There's no question about the rules for some 18 million Americans who've made something good for themselves in the world of self-employment. Professionals who earn a decent living at what they do, working for themselves, face quarterly taxes.
If you expect to owe more than $1,000 to the IRS -- after figuring income-tax withholdings and credits -- then you're in the quarterly category of payers. In a sense, congratulations are in order: You've built up your business enough that even the taxman takes notice.
But here's a not-so-wonderful truth about the financial lives of the self-employed: They can slip into underpaying quarterly taxes, quarter to quarter, and they can even miss quarterly payments altogether. Bottom line, when the rent is due, and that $2,500 you intended to give to Uncle Sam makes up the shortfall for the landlord, rent gets paid first. However, decisions like these can build up, especially in the early years of hardscrabble self-employment.
"It does frequently happen that people don't have enough money at the end of the quarter to make their estimated tax payment, particularly when they're just starting out," said Jan Zobel, a tax preparer and consultant, in an email interview. "It seems as if all they can do is keep up with whatever bills they have and there's nothing left over to pay the IRS and/or the state."
Our subjects, the self-employed, presumably fall within a segment of honest but problem-ridden payers. They mean to pay their bill to federal and state coffers, but they underpay. And when they do, it means trouble. Let's look at what can be done.
Tackling your quarterly tax backlog
Perhaps it happens because cash flow doesn't cover costs of living, or maybe you've realized that not all sole proprietors are as good at accounting as they are at, say, graphic design. Whatever the reason, if you're in a quarterly tax fix, let's look at some strategies for coping with your looming bill and some steps that can help get your tax situation back under control.
The focus will be on the IRS side of the equation, but these strategies can transfer to state bills as well (though details of penalties and interest will vary).
- File on time, every time. It's in your best interest to file your tax forms by April 15 to avoid failure-to-file penalties. These represent an expensive error: The IRS assesses penalties against the amount you owe -- 5% for every month past due, up to 25%. If you can make a partial payment, do it. Paying down any amount of the balance only helps you in the long run. IRS tax bills can take weeks to arrive after you file, so if you have the ability to come up with the balance owed, then you can cut a check when the amount due does appear. Know that you'll be assessed late-payment penalties on the estimated quarterly taxes you did not submit. This is 0.5% for every month the balance is overdue, up to 25%. In certain cases, you can seek a waiver of these penalties -- casualties, disasters, and other unusual events typically warrant waivers. Finally, there's also interest to pay on your balance, which the IRS calculates every three months according to federal short-term rate plus 3%.
- Buy time for paperwork with an extension. If you need more time to prepare your paperwork -- that is, you haven't pulled together records of expenses and the like -- file Form 4868 with the IRS by April 15, and you'll automatically receive a six-month extension. But you still owe the balance on the original April 15 deadline. This means a late-payment penalty, plus interest, will be assessed on the unpaid balance of your quarterly taxes. So this is not a way to put off your bill until Oct. 15; it's just a method of avoiding failure-to-file consequences if your record-keeping is in disarray.
- Consider an installment plan. Getting your paperwork in on time gives you the opportunity to ask the IRS for an installment plan. You'll still incur interest and penalties -- in this case, the late-payment penalty drops to 0.25% -- but you'll be on the path to getting free and clear of what you owe. Installment plans can take some time to get started; the IRS doesn't tend to process its paperwork quickly. But once you have your monthly amount due set on auto-pay, last year's mistake(s) will shrink until you can finish the balance off with a lump final disbursal.
Finally, if your bill is extraordinary, and/or your circumstances won't allow you to pay what you owe under the methods we've just considered, you can seek to make an offer in compromise. This means a negotiated amount paid to the IRS as either a lump sum in cash or in installments. It can be a thorny process, and you'll likely want a tax expert's help along the way.
Moving forward: Better strategies for your tax future
In all of this, there could be an argument that the self-employed need time to build a business under a lesser tax burden than quarterly filings can pose at the start, and that the IRS ought to bill them differently to foster entrepreneurship.
Until such a discussion arises, however, know this: If you're having trouble keeping up with quarterly estimated taxes, you're not alone -- but you can build a better go-forward strategy to stay out of trouble.
Once you've got your tax bill back under control, it's time to recognize one likely root of the problem -- which is almost always that sole proprietors mix the money needed to pay taxes with money used to operate the business and pay costs of living. A smart way to keep current with quarterly taxes is to avoid this by opening a separate bank account -- one from which you can't easily transfer funds to your primary or business monies. Sock away some 30% every quarter and make your payments on time from that account. Do this, and you'll never need the preceding advice again.
Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
James O'Brien is a contributor to WiserAdvisor.