As a self-employed tax payer, and as an accountant and advisor to many small business owners, I am well acquainted with the shock and disgust of what I call the “April First-year Tax Sucker Punch”. Perhaps you are familiar – it’s that first tax return you file that shows a profit on your Schedule C, your independent business activity, for which you probably have not paid any withholdings or estimates during the year. That’s when you learn your first hard lesson about self-employment and income taxes – it’s called the “Self-Employment Tax”.
What is the tax rate, and what gets taxed? Short answer – 15.3% of the profit shown on Schedule C. That’s 15.3% on top of the regular income tax that you will pay on that same income.
What does a heart attack feel like? Sorry – I’m just an accountant – if that last paragraph gave you chest pains dial 911.
Any more surprises? If you haven’t paid in quarterly tax estimates and this is not your first year to show self-employment income, you may also be penalized for not paying in tax estimates during the year. The amount depends on how much tax you owe, and how much your self-employment income was the previous year. Interest is added to that amount (and the interest rate that the IRS is using, has been rising, just FYI).
How do I know how much I need to pay as an estimate? The IRS calculates your required estimate payment for the current year based on your previous year’s tax return. According to IRS Publication 505, if you pay estimates equal to 100% of the total tax shown on your prior year tax return (and make the quarterly payments on time), you will meet the requirements. This doesn’t mean you will not still owe some income tax, but it will prevent you from being penalized for not paying estimates. An even better way to figure out how much you need to pay in involves knowing how much profit you have in your self-employment activities and calculating the actual taxes on that amount each quarter. While this is a more accurate calculation for your taxes, it is also difficult for most people to account for all of the adjustments and deductions that will eventually show on the tax returns in order to get that profit calculation correct.
When, and how? Your first estimate of the year is due on the due date of your tax return – usually April 15th. Estimate payments are not eligible for extension, even if you extend your tax return. The 2nd quarter is due June 15th, the third quarter September 15th, and the final estimate is due on January 15th. *Tip – if you miss the deadline, send the payment in as soon as you can – remember the penalty, if you owe any, will involve interest from the due date until it is paid, every day counts).
Your tax preparer can not only help you calculate your required estimate, but should also prepare payment vouchers for you to mail in the check each quarter. The easiest way to pay, however, is on irs.gov, with a bank account or credit card (fees may apply).
*Please discuss these options and calculations with your tax preparer, as there are exceptions and variations to some of the rules and calculations based on your circumstances. There could also be similar requirements for your state tax return as well.