Last week we talked about how income taxes work for the owner of a small business. It is a subject which confuses many and can cause problems if not handled properly.
This week, we will focus on estimated taxes and how best to handle them. Employees have their income taxes obligations handled via payroll deductions. Every paycheck, an employee will have payroll taxes deducted which covers medicare and social security. They will also have the amount they have requested deducted for income taxes. When the employee goes to file an income tax return, the amount of taxes owed is reduced by the amount already paid via paycheck deductions.
The owner of a small business handles income taxes differently. They generally do not get a true paycheck and instead receive what the government and accountants refer to as an owner's draw. There are no deductions for medicare, social security or income taxes deducted from an owner's draw. As we said last week, the government doesn't care about draws when taxes are calculated. Small business owners take care of medicare and social security obligations once a year when they file their income taxes and pay Self Employment tax which is added onto the income tax everyone pays. To handle income taxes, it is usually recommended that small business owner's make quarterly estimated income tax payments. Once a quarter, you fill out 1040-ES and make a payment to the federal government. How much? That is always an interesting question. You need to cover 90% of the current year's income tax with estimated taxes or 100% of the prior year's tax obligation. Many tax preparers focus on the 100% and calculate the estimated taxes to cover this obligation. This method removes any penalties from under payment but may leave the tax payer with a large bill come April.
We believe it is better to look at the current year's income and if it is significantly more profitable than the previous year, pay more in estimated taxes. If the tax payer has the ability to plan and save and prefers to set the money aside and pay the additional taxes in April, that is perfectly fine. Many small business owners are busy running the business and don't keep an eye on the checking account and may find the additional cash has been eaten up by operating costs and they are in a panic come tax time.
Some owners find it helpful to have a separate checking or savings account to taxes. They transfer money into this account for payroll or sales taxes if they do not have to remit these monthly so the funds are available when the taxes are due (quarterly or annually). Others do the same with income taxes, they essentially withhold from themselves so they have the money not only when the quarterly estimated taxes are due, but also when the tax return must be filed and paid.
Estimated income taxes are paid on April 15th, June 15th, September 15th and the following January 15th. IRS Publication 505 covers estimated taxes in detail. http://www.irs.gov/pub/irs-pdf/p505.pdf