A common question I hear from small business owners is “How much should I set aside for business taxes.”
If you are a sole-proprietor, LLC, Partner or S-Corporation shareholder it is very likely that you fall into the category of needing to make estimated tax payments. But what are estimated tax payments?
If you are an employee, every time you receive a paycheck a certain amount of taxes are withheld. Not just payroll tax, but both federal and state income tax withholding. The amount that is withheld is determined by you by claiming allowances on your W-4. Does this sound familiar?
Well, it’s the same concept with estimated taxes except, in this case, you are not just an employee but rather self-employed. When you are self-employed you are considered both the employer AND the employee. As an employer, you are required to withhold taxes on behalf of your employee and remit them to the appropriate taxing authority. You do this by making a payment every quarter to the federal government and the state in which you conduct business (unless you reside in a state that does not collect income tax ).
Let’s face it, the government wants their share of your income. If you don’t pay it quarterly throughout the year, it will get charged to you in the form of your tax liability that is due when you file your tax return. As a bonus for not paying quarterly (or in a timely manner), you will also be charged an underpayment penalty and possibly interest. So it is good practice to make these quarterly estimated tax payments unless you don’t mind paying more come tax time.
So back to the initial question, “How much should I set aside to pay my taxes for my business?” Here’s where it can get a bit confusing. As a self-employed, yes, you are paying taxes on your business. BUT your tax liability is calculated as part of your overall individual tax return or Form 1040. So it’s not as simple as looking at your net profit from your business and designating an amount to set aside. Don’t get me wrong, you can make it that simple. But will it be enough? Will it be too much? Hard to say without looking at the entire picture.
Because your business tax is part of your overall individual tax situation, there are many issues at play in determining what tax bracket you’re in and calculating what you owe. Here are some things to consider.
- What is your filing status? Single, Married, Head of Household?
- Do you have dependents?
- Do you have other sources of income? From your spouse or investments?
- Have any taxes already been withheld (example from spouse wages)?
- All of the answers to these questions will affect the calculation of what you owe. You must take into consideration not only your business income but all sources of income and any eligible deductions to that income.
Tax professionals have it easy. We can plug these numbers into our software, create a projected scenario and run an estimate of what your tax liability will be. But what if you want to do this yourself? Can you? The answer is YES! It’s really not that hard, you just need to know how it works.
Understanding that your self-employed income is just part of your overall tax liability, which may be subject to estimated tax payments, is truly half the battle. Many small business owners I’ve spoken to didn’t understand this fact and they were setting aside money each quarter from their business account and either paying too much or too little. Keep in mind, we are talking about ESTIMATES. This is not an exact science. But it should give you an idea of what you owe and allow you to monitor your cash flow.
There are two ways to look at this – the easy way and the hard way. We’ll cover the easy way first.
Pull out last year’s tax return and see what your tax liability was (Form 1040, Line 15). If you’re married or have W2 income, see how much is currently being withheld. If you look at a paystub, it will tell you but you’ll need to multiply this by the number of paychecks to be received in the current year. We’re projecting your tax liability for the current year.
Once you have the total tax being withheld for the current year, subtract that from line 15. The difference is what you should make up for in estimated tax payments. If you’re withholding more than what is on Line 15, then you are most likely in a refund standing so no need to make an estimated tax payment. If you’re in a higher tax bracket (22% and higher), you may want to take Line 15 and multiply it by 1.1 and then deduct any tax that has already been withheld. This is often referred to as a safe harbor method.
This method of basing your estimated tax payments on last year’s liability doesn’t guarantee that you’re paying enough, or not paying too much, but it will make you penalty-free. As long as 100% of your prior year’s tax liability is being paid, or 90% of the current year’s liability, the IRS will not charge any underpayment penalty.
This is an easy way to make a guesstimate. But if you want to avoid paying tax in April, then read on.
Here’s how to do it the hard way (it’s actually not that hard). How do we calculate it?
Here is what you need:
- Wage Income
- Investment Income (interest, dividends)
- Self-Employed Income (Schedule C – sole proprietors and LLC’s)
- Flow Through Income (Schedule E – S-Corp shareholders or Partnership Income)
- Other Flow Through Income (Schedule E – real estate holdings, trust distributions)
For self-employed income, you need your net earnings for this calculation, not your gross. If you’re using accounting software, you may simply run an income statement or profit & loss report. Be sure to project out the annual net earnings, not just to year-to-date.
Once you have your total gross income from all sources, then take your standard deduction. If you took the itemized deduction last year and know that it will be the same this year, go ahead and deduct an itemized deduction amount. This will give you your taxable income.
Please note, there is more that you can deduct to lower your taxable income but for the purpose of making an estimate, I want to err on the conservative side and if anything, aim higher rather than too low and be subject to penalty.
Once you have this number, find out what tax bracket you’re in. Let’s say your taxable income is $100,000 and you’re married filing jointly. This puts you in the 22% bracket. Does that mean you pay 22% of $100,000? No. The 22% tax bracket is for income between $78,951 – $168,400. You would pay 10% on the first $19,400, 12% $59,550 and then finally 22% on the remaining $21, 050. How did I get those numbers?!? All of these numbers are from the 2019 federal income tax bracket chart. The concept is you pay the percentage tax rate up to the maximum dollar limit in that bracket and then move up the next bracket calculating the remaining income up to that maximum in that bracket, and so, and so on…
Is that all? Not quite.
The above calculation gave you your tax due. Now you can deduct any eligible credits. If you have a child under 17, you can deduct $2,000 from this amount. Children or dependents over 17 are eligible for a $500 credit. Tax credits are awesome! They lower your liability dollar for dollar so you want to take advantage if you can.
Now you should have your final ESTIMATED tax liability. This is the amount you should withhold throughout the year. If you’re married and your spouse is an employee, take into consideration what is already being withheld from his/her check. This amount counts towards your total withholding. It is possible that your spouse is withholding enough that you may not need to make estimated tax payments at all.
Let’s say you run this calculation and there is still tax liability to be paid. Then take that amount, divide it by 4 and this will give you an estimate of what you should pay quarterly.
If your business income fluctuates a lot throughout the year, you may wish to run projections each quarter to see how your liability changes. This is a great way to monitor cash flow. Cash is king to small business owners so paying too much in tax may prevent you from investing in your business. But paying too little may put you in a tight situation come April. It truly is a balancing act. But if you understand how the tax is calculated, you can at least make a decent estimate and hopefully avoid any April surprises!