Quarterly self-employment tax payments/estimations

[savedandsaving]

Hey, Mustachians! DH and I are in our first full year of both being self-employed as opposed to one or both working W2 jobs. DH was wise enough to research tax burden specifics and find out about quarterly estimated payments (federal and state, for any who might not know) - which I was loathe to pay (how am I supposed to know exactly how much we'll make by the end of the year? What if I'm giving the government an interest-free loan of far more money than they should get from me? I thought self-employment freedom would also come with the freedom and time to set money aside and get my tax affairs in order by April of each year!)

All the same, we faithfully paid a massive amount in the first and second quarter of the year - until we hit this quarter - our lowest-earning yet by far. This was planned for to some extent: we anticipated the end of DH's largest contract and some other personal events, but I'm embarrassed to say that it wasn't planned for as well as I thought. We're currently a bit cash poor and dipping lightly into the EF. The monthly budget is tight. And then, an apparent lifeline: one of DH's friends and fellow freelancers (who has been in the same career and working the same types of jobs for much longer) says he doesn't ever pay quarterly payments and just eats the IRS penalty after filing each year. My mind was blown. We aren't comfortable with that level of risk, but in response, we wondered if we'd ever be open to paying a lower amount than required - only what we could afford at the time if we happened upon another dismal earning quarter.

My questions for other self-employed folks and any tax experts out there: What kind of a penalty would someone be looking at if they didn't pay quarterly at all? Are we talking around or less than $100? Hundreds? Thousands? A percentage of total tax burden?

What about the penalty if someone pays quarterly, but pays less than they owe because they simply can't afford it at the time? Does the IRS look favorably on that? Thanks in advance for any help.

[Sibley]

You know how sometimes you look at your kid's friend and wince because the friend is a fuck up and going to make their life harder for no good reason, and now your kid is being influenced by the friend and is becoming a fuck up as well? Yeah. Please don't take tax advice from your husband's friend.

Here's the IRS rules on estimated taxes. https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes

Unless your AGI is more than $150k a year, you need to make safe harbor estimated payments - 100% of the prior year's tax liability. That's it. As long as you pay that amount, you won't have penalties. You should have taken that amount, divided it by 4, and that is your quarterly estimated amounts. Then next year, you'll reset and pay 100% of this year's liability.

Here's a plain English write up:
https://www.hrblock.com/tax-center/irs/tax-responsibilities/avoiding-underpayment-tax-penalty/

[MDM]

What kind of a penalty would someone be looking at if they didn't pay quarterly at all? Are we talking...percentage of total tax burden?

Yes, that's how it works.  See Form 2210.

I've toyed around with the idea of adding a Form 2210 sheet to the Case Study Spreadsheet.  Schedule AI and the Penalty Worksheet are the two most complicated parts.  Even the commercial software folks (Turbotax, etc.) often struggle to get a working 2210 delivered in a reasonable time each filing season.

A worst case estimate might be
Penalty = (total tax liability * 90%) * 25% * (365/365 + 304/365 + 212/365 + 90/365) * 3%
             = (total tax liability * 90%) * 25% * (2.66) * 3%
             = (total tax liability) * 0.6 * 3%
             = (total tax liability) * 1.8%

The 90% comes from 2210 line 5, the 25% comes from 2210 line 10, and the 365, 304, 212, and 90 come from summing the columns in Table 2. Chart of Total Days and assumes you don't pay anything until April 15 of next year.  The 3% is the 2021 late payment interest charge - don't know what it is for 2022.

What about the penalty if someone pays quarterly, but pays less than they owe because they simply can't afford it at the time? Does the IRS look favorably on that? Thanks in advance for any help.

Yes, you only get charged interest on the amounts you haven't paid on time.  Paying "too much" early in the year reduces (in the extreme, eliminates) the penalty because any extra amounts carry over to the next quarter.

[savedandsaving]

You should have taken that amount, divided it by 4, and that is your quarterly estimated amounts.

My mind is absolutely blown. Again. Based on this, we've already way overpaid and don't need to pay anything else for federal come December. Thank you so much.

Additional question: CA has the same rules, except it's 110% (of the previous year's liability.) We got a tidy little refund from CA last year...because we spent so dang much moving here, but still. It was nice. Since we got a refund, aka had a ~negative~ tax burden, does this mean we technically don't owe CA anything in quarterly payments?

[MDM]

Additional question: CA has the same rules, except it's 110% (of the previous year's liability.) We got a tidy little refund from CA last year...because we spent so dang much moving here, but still. It was nice. Since we got a refund, aka had a ~negative~ tax burden, does this mean we technically don't owe CA anything in quarterly payments?

Not necessarily.  The "previous year's liability" is the amount of tax you owed before subtracting withholding and estimated payments.

[ixtap]

You should have taken that amount, divided it by 4, and that is your quarterly estimated amounts.

My mind is absolutely blown. Again. Based on this, we've already way overpaid and don't need to pay anything else for federal come December. Thank you so much.

Additional question: CA has the same rules, except it's 110% (of the previous year's liability.) We got a tidy little refund from CA last year...because we spent so dang much moving here, but still. It was nice. Since we got a refund, aka had a ~negative~ tax burden, does this mean we technically don't owe CA anything in quarterly payments?

Your tax liability - taxes actually paid = refund/amount owed. Alone, you refund doesn't really tell you anything about your tax liability. You need to find out how much tax you paid last year (aka withheld + estimated + amount owed at end of year/-refund).

Also, as a self employed individual, your self employment taxes will be applied before income taxes. You may still want to submit that amount, unless you have gone far over the safe harbor amounts.

[savedandsaving]

The "previous year's liability" is the amount of tax you owed before subtracting withholding and estimated payments.

Ah, I see. Thank you. That number is still quite small - less than $200 - but I'm guessing that means as long as we pay CA $200 this year, we'll be safe from penalties.

(aka withheld + estimated + amount owed at end of year/-refund).

Sorry to ask, but could you explain this formula a little more? Like I'm 5 (because apparently I am?)

Also, as a self employed individual, your self employment taxes will be applied before income taxes. You may still want to submit that amount, unless you have gone far over the safe harbor amounts.

Thank you for this warning. Looking at total federal tax liability from last year, it was a larger number than I was working off of yesterday, but we had still paid well over 100% of it by June in estimated payments. Since we would struggle to pay the same amount in December, I think it make sense to drastically step down what we pay and see where that gets us come April.

[dandarc]

Numbers completely made up, but hopefully illustrates well enough.

$120,000 - taxable income

$15,000 - self employment tax
$13,000 - federal income tax

$28,000 - total federal taxes owed

$30,000 - estimated tax payments for that tax year

$2,000 - refund

NEXT YEAR SAFEHARBOR: $28,000 / 4 = $7,000 payment due each quarter.

Edit: Seattle cyclone pointed out I can't add

[seattlecyclone]

(aka withheld + estimated + amount owed at end of year/-refund).

Sorry to ask, but could you explain this formula a little more? Like I'm 5 (because apparently I am?)

Tax liability is the total amount that you owe to the government throughout the year. In the spring when you fill out your 1040 you calculate this number, and you also reconcile this number against what you've already paid through withholding and/or quarterly payments. If you've already paid more than your tax liability you get a refund for the difference.

Algebraically speaking, the following two equations are saying the exact same thing:
1) Refund = amount withheld + amount paid quarterly - tax liability
2) Tax liability = amount withheld + amount paid quarterly - refund

$3,0002,000 - refund

Fixed that for you. :-)

[phildonnia]

My questions for other self-employed folks and any tax experts out there: What kind of a penalty would someone be looking at if they didn't pay quarterly at all? Are we talking around or less than $100? Hundreds? Thousands? A percentage of total tax burden?

The current penalty rate (which changes all the time) is 0.0137% per day, from the time the payment should have been paid until the time it actually is paid.  For example, a $5000 payment due on September 15, 2022, but not paid until April 15, 2023 will get a penalty of $145, assuming the penalties don't change.   That's just the penalty for that one payment.

That's roughly equivalent to a bank car loan interest.  I'm not going to opine on whether this is a legitimate strategy.  But if it's between that and a check-cashing store or a credit card advance, I would absolutely take the IRS penalty rate.    Make absolutely sure that you have the money ready at tax filing time, or the penalties get a lot worse. 

This is complicated by a few other things, which you should be aware of. First, "How much you should have paid" is determined by how much your total tax liability turns out to be, and as you pointed out, you can't know that until you file your taxes. 

Second, you have the option to decide at filing time to average your amounts due over each quarter, if that will make your penalty less. Since you said you paid a "massive amount" in the first two quarters, this may be the answer you're looking for.  A massive amount of tax due, averaged with two lean quarters may mean that your amounts due are less than you think.  Then if you've overpaid for the first two quarters, those overpayments are applied to subsequent payments.

And finally, you are allowed to calculate your penalty based on the tax liability from the previous year.  That is, you can ignore this year completely, and pay according to how much you owed last year (110% of that if you were "high income" last year.) 

I hope that made sense.  You may want to go through the worksheets in the Form 1040-ES instructions.  Another option is to get a Form 2210 from last year, and fill it out with hypothetical numbers for this year.  If you had a lot of income early in the year, try not using "Box C".  (Box C is a pain in the butt anyway).

What about the penalty if someone pays quarterly, but pays less than they owe because they simply can't afford it at the time? Does the IRS look favorably on that? Thanks in advance for any help.

You can get a waiver of the penalty if you were hit by a bus and were in a coma, and weren't able to send in a check.  But you don't get a waiver for being unable to pay.  In the IRS's view, you had the income, so you must be able to pay. 

[phildonnia]

My mind is absolutely blown. Again. Based on this, we've already way overpaid and don't need to pay anything else for federal come December. Thank you so much.

Additional question: CA has the same rules, except it's 110% (of the previous year's liability.) We got a tidy little refund from CA last year...because we spent so dang much moving here, but still. It was nice. Since we got a refund, aka had a ~negative~ tax burden, does this mean we technically don't owe CA anything in quarterly payments?

I just wanted to add something else, since you mentioned California: Instead of dividing your payments equally across four quarters, California requires 30% in the first quarter, 40% in the second quarter, and 30% in the fourth quarter.  I have no idea why this is, other than they just want to get more of your money sooner.  But there it is.

[MDM]

The 3% is the 2021 late payment interest charge - don't know what it is for 2022.

The current penalty rate (which changes all the time) is 0.0137% per day, from the time the payment should have been paid until the time it actually is paid.

Found the reference: Quarterly Interest Rates | Internal Revenue Service

For tax year 2022, the annual interest rates announced so far, applied to underpayments for that quarter, are
2nd Quarter (Apr–Jun)  4%
3rd Quarter (Jul–Sep)   5%
4th Quarter (Oct-Dec)   6%

Given the Federal Reserve's current policy, one would not expect the 1Q23 rate (that also applies through 15-Apr-2023 for TY2022 penalty purposes - see 26 USC 6621: Determination of rate of interest) to be any lower than 6%.

[SeattleCPA]

And then, an apparent lifeline: one of DH's friends and fellow freelancers (who has been in the same career and working the same types of jobs for much longer) says he doesn't ever pay quarterly payments and just eats the IRS penalty after filing each year. My mind was blown.

The friend's idea actually isn't that terrible. And he is doing what a lot of people do. (Lots of entrepreneurs consider the combined penalty and interest charges a relatively reasonable interest charge on what amounts to an extremely convenient loan.)

What I, as a tax accountant working with small businesses, always worry about: Some business owner ignores the taxes they're incurring over the year. And then they get out to April or whatever. And then at that point, slam, someone does the tax return and realizes, "Oh boy, we owe $6K... or $16K... or $60K".

My boilerplate suggestion: Come up with a simple formula you can apply to your quarterly profits. If you're paying the 15.3% SE tax rate on all your income and then a 10% or 12% marginal tax rate, maybe you figure your average tax rate is 20%-ish. So then you use that 20% rate to estimate each quarter's federal tax liability. And you pay that amount.

If the quarter shows $50K in profits, you pay $10K. If it shows $1K in profits, you pay $200.

BTW if you can't pay the formula's amount? You pay as much as you can.

And then, just to say it again, what you really don't want to do--and this is experience talking--is ignore the fact that you will owe some significant amount of tax (probably and hopefully) at tax time. Because the mother of all tax battles is getting blindsided by some tax bill you can't pay.

[Catbert]

The "previous year's liability" is the amount of tax you owed before subtracting withholding and estimated payments.

Ah, I see. Thank you. That number is still quite small - less than $200 - but I'm guessing that means as long as we pay CA $200 this year, we'll be safe from penalties.

(aka withheld + estimated + amount owed at end of year/-refund).

Sorry to ask, but could you explain this formula a little more? Like I'm 5 (because apparently I am?)

Also, as a self employed individual, your self employment taxes will be applied before income taxes. You may still want to submit that amount, unless you have gone far over the safe harbor amounts.

Thank you for this warning. Looking at total federal tax liability from last year, it was a larger number than I was working off of yesterday, but we had still paid well over 100% of it by June in estimated payments. Since we would struggle to pay the same amount in December, I think it make sense to drastically step down what we pay and see where that gets us come April.

It concerns me that you believe that your CA income tax was $200 last year.  Are you sure that's right?  That would mean that you had less than 22K of taxable income last year (if I'm reading the CA brackets right).

[savedandsaving]

My boilerplate suggestion: Come up with a simple formula you can apply to your quarterly profits. If you're paying the 15.3% SE tax rate on all your income and then a 10% or 12% marginal tax rate, maybe you figure your average tax rate is 20%-ish. So then you use that 20% rate to estimate each quarter's federal tax liability. And you pay that amount.

If the quarter shows $50K in profits, you pay $10K. If it shows $1K in profits, you pay $200.

Nice to hear from a tax expert. Would you consider the strategy above to be more or less safe than making safe harbor payments based on the previous year's tax liability, as others in this thread have suggested? Or about the same?

It concerns me that you believe that your CA income tax was $200 last year.  Are you sure that's right?  That would mean that you had less than 22K of taxable income last year (if I'm reading the CA brackets right).

I'll double-check, but that sounds close. We moved to CA partway through the year, and DH was unemployed for a bit. That was just the portion of the year's income that we actually made while in CA. (We also had to file a state return for the state we moved from.)

[SeattleCPA]

Nice to hear from a tax expert. Would you consider the strategy above to be more or less safe than making safe harbor payments based on the previous year's tax liability, as others in this thread have suggested? Or about the same?

Oh, gosh, I'd make some estimated tax payments. That'll prevent you guys from getting squeezed for cash at tax time. But I wouldn't worry a ton. And I'd basically look at any penalty and interest charges in relation to the work required to avoid them.

[dandarc]

I imagine one of a tax accountant's least favorite things to do is telling a business owner "did your return and you owe $30,000 . . ." if you're doing the safe-harbor based on last year's taxes owed thing and your income goes up significantly, that huge tax bill is going to be on the table. If you can easily handle something like that and pay up when you need to, then more power to you. If not, best to try to estimate current year taxes and pay along the course of the year, and sending in a percentage each quarter is a convenient way to do that.

[savedandsaving]

Oh, gosh, I'd make some estimated tax payments. That'll prevent you guys from getting squeezed for cash at tax time. But I wouldn't worry a ton. And I'd basically look at any penalty and interest charges in relation to the work required to avoid them.

If you can easily handle something like that and pay up when you need to, then more power to you. If not, best to try to estimate current year taxes and pay along the course of the year, and sending in a percentage each quarter is a convenient way to do that.

Thanks, both of you. This is all extremely helpful. The way I see it, assuming we increase our earnings each year (let's hope!), we should realistically approach each quarterly payment amount as a range between [safe harbor payments based on last year's liability] and [liberal estimate of this year's liability, perhaps 20-25% or so of quarterly earnings]. It's always great to hit the upper limit of that range, but if we have to just make do with the lower limit, that's fine, too - assuming we'll have the cash on hand to pay our whole tax bill come April.

[dandarc]

One thing to watch out for - the due dates are April, June, September, January, so that June one in particular can be a pain cash-flow wise since the payment is due before the calendar quarter is over. Manageable, but not always easy.

Technically, only 2 months of estimated tax is due then, but if you take them up on that, then you get to do the long annoying worksheet to decide if you paid enough each time or owe a small penalty.

[MDM]

One thing to watch out for - the due dates are April, June, September, January, so that June one in particular can be a pain cash-flow wise since the payment is due before the calendar quarter is over. Manageable, but not always easy.

Technically, only 2 months of estimated tax is due then, but if you take them up on that, then you get to do the long annoying worksheet to decide if you paid enough each time or owe a small penalty.

If, on Form 2210, line 11 (25% of withholding plus actual estimated tax paid) is equal to or more than line 10 (25% of the smaller of Safe harbors #2 and #3) for all payment periods, no more is needed.  Yes, if Schedule AI is needed, that can be annoying.

[Reynold]

What about the penalty if someone pays quarterly, but pays less than they owe because they simply can't afford it at the time? Does the IRS look favorably on that? Thanks in advance for any help.

You can get a waiver of the penalty if you were hit by a bus and were in a coma, and weren't able to send in a check.  But you don't get a waiver for being unable to pay.  In the IRS's view, you had the income, so you must be able to pay.

I read of some cases around 2000 where dot com day traders really got bit by that, say you invest $20k in idiotproduct.com and it soars to $200k, you sell and reinvest in vaporconcept.com, which goes bankrupt, all in the same year.  As far as the IRS is concerned, you owe taxes on $180k in short term capital gains, though they will generously allow you to deduct $3k/year worth of capital losses against that, I think.  Good luck finding another ~$60k for your tax payment. . .

[seattlecyclone]

What about the penalty if someone pays quarterly, but pays less than they owe because they simply can't afford it at the time? Does the IRS look favorably on that? Thanks in advance for any help.

You can get a waiver of the penalty if you were hit by a bus and were in a coma, and weren't able to send in a check.  But you don't get a waiver for being unable to pay.  In the IRS's view, you had the income, so you must be able to pay.

I read of some cases around 2000 where dot com day traders really got bit by that, say you invest $20k in idiotproduct.com and it soars to $200k, you sell and reinvest in vaporconcept.com, which goes bankrupt, all in the same year.  As far as the IRS is concerned, you owe taxes on $180k in short term capital gains, though they will generously allow you to deduct $3k/year worth of capital losses against that, I think.  Good luck finding another ~$60k for your tax payment. . .

Yep. The fact that you put the money you should have set aside for your capital gains taxes on investments that didn't work out is not the IRS's problem.