Estimated Taxes: How They Work & Who Must Pay

At a glance: 

• The main takeaway: Estimated taxes are a vital component to the U.S. tax system for individuals and businesses that do not withhold income tax.   
• Impact on your business: To avoid costly penalties, it’s important to understand who must pay, how to calculate payments, and the deadlines that must be met.
• Next steps: Aprio’s Tax advisors can help determine your estimated taxes, so you remain compliant with the IRS.   

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Full story 

For many taxpayers, income tax is withheld from paychecks by employers, to ensure tax obligations are met throughout the year. However, for self-employed individuals, freelancers, business owners, C corporations, and others who do not have taxes withheld, the responsibility falls on them to pay taxes periodically through estimated tax payments. Understanding estimated taxes is crucial to avoid penalties and stay compliant with IRS requirements.

What are estimated taxes?

Estimated taxes are periodic advance payments made to the IRS on income that is not subject to withholding. This includes income from activities such as self-employment, rental properties, investments, dividends, and other non-wage sources, as well as C corporations with expected taxable income. The tax system in the U.S. operates on a “pay-as-you-go” basis, meaning taxpayers are required to pay taxes as income is earned rather than in one lump sum at the end of the year. If a taxpayer does not have sufficient withholding from a job or other sources, they may be required to make estimated tax payments.

Who is required to pay estimated taxes?

Generally, individuals, including sole proprietors, partners, and S corporation shareholders, must make estimated tax payments if they expect to owe at least $1,000 in tax when their return is filed. Whereas C corporations typically must make estimated payments if they expect to owe $500 or more. Those who receive substantial income from self-employment, interest, dividends, alimony, rent, or capital gains are often required to make estimated payments.

Taxpayers who do not make estimated payments when required may be subject to penalties for underpayment, even if they ultimately owe little or no tax when they file their return. The IRS assesses penalties based on the amount of underpaid tax and the length of time the tax was unpaid.

When are estimated taxes due?

Estimated tax payments are due four times a year, generally following a quarterly schedule. For the calendar year, the due dates for individual taxpayers (filing on form 1040) are as follows:

• 1^st Quarter, due April 15 for income earned from January 1 to March 31
• 2^nd Quarter, due June 15 for income earned from April 1 to May 31
• 3^rd Quarter, due September 15 for income earned from June 1 to August 31
• 4^th Quarter, due January 15 of the following year for income earned from September 1 to December 31

C corporations that pay estimated taxes follow the same calendar year schedule above, except the fourth quarter payment is due December 15 for income earnings from September 1 to December 31. It’s important to note that the fourth quarter payment for C corporations involves an estimate of income through the end of the year. 

If a due date falls on a weekend or legal holiday, the deadline is typically extended to the next business day. Missing these deadlines can result in penalties and interest, so it is essential to keep track of them.

As a reminder, taxes withheld from wages are treated as having been paid pro-rata throughout the year. For some individual taxpayers who have both taxable wages and non-wage income, it may make sense to increase the withholdings on their wages to either fully cover or reduce the amount of estimated payments the taxpayer must make. However, since cash flow needs vary based on the taxpayer, this may not be a good strategy for all. Be sure to analyze how a change in withholdings may affect your ability to meet your weekly or monthly cash needs.

Safe Harbor Rule: How much should you pay?

To avoid an underpayment penalty, taxpayers can rely on the IRS “safe harbor” rule. This rule provides that no penalty will be assessed if the taxpayer pays at least the amount defined in the safe harbor. For individuals, the safe harbor amounts are:

1. 90% of the current year’s tax liability, or
2. 100% of the prior year’s tax liability (110% if the prior year’s adjusted gross income (AGI) was more than $150,000 for married filing jointly or more than $75,000 for single filers).

For C corporations, the safe harbor amounts are:

1. 100% of the current year’s tax liability, or

2. 100% of the prior year’s tax liability.

By adhering to one of these thresholds, taxpayers can ensure they do not face underpayment penalties, even if they end up owing additional tax when filing their return.

How to calculate and pay estimated taxes

To determine estimated tax liability, taxpayers can use Form 1040-ES (Estimated Tax for Individuals) or Form 1120-W (Estimated Tax for Corporations). These forms include worksheets to help estimate income, deductions, and credits, allowing taxpayers to calculate how much they should pay each quarter.

Payments can be made electronically through the IRS Direct Pay system, the Electronic Federal Tax Payment System (EFTPS), or by mailing a check with a payment voucher from Form 1040-ES. Many states also require estimated tax payments, so it is important to check state tax agency requirements.

Special considerations and common pitfalls

Some taxpayers may have irregular income streams, making it challenging to estimate their tax liability accurately. The IRS allows taxpayers to adjust their estimated payments each quarter if income fluctuates. Those with seasonal or variable income may benefit from the annualized income installment method, which calculates payments based on actual income earned each period rather than a fixed quarterly amount.

One common mistake is failing to factor in self-employment taxes, which consist of Social Security and Medicare taxes. Self-employed individuals must pay both the employee and employer portions, totaling 15.3% of net earnings. Factoring in these taxes is crucial to ensuring the proper amount is paid throughout the year.

The bottom line

Estimated taxes are a vital component of the U.S. tax system for individuals and businesses that do not withhold income tax. Understanding who must pay, how to calculate payments, and meeting deadlines is crucial to avoiding penalties and staying compliant with IRS rules. By following the safe harbor guidelines and using available resources such as Form 1040-ES, taxpayers can effectively manage their estimated tax obligations and prevent unnecessary financial strain at tax time.

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