Note: I am not a Certified Public Accountant, Public Accountant, or Enrolled Agent. This is not to be construed as tax advice. Please seek the services of a professional for your specific situation.
The U.S. tax system is pay-as-you-go. If you are an employee, your company takes out taxes from each of your paychecks.
If you are self-employed, however, nobody does this for you. You must do it for yourself and do it every quarter. This would be very simple if you could tally your revenues and pay an appropriate amount at the end of the quarter, but the IRS does not work this way.
It wants you to guess, at the beginning of the year, what you will make for the entire year and pay taxes on this amount in four equal installments. These installments are called estimated tax payments. (Obviously, the regulation writer has never been self-employed!)
This doesn't seem reasonable at all! How can you know what you'll make?
Wait! There's more: your guess must be a minimum of 90% of what the actual tax liability turns out to be, which you won't know for sure until Dec. 31 of that year. (Tax liability means taxes owed.)
If you don't guess correctly, you will be hit with a penalty. And interest.
No, I'm not.
What if my business improves over the course of the year? Why would the IRS penalize me for making -more- money and hence my giving them -more- money in tax?
I don't know, but there is a protection from this irrational mandate of being within 90% or more accuracy.
IRS has what's called the safe harbor rule. This means that if you pay 100% (in some cases, 110%) of last year's tax liability, you won't be hit with the penalty. You'll still have to pay interest, though, if you underestimate (and underpay) your quarterly taxes.
Whether you must pay 100% or 110% depends on your AGI. See the end of this file for a discussion of AGI and other tax basics.
Another option to avoid a penalty for underpayment of estimated taxes is to use the annualized income method of figuring your estimated payments. Again, you are liable for interest if you err, even if you avoid a penalty.
One final kick: this penalty is computed for each estimated payment, so if you underpay in one quarter but make it up in the next quarter, you still will have to pay the penalty. Unfair, I know. Call your Congressperson. (While you're at it, ask for Congress to do something about the AMT [alternative minimum tax], an evil plague upon the middle class originally designed to keep the top few money-makers in the country from escaping tax liability - - but it was written without an inflation clause, so the "trip" number now trips up middle-class families because there has been inflation but no change in the law).
If you make quite a bit of income, your family's AGI is high, or your family comes into some unexpected taxable income, you may be caught by your inaccurate estimated tax amounts. Accountants say that your best bet for protection - - if you are married - - is to have extra withholding taken from your spouse's paycheck. If you have another job which withholds taxes from your paycheck, increase the withholding there. Or do both. Some accountants also would advise you to pay in 110% on estimated taxes, regardless of what your AGI is.
I recommend you see an accountant for help in this area. Accounting fees paid are deductible business expenses. (Note: These are deductible -only- if you file a Schedule C. If your income is above the current IRS floor, you will have to do this anyway for that reason. More in the section below, mentioned earlier.)
See Publication 505 (Tax Withholding and Estimated Tax) for information on quarterly estimated taxes and/or if you would like to make a stab at figuring the annualized income method by yourself.
If your business income is -very- small, you may not need to pay estimated taxes. Each year the IRS sets a floor (minimum amount). If you make more than this amount, you must make quarterly estimated payments.
Suppose the floor is $100. If you make $100 or less, you pay tax due on this $100 when you file your Form 1040 next April 15. If you make $101, you must figure and pay estimated taxes on the entire $101 (not just the extra $1) over the course of this year. Call the IRS or your accountant to find out what the floor is for this year's income and whether it would make tax sense for your to file a Schedule C even though your business income does not require you to.
Be aware that the IRS doesn't guarantee its answer is correct.
Ok, you must make estimated payments. How can you know what your income will be? As I said, you guess.
If you're lucky, you have some data from last year to use as a basis for that guess.
Estimated taxes are reported on Form 1040ES, which you enclose with your check on April 15, June 15, September 15, and January 15 of the following calendar year.
If you have a refund due from the previous year's taxes paid, you can apply that toward your April 15 payment (the first for the new year), rather than physically taking delivery of the IRS's refund check and writing a check for your first quarterly payment on your business account. Your adviser can counsel you about what seems best for you.
You haven't seen a blizzard of jargon until you've spent some time with the IRS and tax accountants! (Well, ok, maybe the military is right up there...) What you've read here is just the tip of the iceberg!
The Form 1040 is the main tax form. The front page of the sheet is where you figure how much money you took in (called gross income), which can be both earned and from other sources (such as investment income or gambling winnings). On the reverse of the 1040 is where you figure the tax owed on the amount calculated on page 1.
That's right! The main tax form is a two-sided sheet of paper!
If you have a business, you doubtless will be required to file a Schedule C. Although this is more work, filing a Schedule C usually is beneficial because you'll be able to "write off" legitimate business expenses.
As mentioned above, check with your accountant to see whether it makes sense for you to skip doing a Schedule C if you qualify to do so.
All right, back to gross income. This is your total income before anything is taken from it. The IRS allows certain amounts to be removed from gross income before you figure the tax you owe. After these certain amounts are removed, you have what's called adjusted gross income, or AGI for short. AGI is the number which appears at the very bottom of page 1 of the Form 1040, hence the term "the bottom line", because the AGI is the number on which all important calculations are based.
The basic tax strategy for everyone is to make the AGI as small as possible. That means there's less money to tax, and so (1) you'll have pay less money; and (2) your tax bracket will be lower. To reduce AGI is why filing a Schedule C is a good idea, even if you don't have to (see above).
Here's how the 1040 works.
Income from your business goes on page 1 of the 1040 and thus increases the size of the AGI.
Your business deductions -also- go on page 1 and thus decrease the size of your AGI. The mechanism for this reduction is the Schedule C. You list your gross income and subtract your deductions. Then -this- lower number goes on page 1 as income.
If you don't file a Schedule C, your gross business income is used to figure your AGI.
To reduce your gross income, subtract:
There are a large number of tax guide books on the market, and advertising heats up toward the end of the year. The Big Names (Lasser, H&R Block, for example) are always safe, as to accuracy of the information. If you want to look for particular ways to reduce your AGI, your best bet is a human accountant, however, who can look at your overall tax situation and suggest options tailored to you.
Both tax books (and also tax software) and accountants' fees are deductible business expenses.