estimated tax infractions, the penalty is based on current interest rates, which are relatively low now. Still, the penalties can mount up, for large underpayments, and those penalties can be easily avoided by mooring in safe harbors.
(BiggsKofford, AICPA Client Newsletter 2nd Quarter 2014)