By Christine Graf
As 2019 draws to a close, local tax professionals advise individuals who pay estimated quarterly taxes to review their annual income in order to determine if they will owe a penalty to the IRS.
Estimated tax payments are paid by business owners who operate partnerships, LLCs, sole proprietorships, and S corporations. Business income from these pass-through tax entities passes through to business owners on their personal income tax returns.
Those who operate pass-through tax entities are required to make estimated quarterly tax payments to pay income tax and self-employment tax on income that is not subject to withholding.
The IRS requires estimated quarterly tax payment to be filed by anyone who expects to owe at least $1,000 in federal income taxes. This year’s fourth quarter estimated tax payments are due on Jan. 15. Estimated taxes must also be paid quarterly to New York state.
According to Kevin Hedley, CPA, of Hedley & Co. CPA’s in Clifton Park, business owners who are in an underpayment penalty situation should consider making contributions to a retirement plan.
“If you have a good, profitable year, you should evaluate your retirement plan. Do you have a retirement plan and are you making best use of it? There is still time in the current year to set one up and reduce your tax. A company can give a match for employees including the owner of the business. Money can be put away tax deferred,” he said.
According to Jim Amell, CPA and a director at Marvin & Co., CPA firm with offices in Queensbury and Latham, it is important for pass-through entity business owners to understand the tax laws regarding penalties for underpayment of estimated taxes. Penalties for underpayment are assessed even in cases where taxpayers are entitled to a refund.
“The IRS wants their money throughout the year in equal quarterly installments. If it’s not paid equally throughout the year, you are potentially in a penalty situation,” he said. “If you decide you are going to catch up on your estimated taxes on your last payment, that’s fine but the IRS is going to say you should have paid us quarterly. So they are going to assess a penalty which is really interest on underpayment. They use the word penalty but it’s interest.”
The tax laws are complicated, and there are exceptions to the underpayment penalty laws. In certain cases, penalties are not assessed. For example, exceptions are made for recent retirees, the recently disabled, victims of casualty, disaster, or other unusual circumstances. Underpayment penalty exceptions also apply to more common circumstances.
“If you have paid in equal to 100 percent to last year’s tax—as long as you paid in timely installments in the last year—you will have met the underpayment penalty exception even if you owe,” said Amell. “That 100 percent of prior year tax rule increases to 110 percent of last year’s tax for individual who has taxable income over $150,000. Another exception from needing to pay a penalty is if 90 percent of your tax is paid through withholding.”
Amell said seasonal business owners can reduce or avoid penalties by utilizing the annualized calculation method for their estimated payments. This allows individuals to make unequal payments throughout the year. Amell used the example of the owner of a seasonal restaurant who makes the majority of their income in July and August.
“Because of their cash flow, they don’t make payments in the first and second but they do in third and fourth. We can annualize the income, and if they have a penalty, it won’t be calculated from the first two quarters. It would only be from the last two quarters.”
“Rules for estimated payments are more complicated for business owners when income isn’t always as predictable as for people who have taxes withheld,” said Amell. “One of circumstances we see that creates variability with certain businesses owners is the self-employment tax (15.3 percent of income). When planning for making estimated payments, you have to factor in self-employment tax and keep up with the estimated payments. There is no self-employment tax at the state level.”
Amell typically advises clients to set aside 30 to 40 percent of their self-employment income for taxes.
“If it’s November or December and it looks like they are going to owe a fair amount of money, sometimes we have them withhold it from, for example, an IRA distribution. The fact that it is paid by withholding versus estimated payment gets them out of that underpayment penalty calculation,” he said. “If an S corporation elects to be taxed personally, they are probably taking a salary. They could do a bonus at the end of the year and withhold extra taxes and get caught up with tax payments that way. Sometimes we have them back off on the estimated payments that were scheduled when we know their income is down.”
Hedley offered other suggestions on how business owners can lower their income and can save money on their fourth quarter tax estimated tax payment. One involves disposing of obsolete inventory. In some cases, it can be donated and written off as a charitable contribution.
“You may have obsolete inventory you can get rid of,” he said. “You can write it off because it’s obsolete, or you may be able to sell it on a secondary market. You also may be paying an insurance premium on inventory that doesn’t have a lot of value.”
Hedley said business owners who have higher than anticipated income consider making capital expenditures before the end of the year.
“If you need new equipment, whatever it may be—big or small—only get it if you need it. Not because it saves taxes,” he said. “If you’ve underestimated your taxes during the year, you are definitely going to want to look for ways to get your income down so that you can avoid the penalties for underpayment of the tax.”
Hedley said owners may be able to save money by switching to a different entity.
“Everybody should be evaluating their business to determine if they are using the right entity,” he said. “It’s worth having that conversation because the law has some unintended consequences for different businesses based on profitability. Some businesses would be better off, for instance, being an S corporation because then they pay wages to their owners. Other businesses may be better off being a LLC or a partnership.”
Entity choice should be made only after careful consideration of many variables including income, wages, and assets invested into the business. Hedley recommends business owners meet with someone who is versed in the law to review their entity selection.
“It’s better to do it late than not at all,” he said.
By Christine Graf