Importance of small business owners accurately estimating tax liability throughout the year
MARTIN A. SCOTT, CFP®, EA
For any small business owner, taxes are a primary concern. Estimating tax liability will never be perfect, but it is very important to do so throughout the year as it helps with cash flow management (financial health of business), maximizing deductions/credits (minimizing tax liability), and avoiding penalties/interest (complying with tax obligations).
Estimating and paying taxes as an employee is different than those who are small business owners. For employees, they generally have an employer who withholds taxes from their paycheck (this withholding amount is based on what the employee expects to owe). Upon filing their tax return, this amount gets reconciled with either a refund (withholdings were too high) or liability to pay (withholdings were too low). On the other hand, small business owners generally pay estimated taxes at the end of each quarter. The estimated tax payments due dates are listed in the table below (per instructions from the IRS).
Although calculating what is owed each quarter will require more time and attention of the small business owner (and/or their tax advisor), it will lead to better accuracy (i.e., lessening the chance of significantly overpaying or underpaying on their estimated quarterly tax payments throughout the year).
Cash flow management
As opposed to large corporations that have massive budgets, small business owners must be more prudent with the timing and allocation of their resources. Estimating tax liability leads to effective cash flow management because it provides a small business owner the appropriate amounts to earmark for tax obligations, which ultimately helps their business run smoothly (i.e., significantly lessens the chance of an unexpected, sizable tax liability at the time of tax filing).
For example, Mary has been self-employed for seven years and sells health food products. Within her business, revenues fluctuate throughout the year with summertime being the peak season. Per the advice of her tax advisor, she follows the IRS estimated tax payment due date schedule (Mary notices that her September 15 estimated tax payment is the highest one every year because a high percentage of her income is generated in the summertime from June 1 to August 31 each year). As a result, Mary is being prudent with her cash flow management despite the fluctuations of revenues by matching each estimated tax payment to what income was earned during the corresponding period.
Maximizing deductions and credits
Small business owners with a more accurate knowledge of their tax liability can explore eligible tax deductions and credits, which could lead to tax savings. Any amount of savings for a small business owner provides value as it can be used to reinvest in their business, leading to further growth.
For example, monitoring tax owed (based on income earned) throughout the year can let a small business owner know if they are eligible for the Qualified Business Income (QBI) deduction (note that the QBI deduction was created by the 2017 Tax Cuts and Jobs Act and is effective from the 2018 tax year through the 2025 tax year). The deduction depends on taxable income level and could allow for a small business owner to exclude up to 20% of their qualified business income from federal income tax.
Avoiding Penalties and Interest
Keeping accurate calculation of tax liability throughout the year also helps a small business owner avoid the underpayment of estimated tax (note that underpayment of estimated tax could result in penalties and interest imposed by tax authorities). Tax authorities (IRS and your individual state) have these types of penalties and interest in place because they are ultimately trying to get tax payments made to them accurately and in a timely manner. It is prudent for a small business owner to be proactive and stay ahead of their tax obligations to make sure they are not in a situation where they owe penalties and interest, which are detrimental to the overall cash flow of their business.
For example, Michael has been self-employed for eight years and provides fitness training for his clients. Each year, he makes estimated quarterly tax payments, but has never precisely tracked his earned income throughout the year. Fortunately, he has never had to pay an underpayment penalty. Michael got 21 new clients, which was exponential growth for his business this year, which significantly increased his revenues. Again, he made estimated quarterly tax payments, but this time the payment amounts were not nearly enough given the very high-income level for this year. This underpayment led to certain penalties and interest. It would have been beneficial for Michael to be more precise when making his estimated tax payments throughout the year, which would have helped him avoid the underpayment penalty.