The Importance of self Employed Individuals Making Estimated Tax Payments

The self-employed person has more responsibility than the wage-earner when it comes to taxes. He not only must pay income taxes on the profit from his business, but he must pay self-employment tax as well, which guarantees his Social Security and Medicare benefits will be properly applied to his retirement account. A wage-earner pays similar taxes in the form of FICA withholding from his wages, but he doesn’t have to think about it, it is done for him. The wage-earner pays one half of the Social Security and Medicare tax, and his employer pays the other half. 

Since the self-employed person is both worker and employer, he is responsible for both halves of the payment, which historically represents approximately 15.3 percent of his profit. The wage earner pays percentages on his wage income, which is defined for him on his W-2 form, but the self-employed person must determine his taxable income by diligent record-keeping and deduction of allowable expenses, many of which are not available to the wage-earner. Recent changes in the tax law will alter the employee portion of the withholding, thereby reducing the percentage for self-employment tax to approximately 13.3 percent for the 2011 tax year. Look for further changes to this tax law as Congress considers tax reform.

Many people who report independent contractor income do not make all of their money from this self-employment, and do not make estimated tax payments because their tax bill is covered by the withholding from their job. This is acceptable practice, as long as they do not owe more than $1,000 on the bottom line of their 1040.

Even though an employee’s FICA and income taxes are withheld with each paycheck, and deposited regularly, the taxes are actually paid on a quarterly basis when the employer files the 941 form. Theoretically, all income and FICA taxes are paid quarterly, no matter when they are withheld or deposited.

It is common for a business, whether it is a part-time business or a full-time business, to show a loss from time to time, and if the sole proprietor knows that he will show a loss on his tax return, then there is no need to make estimated payments, since the income tax and the self-employment tax is only levied on profit. But a prosperous quarter will be reported within the figures, and estimated amounts will have to be re-figured each year.

If the self-employed person has employees, then the taxes that he withholds in their behalf are not “estimated payments,” they are carefully calculated amounts that must be filed in a timely manner through the 941 or 944 forms on a regular basis. Any employer who ignores this responsibility will face the unmitigated ire of the IRS, regardless of the profitability of the business.  The penalties are severe, and it is not uncommon to face the loss of business, bankruptcy, or even more serious consequences if these deadlines for other people’s FICA benefits and income tax withholding are not met.  If you cannot afford to make these deposits and quarterly payments, then you cannot afford employees.

If the profit from the business is less than $400 for the year, then self-employment tax is not due, but the income is still reportable for income tax purposes.

A self-employed person must at all times be aware of his income and expenses, and have an idea of whether or not the quarter has been profitable for him. The due dates for quarterly tax payments are April 15th, June 15th, September 15th, and January 15th, one month into next year. Taking the last year’s tax liability and dividing it into quarters will give proper amounts to send in for these dates as estimates. Refer to the Form 1040 Schedule SE and Schedule SE Instructions on the website for proper handling of estimated payments, including the deduction of one half of the tax from taxable income. These forms, at the time of writing, have not yet been updated for the 2012 tax law.

A self-employed person who is too busy to send in estimated payments is often too busy for other tasks as well, such as keeping track of mileage, keeping dates and amounts for the acquisition of assets, and adequately labeling receipts for travel or entertainment expenses. He will find a tax accountant reluctant to allow him expenses that he cannot verify at an audit, and he will find himself faced with paying more taxes than would be necessary had he accepted the responsibility for adequate bookkeeping.  Filing an unverifiable tax return, and facing an audit, is another unpleasant experience that can be avoided by diligence in record-keeping.

Being self-employed has definite advantages, in that the self-employed person can deduct his expenses from his taxable income.  But failing to take responsibility for the bookkeeping that a business person must do can be a fatal mistake in maintaining a seamless relationship with the Internal Revenue Service.  To the IRS, payment of taxes is the most important task of the business owner. Detailed, consistent record-keeping and compliance is the self-employed individual’s best weapon against tax penalties or overpayment of taxes.