Estimating Taxes
If you are an employee working for a company, estimating taxes is not something you need to concern yourself with. Once you become a business owner, your perception and knowledge about taxes change since they become much more important. You need to understand the tax code and how your decisions affect your bottom line.
Regardless if you are an employee or an owner of a company, you need to know how much income you expect to have for the year. Use your gross household income, minus any pre-tax retirement contributions and standard deductions, to arrive at your taxable income. This number will be compared against the marginal tax rates applicable to your household.
The above scenario is pretty straightforward. There aren’t a lot of moving parts and you can gather this information from your paycheck or P&L if you have fairly consistent income for the year.
The purpose of this article is to focus on business owners experiencing high growth who are self-employed. This includes sole proprietors and partnerships. This mostly includes anyone who is not receiving a w2.
The more money you make the more complicated things get, particularly around taxes. If you are a glass half full kind of person, this also creates an opportunity for you to save more money and build more wealth to live the life you want!
Estimating taxes are necessary when you have large tax bill coming due and you expect to owe money come tax time. This can be an issue when owning a business, being self-employed, or even when selling an asset for a substantial gain.
The bottom line is the government wants their money. They want you to pay what you owe on a timely basis from any source of income or capital gain that you have. If there is no mechanism for this, such as payroll deductions for income, you need to send in estimated tax payments.
When are estimated taxes due? These are due on a quarterly basis in April, June, September, and January.
How Do I Calculate Estimated Taxes?
A lot of practitioners will tell you to use your projected marginal tax rate as a rule of thumb. This can be a good starting point since your marginal rate is higher than your effective tax rate, which is more of an average rate. Of course, nothing is ever that simple.
If you want to go the easy route, do as follows:
- Project your taxable income for the year
- Apply the appropriate marginal tax rate for the year
- Divide by 4
- Pay the quarterly amount
Now this becomes much more difficult if you have variable income or are experiencing high growth with your business. A lot of people will use their previous year’s return to estimate taxes. This becomes troublesome if your income is jumping dramatically.
Safe Harbor Tax Payments – Prepare to Potentially Owe
If you want to be on the safe side you can pay 90% of your current year’s tax liability or 110% of the previous year’s. This makes for an easy calculation: just take your tax liability amount and divide by 4 and that’s what you send in each quarter. As long as you do this you will not be penalized. That said, you could still owe a substantial amount of taxes come April. I’m talking well into 5 figures and possibly six figures.
The safe harbor approach may provide you with peace of mind but that only accomplishes not being penalized, and in the grand scheme of things typically the penalty isn’t too terrible. Some people prefer to be penalized and just calculate their tax liability at the first of the year so they aren’t giving the government too much money. They’d rather keep the cash during the year.
Things to Consider:
Income
Projecting income can be difficult but it is necessary to create likely scenarios based on your current and expected growth for the year. This way you can better understand what is likely to happen and pay the appropriate amount of taxes.
You can create a low, middle, and high-income scenario to see how they will impact your financial situation. Depending on various financial factors, new tax planning strategies could apply to you.
Expenses
Estimating annual expenses is important because this impacts your bottom line. Calculate your current fixed expenses for the year. If you have any variable expenses do your best to set a budget on each expense to better estimate the cost for the year. If you have a set budget in place you can plan better when looking at tax deductions and financial planning for future goals. Arriving at a net income number should be the goal here.
QBI Deduction
The QBI deduction, aka the qualified business income deduction, was established with the 2018 TCJA changes. This rule and calculation can get extremely complicated but the bottom line is, it can help business owners deduct up to 20% of their qualified income. Just like anything else with the tax code, this depends on your industry and income.
This will change depending on these things. Comparing your previous year’s tax return with a projection of the current year’s income can help estimate the impact of the QBI deduction. This will help save you money in taxes and therefore how much you will send into the IRS for estimated tax payments.
Here is a helpful Q&A from the IRS’s website on the QBI deduction for pass-through entities
Here is a QBI deduction calculator from The Bradford Tax Institute.
Keep in mind that these links are for informational purposes only and should not be taken as tax advice. Always seek a professional when considering your tax situation and options available to you.
Self-employment Tax Deduction
If you are taxed as a partnership or sole-proprietorship you will have to take self-employment tax into consideration as a deduction. Since you are acting as both the employer and employee you are responsible for both sides of the FICA tax. This is comprised of social security and medicare tax of 12.4% and 2.9% respectively, for a total of 15.3%. Social security is phased out after $147,000 for 2022, so if you are making more than this your SE tax and deduction will be decreased.
You can deduct roughly 50% of your self-employment taxes against income. If you were an employee of a corporation you would not be responsible for your employer’s half of social security and medicare of 7.65%. Therefore, the IRS gives self-employed individuals this deduction.
You can reference this calculator from Tax Act to estimate your self-employment tax deduction.
Retirement Planning
Retirement planning should be a major priority for business owners. I know a lot of business owners consider their business as their retirement plan. However, this way of thinking can leave you open to greater risks in the future that could negatively impact your ability to comfortably retire on your own terms.
There are various types of retirement plans to consider depending on your business. For purposes of this conversation, just be aware that a major benefit of retirement plans is the tax deferral for contributions and diversification of your assets. You are accumulating investments outside of your business, so to speak, so you are not solely dependent on the business valuation or sale itself at a later date.
The point is, pre-tax retirement contributions will impact your estimated tax payments. Be aware of the different plans available to you and which one will suit you best as your circumstances change. It is not a one size fits all situation. Certain plans allow you to save more and receive greater deductions. This will impact your tax liability and therefore your quarterly tax payments when making projections.
At first glance, estimated taxes seem simple enough to calculate and submit payment. Unfortunately, that is rarely the case due to the complexity of the tax code. The bigger your business gets the more complicated things become. Hopefully, some of these points are helpful in raising your awareness about your tax situation and options that are available to you.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at [email protected] or fill out a contact form.
DISCLAIMER
This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.