Failing to Pay Quarterly Taxes Has Become Very Expensive
Most of my clients are taxpayers who own small businesses themselves or file jointly with a spouse who owns a small business. Some of these small businesses are organized as C or S Corporations, and the owners pay federal and state taxes throughout the year through their W-2 wages (based on their set salaries and W-4 exemption setup). However, this withholding is usually insufficient to cover the owners’ entire federal or state tax liability on their individual tax returns. Taxpayers who file Schedule C or whose entities are classified as partnerships generally have no withholding at all and must pay quarterly against their expected taxable income.
Most small business owners know that the U.S. and most states have a “pay as you go” tax system that requires them to make tax payments throughout the year based on their expected tax liability for that year. If a taxpayer’s tax liability is not sufficiently covered through wage withholding, he is required to make estimated tax payments each quarter.
I have been practicing as a CPA for over 15 years. It is generally known in the profession that many self-employed taxpayers and small business owners repeatedly fail to make their quarterly estimated tax payments. Why? Largely for cash flow reasons, but also because the penalty for failing to do so didn’t provide much of a bite. Some tax years this penalty could be as low as 3%, and it was sometimes ignored because in comparison to surrounding interest rates for other business expenditures (such as loans, credit cards, and the like), many taxpayers felt it was a smarter move to pay the higher interest debt first, ignore the quarterly tax payments, and then pay whatever estimated tax penalties are assessed on their return when they file. This analysis will now need to change, as the failure to pay quarterly taxes just became very expensive! If you would like to learn more, read on.
IRS Penalty for Underpaying Estimated Taxes Jumps to 8%
Effective October 1, 2023, the underpayment of estimated tax penalty jumped to 8%. This penalty is adjusted quarterly by the IRS and fluctuates based on the Federal Reserve’s benchmark rate. Many taxpayers may not have been expecting this or planning for it to happen.
Who Must Pay the Underpayment of Estimated Tax Penalty?
Generally, the IRS will assess the underpayment of estimated tax penalty if a taxpayer owes more than $1,000 when her tax return is filed and if the total payments made to the IRS for that tax year did not equal at least 100% of last year’s tax (110% of last year’s tax for “higher-income” taxpayers) or at least 90% of the current tax year’s liability. Most states that have an income tax also impose their own underpayment of estimated tax penalties, so it is important that taxpayers are aware of the consequences of underpayment in their respective states as well.
Who Is Exempt from the Underpayment of Estimated Tax Penalty?
Some taxpayers may be exempt from the underpayment of estimated tax penalty by having no tax liability in the previous year, through using permissive alternative methods of penalty calculation, or by the taxpayers’ presence in a federally declared disaster area during portions of the tax year. For all others, it is imperative to make quarterly estimated tax payments as necessary to avoid this penalty.
If you are a small business owner who has not been making quarterly estimated tax payments and need help determining whether you are required to do so—and an estimate of how much to pay in—please contact me using the form below.