How To Avoid Paying Too Much Estimated Tax

by: Wayne M. Davies

Many self-employed people and small business owners makequarterly estimated tax payments at both the federal andstate level. (Sigh!)

If you're newly self-employed and perhapsunfamiliar with the government's estimated taxpayment schedule, here are the due dates for the Year2006 quarterly estimated tax payments:

QTR 1: April 15, 2006
QTR 2: June 15, 2006
QTR 3: September 15, 2006
QTR 4: January 15, 2007

The form used to accompany the payments is Form 1040-ES.You can download the form and its instructions here:

www.irs.gov/pub/irs-pdf/f1040es_05.pdf

By the way, I have no idea how they came up with these”quarters” — the first quarter coincides with the calendarquarter, but the other three don't. Two of the “quarters”aren't even three months. Go figure.

Still with me? Good. Let's get down to business.

If your business income fluctuates from year to year, as isoften the case for the small business owner, it can bedifficult (if not impossible) to know exactly what your taxliability is going to be for the whole year until the yearis over.

So many self-employed people end up being too conservative.They fear having a balance due on their tax return and payway too much estimated tax during the year. They end up justlike the W-2 employee who has too much income tax withheldfrom his/her paycheck. The end result — the self-employedperson also gets a large refund, and has given the IRS aninterest-free loan of his hard-earned money. Not good!

The self-employed person has two options to avoidoverpayment of estimated tax.

OPTION 1:

Do your best to track your income and expense during theyear. If you are running a successful small business, youshould be recording your income and expenses eachmonth, and you should be able to produce reports that tellyou exactly how your business is doing each month. Eitheryou are doing this yourself with the help of a softwareprogram or you are paying a bookkeeper or accountant to dothis.

The point: if you don't know what your bottom line is everymonth, you are making a big mistake! If you are waitinguntil the end of the year to see what the numbers look like,you are mismanaging your business.

This monthly financial summary is essentialboth from a business management/cash flow standpoint, andalso from a tax standpoint. From a tax standpoint, once youknow your profit for a given quarter, you can then calculatethe resulting tax liability on that quarter's profit, andyou can make a reasonably accurate quarterly estimated taxpayment instead of just “winging it” and paying too much (ortoo little).

OPTION 2:

Here's another great way to take care of your quarterlyestimated tax payments. Option 2 is what the Tax Code calls”The Safe Harbor Method,” defined as follows:

The Tax Code says that most taxpayers can calculate theminimum amount of estimated tax by paying the previousyear's tax liability in the current year. Let's say you aretrying to figure out how much estimated tax to pay for Year2006. Let's also assume your Year 2005 federal income taxliability was $10,000. For Year 2006, you take the $10,000and divide it by 4, and you would pay $2,500 per quarter.Now that wasn't too hard, was it?

As you can see, this is a much easier method to use thanOption 1, because it takes less time to calculate.

There is another advantage to The Safe Harbor Method: ifyour income (and resulting tax liability) increases in 2006compared to 2005, you can still pay the Year 2005 taxliability amount in Year 2006 and not incur any penalty orinterest for having a balance due on the Year 2006 return.

As long as you pay that Year 2006 balance due by April 15,2007, it doesn't matter how much you owe on the 2006return. You have complied with the “safe harbor” rule forquarterly estimated tax payments.

So Option 2 lets you calculate your estimated tax paymentamount in literally seconds, and it also lets you “get away”with paying a minimum amount of tax during the year withoutany fear of penalty for waiting until April 15 to pay therest.

Practically speaking, Option 2 is often best for self-employed people whose income remains relatively constantfrom year to year. If your income dramatically increasesone year, keep in mind that you can still pay the previousyear's tax liability and hang on to your money for a fewextra months, but eventually you will have to come up withthat large balance due. If you like waiting until the lastpossible day to pay your balance due, then Option 2 is foryou. Just make sure you “put something aside” to take careof that large balance due.

Also, please notice that I said that “most” taxpayers canpay last year's tax liability to qualify for the Safe Harbormethod. If your income is over $150,000, then the amount ofestimated tax you are required to pay is 110% of theprevious year's tax liability, not 100%.

Just another example of an exception to a tax rule.