Q2: Do I have to pay my estimates?

Quick Question (Q2) – Do I have to pay my estimated taxes? Like all accounting and tax questions – the answer is “it depends” and it’s not quick.

Due to the complexity of the matter our firm implements the IRS safe harbor guidelines when providing estimates for our clients. This is the most effective way for our firm to ensure our clients are compliant with IRS guidelines and requirements and do not incur any penalties or interest. For the full story, read on, the answer to this quick question is just a little over a 1,000 words (and probably should be longer)…

Even though the IRS uses words like “must”, “compliance”, “have to”, “penalty” – nobody will force you to do it if you don’t want it, you have free-will – there is no proverbial “gun to your head” – the IRS is not going to notify you in July that you didn’t pay your June estimate – in fact they don’t know that you should have paid estimates until you file your return. However, they will get their pound of flesh, keep reading.

So let’s start from the beginning… Who is supposed to pay estimates? From the fine folks at the IRS:

Taxes must be paid as you earn or receive income during the year, either through withholding or estimated tax payments. If the amount of income tax withheld from your salary or pension is not enough, or if you receive income such as interest, dividends, alimony, self-employment income, capital gains, prizes and awards, you may have to make estimated tax payments. If you are in business for yourself, you generally need to make estimated tax payments. Estimated tax is used to pay not only income tax, but other taxes such as self-employment tax and alternative minimum tax.
If you don’t pay enough tax through withholding and estimated tax payments, you may be charged a penalty. You also may be charged a penalty if your estimated tax payments are late, even if you are due a refund when you file your tax return.

Notice the use of the “must” and “penalty” – so obviously the IRS is pretty intent on having you pay quarterlies. The IRS (and Massachusetts) use a “pay-as-you-go” system – example:  a taxpayer makes $100,000 in 2018, (and there were no with-holdings on this income), the IRS assumes that you make your money proportionally over the course of the year, so $25k in Q1, $25k in Q2, and so on… therefore they expect you pay your taxes as you go, assume a 20% effective rate, you “must” pay $5,000 each quarter, or be subject to penalties.

More from the IRS:

Who Must Pay Estimated Tax

Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed.

Again – there is that word “must”. Covered under “Individuals” but not explicitly stated is anyone that receives income, that isn’t taxed at the source:  do you have investment income in the form of interest, dividends or capital gains, do you have a rental property that generates income, do you receive social security, unemployment, gambling winnings, alimony (2018 or earlier divorce agreement) – all of these forms of income normally do not have with-holdings, so they end up in your return, creating a tax liability that has not yet been paid for.

So if the IRS says you “must” – how do you know how much?

How To Figure Estimated Tax

Individuals, including sole proprietors, partners, and S corporation shareholders, generally use Form 1040-ES, to figure estimated tax.
To figure your estimated tax, you must figure your expected adjusted gross income, taxable income, taxes, deductions, and credits for the year.
When figuring your estimated tax for the current year, it may be helpful to use your income, deductions, and credits for the prior year as a starting point. Use your prior year’s federal tax return as a guide. You can use the worksheet in Form 1040-ES to figure your estimated tax. You need to estimate the amount of income you expect to earn for the year. If you estimated your earnings too high, simply complete another Form 1040-ES worksheet to refigure your estimated tax for the next quarter. If you estimated your earnings too low, again complete another Form 1040-ES worksheet to recalculate your estimated tax for the next quarter. You want to estimate your income as accurately as you can to avoid penalties.
You must make adjustments both for changes in your own situation and for recent changes in the tax law.

You must now be thinking:  “Well that seems onerous, certainly not something I want to do four times a year, doing my taxes is painful enough just once a year, there must be a better way…”

Enter the IRS’s safe harbor guidelines – you can base your estimates off of you prior year tax return. By meeting 100% of the tax burden of the prior year (110% if your adjusted gross income (agi) was greater than $150,000 (mfj), $75,000 (mfs) – and paying those quarterly tax payments on time – you are in the clear and penalty free.
Take our earlier example, where our taxpayer made $100,000 and had a resulting $20,000 tax burden (in 2017) – if during 2018, the taxpayer made their 4 quarterly estimated tax payments on time, in the amount $5,000 per, totaling $20,000 – even if the taxpayer’s burden for 2018 was $25,000, leaving them $5,000 to pay when the filed on April 15th – there would be no penalty or interest assessed as the taxpayer met the safe harbor guidelines (provided they fully pay by April 15th).

The estimates that we provide to our clients are based upon the safe harbor guidelines. Barring any material changes in income or life we strongly encourage you to make all of your estimated tax payments in full and on-time. Worst case scenario of paying them all (in full and on-time) is that you are overpaid, and that amount can either be utilized to reduce next year’s estimates or refunded to you.

If there are material changes in your income or life situation, we encourage you to contact us so that we can work together to establish a new estimate plan based on a projection of the current year.

As part of a tax planning engagement, we will advise on appropriate changes to estimates based upon your particular facts and circumstances and a projection of the current year which includes all the elements prescribed by the IRS. Absent that engagement and that effort – we advise you to stay the course and make your quarterly estimates as provided to you.

Stephan P. McMahon & Company