Estimated Taxes

I am getting lots of questions on estimated taxes, so I thought an overview necessary. Here 'tis.

Federal income tax, Social Security tax and Medicare tax are pay-as-you-go taxes; that is, the tax must be paid as income is earned. Dennis Dubya-two, shipping clerk for Toys 'n' Things, receives a paycheck every week. Each week Toys 'n' Things withholds all applicable taxes from Dennis’ pay and forwards them to various government agencies. At the end of the year Dennis receives a W-2 which shows income earned and taxes paid.

Self-employeds must follow the same pay-as-you-go method as do wage earners like Dennis. As an entrepreneur brings in income he withholds taxes from himself -- that is, he puts money aside -- and then sends his taxes to the government via estimated tax payments.

Not every self-employed has to make estimated tax payments.
It’s the overall tax liability of a self-employed that determines whether estimated tax payments are required. An indie’s total tax liability is made up of self-employment (SE) tax on his net self-employed earnings and income tax on all his and his spouse’s income.

SE tax and income tax on self-employed income are not the only factors in calculating estimated tax payments. If, for instance, you had a self-employed business income of $10,000 and also had investment dividends of $30,000, both these sources of income (totaling $40,000) would be elements in your estimated tax calculation. And if your wife earned $90,000 at her W-2 job, the taxes withheld from her income would also be a factor in those calculations.

Because someone is self-employed doesn’t necessarily mean that he must make estimated tax payments. Consider the following situations:
** When all income and deductions are combined, there is no tax liability. For instance, enough tax may be withheld via a W-2 job or pension withdrawals to cover the entire tax liability.
** The previous year’s tax refund may be carried forward in a sufficient amount to eliminate the need for estimated payments.

Who must make estimated tax payments?
Although there are exceptions, here's the safe and simple rule:
You must make estimated tax payments to the Federal government if you had a tax liability for the previous year and you expect to owe tax of $1,000 or more when you file your tax return for this year.

For more information on how to calculate estimated tax payments go to my site for Estimated Tax:How much should I pay?

When to make estimated payments:
Under most circumstances you will make four estimated tax payments to the IRS and also possibly to your resident state and, if you earn self-employed income elsewhere, to a non-resident state as well. The methods used to calculate the IRS estimated payment amount usually apply in the same way to the states – but to be sure you ought to confirm this with your tax preparer or state tax office.

The following shows the dates for making estimated payments.

For the period.............................Due date:
January 1 through March 31......April 15
April 1 through May 31...............June 15
June 1 through August 31..........September 15
Sept. 1 through Dec. 31.............January 15, the following year

It is not a crisis if you’re late on a payment due date. Depending on the amount of tax payment, an interest and/or penalty amount will be calculated at the time your tax return is prepared. The IRS rate is lower than most credit card finance charge rates.

How to pay estimated taxes:
There are several ways to pay estimated taxes.

Carry forward a previous year overpayment.
When you file your tax return, if you have an overpayment of tax you can choose to have the refund returned to you or you can apply part or all of it to your estimated tax for the following year.

The amount you have carried forward as payment toward the following year should be taken into account when figuring your estimated payments. You can use all the carry-forward amount toward your first payment, or you can spread it out in any way you choose among any or all of your payments. If you find the January 15 payment difficult because of holiday spending then use your carry-forward to ease your cash flow and have it applied to the fourth payment.

Pay by check.
Use Form 1040-ES, Payment Voucher, to pay Federal estimated tax. There are four numbered vouchers. Include one with each payment by check.

Be sure the voucher is filled in accurately. If you are married then put the names and Social Security numbers in the same order as they appear on your tax return.

Make the check or money order payable to the “United States Treasury.” On the check or money order write your Social Security number and “2007 Form 1040-ES.” Don’t staple or clip the check to the voucher.

If you made estimated tax payments in the previous year, you’ll receive IRS payment vouchers in the mail for the current year. You can get the vouchers and mailing address (it is not the same as that to which you mail your tax return) at www.irs.gov.

Careful! Never send a payment to the IRS (or any government agency) without the correct document – for example, a voucher-- properly filled out, accompanying it.

Pay by credit card, electronic payment or withdrawal.
Be careful if you pay your estimateds, or any other tax, by credit card. Most service providers charge a fee. This is in addition to any finance charges that will accrue, usually daily, on the amount you owe the credit card company. The options for credit card and electronic tax payments or funds withdrawal are changing rapidly. You can get the most current information at http://www.irs.gov/pub/irs-pdf/f1040es.pdf.

Estimated taxes are explained in greater detail in my book, Self-employed TAX Solutions.

Estimated Tax: How Much To Plan For

June --

My accountant told me that, on an income of $72,000, that I should pay $6,215 every quarter as an estimated tax payment. Does that seem accurate? I have colleagues with larger client bases making more than that and paying less, so I'm confused.

Also, I'm a little intimidated since I wasn't planning for such a high tax liability. Guidance?

Jon-David, New York


Jon-David, let's look at income in relation to taxes.

Which income are you talking about? Gross income, which is all the money you bring in; or net income, which is what you have left after deducting all business expenses.

Perhaps your colleagues have a higher gross income, but because they have more expenses, or are better at keeping records of their expenses, or have a sharper tax pro, their net income is less.

As a general rule, I tell indies to plan on 30% to 40% of their net income going to taxes. It can be higher or lower than that depending on income level and state taxes. Your four payments of $6,215 equal about 34% of your $72,000 income, so that may be correct.

You can learn more about taxes in the column on my website Taxes: Which ones and how much do I pay?

Also, check out the post below, Estimated Taxes Paid Late .

-- June

Estimated Taxes Paid Late

June --

I have a question regarding Estimated Tax. My income did not change a lot from last year, but now after I completed the filing and printed the forms I noticed that I have four vouchers for estimated tax and one for my owed tax. So I have to pay $1415 -- the amount I owe for 2006 and the estimated taxes?

I have four payments of $351. It is correct or I did something wrong on my filling?

What’s happens if I don’t make these payments? I think this year I had to pay underpayment penalty of $50.

Thank you for your advice.

Marcel


Hello Marcel,

Four payments of $351 = $1404. If the tax program you're using did it correctly it'll have you pay for 2007 what your tax was in 2006. Was your 2006 tax about $1400?

Nothing terrible happens if you pay your estimated taxes late, or even if don't pay them at all. You'll simply owe some penalty and interest.

I suggest you read the following two columns from my site: Estimated Tax Payments and Estimated Tax: How much should I pay?

Best regards,
June Walker


June, thank you, thank you so much for your response. I wasn't sure and I was afraid to send them away. Also thank you for the stuff you put out there on your website, it helps a lot a novice like me.
Marcel

Tax Pro's Fees for Tax Return Preparation

June --

I am actually sending this for my wife. How much should an accountant charge for doing your taxes? I know I overpaid and it will be a deduction next year. I am learning more and I think I can handle the taxes next year. I went to the pro to see what expenses I missed and I really didn't do that bad the first year so I think I can handle it especially if I have your list of business expenses.

Yvonne's husband in NYC

Hello Caring Husband,

I wish I got a little more info from you so that I could give you a better example of how your question would be posed to someone in your profession.

Let me try. You said your business is Technical Design Consultant/ Fashion Industry, so, here goes: How much should I spend on my 2007 wardrobe? Or, how much should I spend on the design illustration of our main chemical process for my annual report?

You see what I mean? I have no idea of the complexity of your return. Is it a $10,000 or a $500,000 business? Is there an inventory? Are your records professionally kept or do you arrive in the office with estimated amounts? Do you have children? Investments?

And then there's the question of the skill and experience of your tax professional, better skills and experience mean higher fees. And of course, location, for instance, fees are higher in New York City than in Espanola, New Mexico.

A popular tax prep franchise did a return for my friend with only one W-2 and nothing else, and the fee was close to $200. My friend was their retuning client so she was already on their computer and so I estimated that the return took about 20 minutes to prepare. That's a fee of $600 per hour.

So, to answer your question, depending on location, tax professional's competence and complexity of the return, fees vary. Accountants typically charge from $40 to $260 per hour. A very simple self-employed tax return for a returning client with one resident state might take three or four hours.

It's admirable that you are learning more about taxes. The more you know the better prepared you will be to take advantage of all business deductions. Also the better prepared you are the less time your tax pro will need and so her fees will be less. Keep up the good work and your wife can put you on her payroll and give you employee benefits and then you'll pay less tax.

Check out the post below, Pick a Tax Professional: Experience or Price .

I suggest you read my book, SELF-EMPLOYED TAX SOLUTIONS. It answers many indie tax questions in the same easy to understand style you'll find in the columns on my website. And more than just answering those taxing questions, the information in SOLUTIONS will give you a firm foundation on which to make indie business decisions.

Keep in mind, I do not recommend any self-employed do his own return unless it is impossible to find a competent pro!

-- June

Deducting an Attorney's Time

June --

As a self-employed attorney, ordinarily I would charge my travel time to a client, usually at my full billable rate, but sometimes at a reduced rate. I spent several months last year working at a temporary work location as an independent contractor responsible for reviewing my clients' contracts, and negotiating and drafting agreements. The temporary work location in central North Carolina was situated 61 miles from my tax home in southern Virginia, so I spent about 2.5 hours per day traveling to the worksite for which I was not separately compensated, and for which I could not bill to the client (per our consulting agreement, I was responsible for my own travel costs).

Can I claim the 2.5 hours per day of non-productive, otherwise billable, but unreimbursed (by the client) travel time as an ordinary and necessary business expense to offset my gross profits on Schedule C?

The common practice of law firms billing travel time, and the stock-in-trade of an attorney being his/her "time" as measured by billable hours, seems to suggest I can list my expended travel time (necessary in order to reach my distant worksite, and unproductive because i could not work for this or for other clients while driving) as an ordinary and necessary business expense for purposes of trimming my taxable net profit.

Chris

Hello Chris,

Good argument, but no. you cannot claim your time, no matter how valuable, as a business deduction.

The same reasoning applies to contributions of your time and or services to a charitable organization. For instance, were you to donate your services to a non-profit you would get no tax deduction. But, were you to bill me for services and then give to the charity as a donation whatever I paid you, then you'd be able to deduct it. Take a look at No deduction for donated work or services on my website for a little more info.

Best,
June

3 Rules for Home Office Expense ... everybody's asking about them

As an indie in business you may work anywhere you want. You may rent an office or studio, purchase an entire building in which to set up shop, or work out of your home. Whatever suits your situation. If you happen to work out of more than one place you may be able to deduct expenses for all of them.

There’s an old husband’s tale that contends deducting office-in-the-home expense on your tax return is a red, waving flag, so don’t do it. That’s hogwash. If you use your home for your self-employed business, then, by golly, don’t be afraid to take the deduction. By deducting expenses for your home workspace you’ll pay less tax. The only caveat: play by the rules.

The IRS has relaxed the rules in recent years, and they are simpler than you may have been led to believe. There are now only three home office rules.

RULE #1: Exclusive Use
The part of your home used for business must be used exclusively for business. It does not need to be an entire room, but may be a designated area of a room.

• If Lily Legal writes her briefs at the dining room table but also has dinner parties there, well, she has to forgo any deduction for the dining room.

• If Victor Visual and his wife Faye Fabrique, a textile designer, share the same studio-in-the-home, then neither gets the deduction because neither has exclusive use. (It seems unfair, but it's true.)

RULE #2. Used On A Regular Basis
The part of your home used for business must be used on a regular basis for business.

• Almost Sargent has a rented studio in town. He also has great light in a back room of his house. The room is always locked and seldom used. Once in a while he brings a potential buyer to his home to look at a painting and he uses the back room for the viewing. This is not regular use and so he cannot deduct the use of that room as a business expense.

RULE #3. Principal Place Of Business
Your home office or studio or workshop must be your principal place of business. The IRS term principal place of business is confusing. Even if you have more than one place of business, as long as the room or area in your home is used exclusively and regularly for business then your home office qualifies as a principal place of business if it fits any of the following three criteria.

** It is where you perform administrative tasks such as bookkeeping or scheduling.

** It’s a place where you meet clients, or patients, or customers.

** It’s a separate structure.

• Sally Ceramist rents a neighbor’s garage as her work studio. It’s always a mess. She has set up the small sunroom in her home as her showcase studio. Potential buyers come there by appointment to view her work. Although her works also show at a number of galleries throughout the United States Sally can deduct the sunroom as a home office.

• Kyla Chiropractor shares an office with an acupuncturist. They alternate days. Kyla does not keep patient records at the office. Each morning she brings from home that day’s patient folders. She keeps all her patient records, and her professional library, in a small barn on her farmland home. Kyla can deduct the barn.

There are exceptions to RULE #1, which requires exclusive use. The exceptions apply to home daycare businesses and storage of inventory.

What Can You Deduct?
Your home may be any kind of residence: house; apartment; condominium; cooperative; houseboat; mobile home.

And, all expenses for the portion of your residence used for business are deductible; that includes rent, repairs, utilities, security system, and upkeep expenses. If you own the home, deductions include mortgage interest and real estate taxes. If for instance 20% of your home is used for business then you can deduct 20% of all these expenses.

You cannot deduct lawn care unless there is an area that is for the exclusive use of your business.

The housekeeper that you have agreed to pay “off the books” – the one who takes cash only -- cannot be deducted as an expense. You can deduct the costs for a legitimate cleaning service or a housekeeper for whom you pay all payroll taxes.

More about START-UP COSTS: The expense of checking out a new business

Family and wedding photographer, Billy Bridesnapper, was getting itchy about his job at Phil's Photos. He traipsed all around the county, in his own van, hauling his own equipment, getting shots that wowed everyone, yet he was earning only a small hourly wage and a small percent of each photo shoot he did while Phil made the big bucks. Over the course of several years Billy had learned a lot, mostly through observation, about the management end of the business; and via word-of-mouth he’d become known for his untypical black and white photos of typical family occasions. Friends and colleagues encouraged him to strike out on his own but being a savvy businessperson (for a photographer, that is) he decided to first weigh the pros and cons by evaluating the market for his kind of photos and getting estimates of the cost to set up his business. Also, Billy didn’t feel right going into direct competition with Phil, yet all his contacts were in the same geographic location. He’d have to do a lot of planning before he started his own business.

Although only 27 years old he managed to save up enough money to get started in his own business. (I told you he was unusual for a photographer.) When Phil announced he was going to sell the business to his brother Phineas, Billy really got busy, because he knew he did not want to work for Phineas. In a few months Billy spent $7,200 on locating and doing some repair work on a studio (with the help of his cousin, a carpenter) and printing high quality promotional literature which stresses the merits of his exclusive use of black and white photographs for all his assignments, including weddings, bar mitzvahs, retirement parties, and so on.

His decision to concentrate exclusively on black and white photography sets him apart from and avoids competition with Phineas; he can send customers who want the color photograph treatment to Phineas, who can reciprocate by sending to Billy those interested in black-and-white photos. They shake hands, part company, and Billy heads out on his own.

The expenses that Billy incurred in the organizing and planning stage of his new venture can be classified as START-UP COSTS.

The list of possible start-up expenses is as long and varied as a list of expenses for an existing business. Here's a sampling of business start-up expenses:
· Advertising for the grand opening
· Analysis of available facilities, labor, and supplies
· Fees for the professional services of accountants and lawyers
· Office supplies
· Repairs
· Salaries and fees for consultants
· Survey of potential markets
· Training employees
· Travel to find customers, suppliers, or financing
· Travel to look over business sites
· Utilities

Since Billy is now in business, all his start-up expenses are deductible.

However, deducting the costs of checking out a new indie venture are not always deductible. That's because start-up expenses fall into two types, general and specific.

Exploratory or General
These are costs you have before making a decision to begin or acquire a specific business. They include any costs incurred during a general search for, or a preliminary exploration of, a new venture. If you do not go into business then these costs are personal and nondeductible.

Investigative or Specific
These are costs incurred in your attempt to acquire or begin a specific trade or business. Even if you do not go into business, the costs are capital expenses and you can deduct them as a capital loss – similar to a loss on a stock sale.

Looking at the IRS guidelines on start-up costs for a business that never gets off the ground, it's quite clear that the agency wants to rein in people who have a notion to deduct ski trips and South American adventures under the pretext of business exploration.

If a business never gets started then exploratory expenses never can be deducted; but specific expenses always can be deducted. Be aware that when the IRS says "specific business" it means just that -- that the costs are incurred trying to start a new business or buy an existing one. It does not mean exploring a specific type of business.

There's more on Billy's business and a more complete explanation of start-up costs in Chapter Three of SELF-EMPLOYED TAX SOLUTIONS.