Every individual who earns income in the United States is expected to pay income tax throughout the year. For W-2 employees, employers are withholding and submitting the taxes on the employees’ behalf. But for freelance workers and business owners, the payment of income tax falls directly on their own plate of responsibility.
Failing to make an accurate estimated tax payment on a quarterly basis could mean a hefty payment to the IRS when you file your annual taxes. This guide will provide all of the information you need as a small business owner, freelancer, or contract employee filing quarterly business taxes.
What is estimated quarterly business tax?
Quarterly business tax is a pay-as-you-go system for dividing your income and other federal taxes into quarterly installments.
As a small business or freelancer, you’re responsible for managing your own taxes (and those of any employees you’ve hired). Taxes can be complex, and there is a sliding scale for the amounts you’ll owe, so to make it easier the IRS has developed a pay-as-you-go estimated tax system. Businesses and individuals compute how much they’re likely to owe in income, employment, and other applicable taxes and then divide them into quarterly estimates which are met throughout the year.
What taxes should be paid?
There’s a shifting menu of taxes that need to be paid by businesses and individuals, depending on your business structure, location, and tax bracket.
Income tax: Required for all except Partnerships (which file an “information” return), this tax is paid as you go based on the amount of income made.
Sales tax: Nearly all states require sales tax, and many counties and cities tack on their own additional sales tax. Small businesses and self-employed individuals are required to collect sales tax on applicable transactions and pay receiving entities at regular intervals. (This is one tax that does NOT go to the IRS.)
Employment tax: Employers must pay a portion of the Social Security & Medicare, federal income, and federal unemployment taxes for their employees. These taxes are withheld from the employees’ paycheck and paid on their behalf by the employer.
Self-employment tax: In the absence of an employer, the Self-employment tax (or SE tax) is paid by the individual. Self-employed individuals pay the entire portion in quarterly estimated payment (15.3%), and then can deduct the half that would normally be covered by the employer in a traditional employment role.
Excise tax: Certain industries are required to pay specialized taxes. Common examples include fuel, environmental, and gambling/wagering excise taxes.
Who should pay estimated tax payments?
Small businesses, freelancers, sole proprietors, and anyone expecting to owe more than $1,000 in federal taxes in the current year should calculate and pay estimated quarterly taxes.
If you or your business will owe at least $1,000 in income tax for the year, it’s recommended that you pay estimated quarterly taxes. To avoid penalties or unwelcome surprises at tax time, it’s a good idea to calculate your estimated tax payments and make these quarterly payments to protect yourself.
How are quarterly estimated taxes for self-employed individuals different?
For freelancers, sole proprietors, contractors, and other self-employed individuals, quarterly estimated taxes are basically the same as small businesses, with the allowance of the Self-Employment tax deduction. A small business will pay half of the required (about 7 of 15.3%) employment tax, with the employee paying the other half through designated withholdings. Self-employed individuals pay the full 15.3% tax and then deduct about 7% in their annual filing.
How do you calculate quarterly estimated taxes?
Use the IRS Form 1040-ES to understand current guidelines, special rules, and methods for calculating quarterly taxes.
1. Determine tax bracket
The 2020 Tax Rate Schedule is first determined by your filing status (Single, Married filing jointly, Married filing separately, and Head of Household) and your income. Your federal income tax bracket will determine how much you should be paying as a general foundation.
For example, someone making $95,000 annually and filing jointly as a married couple has a 22% tax rate. They’ll owe $9,235 plus 12% of the amount over $80,250 (which comes out to 1,770), totaling $12,775 in taxes for 2020. But that’s without any deductions or credits, so you can reduce your taxable income.
2. Determine deductions & credits
For the year 2020 the standardized deductions are:
- $24,800 for married filing jointly
- $18,650 for head of household
- $12,400 for single or married filing separately
Standardized deductions are automatic, much faster, and easier. However, if you think that your itemized deductions will total more than the standardized deduction for which you qualify, it may be worth the extra time and forms to file itemized deductions. Some business expenses can still be deducted via Schedule C in addition to a standard deduction, so you’ll want to ask your tax preparer to clarify what you are eligible to deduct.
What can you deduct?
- Home office
- Internet & phone bills
- Health insurance premium
- Meals related to business
- Travel related to business
- Vehicle use related to business
- Interest on business loans
- Education, publications, subscriptions
- Business insurance
- Retirement plan contributions
Once you decide on your deduction strategy, you can total and subtract that amount from your taxable income. Using our prior example, if the individual making $95,000 and filing jointly with their spouse decided to take the standard deduction of $24,800 then their taxable income would decrease to $70,200. This would drop them to a 12% tax bracket. They would owe $1,975 plus 12% of the amount over $19,750 (which comes out to $6,054), totaling $8,029 in taxes for 2020.
3. Add self-employment taxes
For the year 2020 self-employment tax is 15.3% up to $137,700 and 2.9% on any net income above that threshold. You can claim half of that on your deductions, since usually the employers pay half of Social Security and Medicare taxes for regular employees. As a general rule 92.35% of your net income is taxable for self-employment.
So our married couple making $95,000 would multiply that income by 92.35% to determine their taxable net earnings for self-employment (which comes out to $87,732.50). That amount is subject to the 15.3% tax rate, totalling about $13,424 in self-employment taxes owed. They will need to add that to your taxes paid throughout the year, but then they can deduct 50% of that ($6,712) when they file at tax time, dropping their taxable income from $70,200 to $63,488.
4. Calculate final taxable income, tax liability, and estimated quarterly tax payment
After jumping through these many hoops we can land on the final taxable income, deductions, and taxes due. Using our example couple, the $95,000 income minus standard deductions and self-employment deduction leaves them with $63,488 taxable income which assigns them a 12% tax rate. They’ll owe $1,975 plus 12% of the amount over $19,750 (which comes out to 5,248.56).
- $1,975 + $5,248.56 = $7,223.56 income tax
- $13,424 in self-employment taxes
- Total $20,647.56 owed in taxes annually
- Quarterly payments of $5,161.89
Safe Harbor method
If your head is spinning, you’re not alone. In order to simplify quarterly taxes the IRS has outlined three methods that provide “safe harbor,” meaning that even if you’ve underpaid you cannot be penalized as long as you use one of these formulas. If you’ve grossly underpaid you will still owe, but safe harbor protects against the penalties you’d normally face.
90% of tax you owe for the current year. Calculating what you will owe and then paying 90% of that in quarterly payments. This can be difficult if you are new or if your deductions are irregular.
100% of last year’s taxes. You can pay 100% of the taxes you paid last year (found on Line 63 on your Form 1040), so long as your income is fairly stable and predictable.
Annualized income installments. Many freelancers and small businesses have very seasonal income, making quarterly payments uneven. Instead you can annualize the payments over 12 months to pay as you go instead of uneven and punitive quarterly payments.
How to plan for quarterly estimated taxes
Once you have a total for your estimated taxes, you need a strategy for setting the money aside so you’re not surprised each quarter, or worse—at tax time. Here are two tried-and-true strategies for managing your quarterly estimated tax payments.
Monthly: Divide your annual estimate by 12 and transfer that amount into a separate tax or savings account each month.
Percentage: Figure out the percentage of your income that will be required, then transfer that percentage of each payment to your tax or savings account. For example, if you will be paying 20% of your income in taxes, you’ll take 20% of each paycheck and transfer it directly to your tax or savings account.
The strategy that works best for you will depend on the stability of your freelance income and any expenses that offset that income. Play around with the numbers to determine which makes more sense for your situation.
When are quarterly business taxes due?
Quarterly business taxes are due on April 15th, June 15th, September 15th, and January 15th (or the next business day if those are weekends or holidays).
In 2020, Tax Day was postponed from April 15th to July 15th to accommodate the unpredictable nature of the economic impact from COVID-19.
In 2021, Tax Day for individual annual federal tax filings has been automatically extended to May 17.
How do you file quarterly business taxes?
Quarterly estimated tax payments can be mailed using the printable vouchers in Form 1040-ES or use IRS Direct Pay to pay online. State and local taxes may not require quarterly filing, and may have their own procedures for payments, so work with a tax professional to be sure you’re paying taxes correctly.
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