Month: February 2024

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Estimated Tax Payments: What are they and How to be sure you aren’t behind?

One question that I get a lot from clients relates to confusion regarding estimated taxes. I get this question most often from taxpayers who have been employees for most of their careers and for whatever reason find themselves self-employed, either full-time or by just having a side gig.

Generally the questions fall around: “Do I have to pay quarterly estimates?”, “When are they due?”, and “How much do I have to pay?”

I’m going to lay down a “brief” primer on estimated taxes and why, primarily self-employed people, have to pay them.

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The Feds require all taxpayers to pay in both Income Tax and FICA taxes throughout the year as you earn your income.  Taxpayers who are classified as employees (those that work for “the man”) have both of these taxes withheld by their employer before they ever get paid .

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This is a pretty crazy development that we accept as the governed in that you agree to work with an employer for money and before you even receive it, the government carves out their share first.  I don’t want to stand too long on this soap box. So, employees have their taxes withheld and remitted to the government by their employer every pay period, generally.

For those who are self-employed, the government does not yet have a practical way to get their hands on the funds nor appropriately assess how much to withhold since self-employed taxpayers pay tax on their net income (income after expenses) rather than their gross income (cash that comes in the door).  Since self-employed taxpayers don’t have withholdings they are required to make tax payments every quarter for what they expect to owe. This is how we get the term “Quarterly Estimated Tax Payments”.  

Taxpayers are required to reasonably estimate how much tax they think they will owe when filing a tax return after the year closes.  Again this process is more difficult for a self-employed person rather than the employee.  A self-employed taxpayer may know how much gross income they have in a quarter, but the net income may be completely different depending on what expenses they incurred to generate that income.  These expenses reduce the amount of income they are required to pay tax on.  FICA taxes complicate matters further.  For employees, the FICA tax responsibility is shared between the employee and the employer, with each group remitting half of the tax.  In reality, the employee bares the cost of the full tax, they just don’t feel it. Therefore it is accepted.  One half of the tax is paid through direct withholding of the employee’s wages, the other half is indirectly paid by the employee in the form of suppressed gross wages that they never see because it is a cost of employment to the company. This unseen half is remitted to the Feds by the employer.   For the self-employed, they are directly responsible for both the employee and employer portions and this is reported to the IRS annually as a part of their income tax return. 

Since knowing what you are going to earn on a net basis may be difficult to predict, the IRS “offers” what are referred to as “safe harbor” calculations whereby, if you pay these safe harbors amounts, you will not be assessed any penalties for the underpayment of tax, even if you owe when you file your tax return.

The most commonly used safe harbor is related to the prior year tax.  If your adjusted gross income (a tax return calculation) is less than $150,000, then as long as your estimated tax payments total at least 100% of the tax owed in the prior year, you will not be assessed a penalty for underpayment of tax, even if you owe $1,000,000.  If your AGI for the prior year is over $150,000, then you have to pay 110% of the prior year tax to be eligible for this safe harbor.

The other safe harbor is much more subjective.  You have to pay in 90% of the tax for the current year to avoid penalties for underpayment of tax.

So, when are your quarterly taxes due?

Payments are due to be sent by calendar year taxpayers (most everyone) on the following schedule:

April 15th

June 15th

September 15th

January 15th (following year)

These dates are adjusted forward if they happen to fall on a holiday or weekend.

Underpayment penalties are assessed on a daily basis, for each day and amount of tax that you are underpaid.  When you file your return, the IRS generally assumes that you earned your income steadily throughout the year.  If you have a highly seasonal business where the bulk of your earnings occurs in the 3rd or 4th quarter, you can fill out the schedule as part of the Form 2210 for calculating underpayment penalties.  This will tell the IRS, “Hey, I didn’t earn my income evenly and I’m not underpaid.”

Still with me?

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I hope this helps you keep up with your tax payments when you start your own business or even a side hustle.  When you want more info on tax impacts of side hustles check out my prior post  HERE

Leave your tax questions or a personal story about estimated taxes down in the comments below.  We will what kind of future post I can cook to answer them.  Thanks for reading!

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New IRS Direct File – Should You Try It?

The IRS is rolling out a new filing option for taxpayers being dubbed “Direct File”.

In a nutshell, the program claims to offer taxpayers the ability to directly file their tax return with the IRS using an application provided by the IRS itself, at no cost to the taxpayer.  In this first year (2023), the program is only open to taxpayers in 12 states, primarily those that either don’t have a state income tax or those that have a similar option available for the state tax returns that need to be filed. IRS Direct File

At first glance, this seems like a pretty simple win for both parties involved, taxpayers have their tax return filed at no cost to them, and the Service has a tax return that it prepared delivered directly to it, in theory cutting down on non-filing as well as accuracy related issues.  But whether this is a good development requires a little more careful consideration.

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The IRS has for a long time now wanted to develop this capability.  The question is why?  On the surface, it claims to be a benefit for taxpayers but the IRS has, for quite awhile, offered free file options to taxpayers who meet particular requirements.  The free file program is a public-private partnership in which the IRS connects taxpayers to private service providers where they can file their tax return.  Per the IRS website, their goal is to connect taxpayers with private companies who are the best at what they do.  If that is the case, why does the government need to spend millions of dollars to accomplish the same thing?  Another possibility would be that by not funding the free file program, the government might save some money.  But when has the government ever really been concerned about saving money?

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Another reason that I’m not gung-ho on the IRS filing system is that I have interacted with varying levels of IRS representatives for the past decade plus some.  The general public has the tendency to assume that the IRS knows the tax rules since they are tasked with assessing and collecting taxes from The People.  This is not an accurate assumption in my experience.  From arguing with agents over application of tax law to just sorting through minor discrepancies, I will tell you the IRS is not always right.  For instance, if you go long enough without filing a tax return when you should have, the IRS will file a return on your behalf referred to as a Substitute for Return.  In my career, I have never seen a Substitute for Return filed where I agreed with the tax assessment.  Admittedly part of this is due to the IRS having limited information, but nonetheless, you never want to blindly accept a Substitute for Return.  I have concerns that the new Direct File system will look closer to the Substitute for Return system rather than a return prepared via a tax professional’s software.

This also brings me to a related point.  It seems to me there is a strong conflict of interest in having the organization charged with collecting tax also preparing the return telling you how much you owe them, as though you were audited.  By including a 3rd party in to the mix, now you have a knowledgeable advocate helping your prepare a return in compliance with the law but also striving to make sure the tax assessment is accurate and as low as possible.  The IRS is more or less charged with collecting as much tax as it can, putting it at direct odds with the taxpayer.  They have no incentive to ensure the taxpayer has maximized the deductions and credits available to them nor does the average taxpayer have much knowledge about tax to hold the IRS accountable if it doesn’t.  The situation doesn’t set up to be taxpayer friendly. As you can see, I’m not a huge fan of the New Direct file system, partly based on my biased prior experience, but as George Clooney once said, “That doesn’t mean that I’m wrong”

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The Direct File program appears to fill a void that doesn’t really seem to exist.  Some people have a term for this: pointless. Something can be pointless and people still use it (I’m looking at you throw pillows), but I won’t be using the Direct File system anytime soon.

If you have a tax question or disagree with me entirely, Great!  Leave me a note in the comments.  I’ll try answering the common questions in a later post.