June 15th is right around the corner!
Do you know the significance of that date? Well, it’s the date in 1846 when the US and Britain signed the Oregon Treaty to establish the border between Canada and the US at 49th parallel. And it’s also Courtney Cox’s birthday! (We have a few Friends fans in the office…) However, since our main purpose is about helping small businesses, it’s more important to let you know that June 15th is when your second quarter estimated tax payment is due.
If you’re a small business owner, you need to know about estimated tax payments. Unless you want to face a penalty, the government is expecting you to make a payment for the approximate amount of taxes you owe, based on how much profit you’ll earn this year.
This might be news to you, especially if you’re just starting your business or you’re earning more this year than last year. Read on to understand the who, what, when, where, and why of estimated tax payments. We’ll also illustrate how you can possibly decrease your tax liability by electing to designate your business as a pass-through entity (PTE) for state tax purposes (we’re discussing Minnesota, specifically).
What are estimated tax payments?
The IRS considers taxes to be “pay-as-you-go.” As you earn or receive income during the year, you must pay taxes on it. This is accomplished through withholdings or estimated tax payments.
States, with the exception of Utah, also require payments of estimated taxes. Each state has different rules regarding estimated state tax payments, so be sure to check with your state’s Department of Revenue to be sure that you’re complying.
Why do we need to make estimated tax payments?
Estimated tax payments help ensure that companies pay their taxes in a timely manner. By making regular estimated payments throughout the year, companies avoid the risk of underpaying their taxes. Penalties and interest may be incurred for underpayment or late payment of taxes.
Estimated tax payments also allow companies to manage their cash flow effectively. Instead of paying a large lump sum at the end of the year, estimated tax payments spread the tax liability over multiple installments, helping companies maintain a more consistent cash flow throughout the year.
Who needs to make estimated tax payments?
As we mentioned before, the IRS requires everyone to pay federal taxes as they earn income. If you are an employee of a company, then you are well aware that your gross pay is reduced by federal and state income taxes, as well as other taxes and deductions. Your employer submits these taxes on your behalf either monthly or semi-weekly.
Self-employed individuals, independent contractors, investors, landlords, and people earning royalties are subject to paying estimated taxes. As we previously explained in a post detailing the different types of business structures, income generated from sole proprietors, partnerships and S corporations flows through to the owners on their personal tax return. Therefore, individuals who use these business structures generally have to make estimated tax payments if they expect to owe $1,000 or more in taxes when they file their annual return. Farmers and fishermen have more leniency when it comes to estimated tax payments, as the IRS details here.
Corporations generally must make estimated tax payments if they expect to owe $500 or more in taxes on their annual return.
How much estimated tax do I have to pay?
Like a lot of things, it depends! The IRS offers two “safe harbor” methods for determining the minimum you must pay in estimated taxes throughout the year to avoid a penalty:
- Pay at least 90% of the tax you owe for the current year. You’ll need to estimate your income, deductions, credits, etc. and multiply that by your expected tax rate. The IRS offers Form 1040-ES to walk you through this process.
- Pay 100% of the tax you owed for the previous tax year.
High-income taxpayers (those making over $150,000 or $75,000 if married filing separately) must pay the lesser of 90% of the tax owed on the current year’s income, or 110% of the tax owed for the previous year.
Simply divide the estimated amount you owe for the year by 4 to figure your estimated quarterly tax payments.
If coming up with a large amount every three months seems daunting, you might consider taking your annual amount due and breaking it down into monthly or weekly amounts. You could deposit that amount into a savings account (and accrue some interest!) until it’s time to send your estimated payment to the IRS.
You can always pay more tax than the minimum amount you’ll need to pay to avoid a penalty. While the IRS will happily accept larger payments, you may think about setting aside that extra in a savings account, should you need it later. For example, you could end up having higher than anticipated revenue later in the year. In this case, you would need to make larger estimated tax payments in September and January.
When are estimated tax payments due?
Estimated quarterly tax payments are due four times a year. However, be aware that the payment schedule is not evenly spaced throughout the year. The dates are as follows (or the following business day, if the date falls on the weekend or a legal holiday):
- April 15
- June 15
- September 15
- January 15
When you file your taxes, your CPA will typically set up future estimated tax payments.
If you have not paid estimated taxes before, you may be in for an interesting couple of months, depending on your current cash flow situation. Not only are your last year’s taxes due by April 15th, but you’ll also need to make your first estimated tax payment by April 15th for your current year taxes. Then you have only two months until your next estimated tax payment is due on June 15th.
Where do I pay my estimated tax?
As we mentioned above, Form 1040-ES helps you to figure out how much estimated tax you need to pay. This form includes the information you’ll need to make the payment of your taxes online, by phone, by mail or in-person. Yes, you really can take your tax payment in cash to a place like Walmart, Dollar General, and Kwik Trip! Before taking your fistful of cash to the store, however, be sure to first visit the federal payment website to submit the necessary information and to get a barcode to take with your cash. The website also has the complete list of places which accept estimated tax payments.
As you would expect to hear from accounting and HR professionals – document, document, document! Maintain detailed records of your estimated tax payments, including dates, amounts, and confirmation receipts. These records will serve as evidence of compliance with tax obligations and will help you during tax filing season.
Minnesota’s Pass-Through Entity (PTE) Tax
Partnerships, S Corps, and LLCs taxed as partnerships or S Corps may be able to save money on federal taxes by paying the state tax liability incurred on the business net income. Remember that income generated from these business structures flows through to the owners on their personal tax return.
Historically, taxpayers deducted state income tax payments as an itemized deduction on Schedule A of their Federal tax return. For high-income taxpayers residing in states with high state income tax rates, such as Minnesota, this meant a substantial reduction of federal taxes paid.
A change came with the passage of the Tax Cuts and Jobs Act (TCJA) at the end of 2017. Among other major changes, the bill limited the federal deduction for the combination of property and state income taxes to $10,000. This left many high-income taxpayers in high tax rate states (Minnesota, for example) with a considerably larger tax bill.
Therefore, in 2020, the IRS permitted states to enact legislation to create a Pass-Though Entity (PTE) Tax as a workaround to the $10,000 federal limit. The business pays the state tax directly, which reduces the net income on the owner’s federal tax return.
Example of No PTE Tax vs PTE Tax Paid by Business
Let’s say that Olivia is the sole shareholder of an S Corp, and is a single tax filer. In 2022, her business brought in $230,000 of taxable income. Olivia used an itemized deduction of $10,000, not including state income tax. To keep it simple, we will assume a flat tax, instead of a progressive tax.
Calculate PTE tax by multiplying the business income by the highest Minnesota individual income tax rate, which is currently 9.85%.
No PTE Tax Paid by Business
Olivia’s Minnesota state tax liability would be $22,655 ($230,000 x 9.85%). Her federal taxable income would be $210,000 ($230,000 – $10,000 itemized deduction – state income taxes capped at $10,000). Her federal tax liability would be $67,200 ($210,000 x 32%).
PTE Tax Elected by Business
Olivia’s business would pay $22,655 ($230,000 x 9.85%). Olivia’s federal taxable income would be reduced to $194,395 ($230,000 – $22,655 PTE – $12,950 standard deduction). Her federal tax liability would be $62,206 ($194,395 x 32%). So electing PTE tax saved Olivia $4,994!
As you may have concluded, the higher your income, the more advantageous PTE tax will be for you. Also important to note: Once you elect to utilize PTE tax for an entity, you cannot revoke your decision.
We hope this helps to give you a better understanding of estimated tax payments, as well as a way to possibly reduce your overall tax burden. If you have additional questions, we can offer guidance on the estimated tax related to your business. For more complex cases, you may wish to work with a tax professional who can tailor advice to your specific circumstances. They have access to your entire tax situation, so can help ensure accurate calculations and compliance with tax laws.