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The New Entrepreneur's Guide to U.S. Estimated Income Tax

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You've started a new business. You've officially entered the world of entrepreneurship. Your product or service is doing great, and you're seeing wonderful things on the horizon. Don't let those wonderful things get derailed by a pesky thing like taxes – and don’t put off dealing with them.  

Why? 

The Internal Revenue Service (IRS) has broad powers to deal with folks who don't comply with U.S. tax law, and you don't want to be on the receiving end of any undue IRS attention. 

U.S. taxes can be insanely complicated. There's layer upon layer of intricacies, and a wide variety of different tax issues that you may be responsible for as a new entrepreneur.  Those issues will vary, but the one you know you'll have to worry about is estimated income tax payments.  

As an employee you had to worry about income tax in the lead up to April 15th, but as an entrepreneur you’ll have to worry about it throughout the year. This article will guide you through some things you need to know about estimated income tax payments.  

What exactly is income tax?  

U.S. income tax is a transfer of money between you and the federal government, the amount of which is some portion of the money that you earn in a year. Nearly everyone in the US who earns any significant income has to pay income tax.  

As a new entrepreneur, you will too.  

Back when you were an employee, your employer withheld money from your check every month and turned it over to the IRS for you. As an entrepreneur, you’ll have to turn it over yourself.  

What is self-employment tax?  

Think back to your old employee pay stubs. You probably remember seeing deductions from your pay. There were deductions for income tax, but there were also a few others.  Many folks refer to one of those other deductions as to Payroll or FICA taxes. Don’t worry about what FICA means, just know that it represent the amounts you owed the federal government for taxes that support Social Security and Medicare (as opposed to income tax). You paid a certain amount and so did your employer.  

As an entrepreneur, you will have to pay both amounts.  

In the IRS's own words: 

Self-employment tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners.

In the simplest term possible, self-employment tax takes the place of Social Security and Medicare taxes that your employer paid for you in the past.  

The news isn't all bad though because there is something called the self-employment tax deduction, which - in the IRS' own words - is:  

You can deduct the employer-equivalent portion of your self-employment tax in figuring your adjusted gross income. This deduction only affects your income tax. It does not affect either your net earnings from self-employment or your self-employment tax.  

How do you pay income and self-employment tax?

Two ways:

First, and likely something you already know: you pay it in when you file your income tax return for the year…the one that's due to be filed on April 15th. But, your income tax is actually due when you earn the money. If you wait to pay until April 15th, you may end up owning something call the Underpayment of Estimated Tax Penalty. That's a penalty, which can be steep, due if you end up owning more that $1,000 at April 15th.

Second, and the way you can avoid that penalty, is through paying quarterly estimated income tax payments. As an entrepreneur, these payments will take the place of withholdings your employer took care of in the past.

How to you deal with this? 

You can either do-it-yourself or hire someone to help. As it can get complicated, you should at least consider hiring a CPA or other tax pro to help you, not just with estimated payments, but with the host of tax issues you'll come across. You may be a bit resistant to spending the money - or you may not have enough cash coming in at first, so here's a few tips to getting it done yourself:  

Use IRS Form 1040-ES. Follow the instructions. 

Read IRS Publication 505, which will give you much more detail on estimated tax payments along with tax withholdings, but Form 1040-ES will get you started and may be all you'll ever want to use.

Right from Publication 505, the general rule for who needs to make estimated tax payments is: 

In most cases, you must pay estimated tax for 2014 if both of the following apply.

1. You expect to owe at least $1,000 in tax for 2014, after subtracting your withholding and refundable credits.

2. You expect your withholding and refundable credits to be less than the smaller of:

a. 90% of the tax to be shown on your 2014 tax return,
or
b. 100% of the tax shown on your 2013 tax return (as long as your return covered 12 months. 

Again, as a new entrepreneur, you will almost certainly fall into the "have-to-pay" camp. 

How do I figure what I owe? 

Form 1040-ES pages 6 and 7 include instructions on estimating what you owe. You'll need to have handy information about the income you expect to earn during the year along with the expenses you expect to incur. You start completing the worksheet on page 7 that - if you complete your own annual income tax return - should look vaguely familiar because the form is essentially an abbreviated version of the full Form 1040. Use last year's return as a guide.  

On page 6 right before the tax tables, you'll see some information on self-employment tax, which will be part of the final amount you owe.  

When are estimated tax payments due?

  • April 15th 
  • June 15th
  • September 15th
  • January 15th of the next year  

You make these payments quarterly, and the exact due date for each year will vary based on weekends and holidays: use the dates above as a guide. 

How, exactly do you get the money to the IRS? 

There's a few methods. 

You can simply use one of the payment coupons attached to 1040 ES, write a physical check, and mail to the address listed on page 4 for your location. You can also pay online or by phone using a few different methods, which are described on the 1040 ES. With all those choices though, a convenience fee applies. Simply cutting a physical check and buying a stamp may be the easiest way to make the payment. 

What about state income tax?

Most states with an income tax have a similar system. Just search for your state department of revenue to find out. 

Good luck with that new business and those estimated taxes! Please know that this article is for general informational purposes and cannot take the place of professional tax advice.

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less
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