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 Jim Amell, CPA, director of Marvin & Company, a 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 IRS’s 2019 interest rate is six percent for the first two quarters, and five percent for the third quarter. The interest rate for the fourth quarter has no yet been announced. New York State charges an interest rate of seven percent on underpayments.
When purchasing vehicles in the fourth quarter or at any time during the year, Paul Dowen, CPA, a partner at Whittemore, Dowen & Ricciardelli, LLP in Queensbury, advises business owners to be aware of tax laws related to vehicle weight. Vehicles must have a gross vehicle weight rating of over 6,000 pounds in order to qualify for full write-offs.
“You have to be really careful purchasing vehicles. If it’s a passenger vehicle, there is a limited write off whereas if it’s a heavy duty truck you can write the whole thing off using Section 179 expensing,” said Dowen.
He advises against purchasing a large amount of equipment during one calendar year in an attempt to reduce taxable income to as close to zero as possible. In most cases, he said it is better to spread these purchases out over two or more years in order to maximize the tax law benefits that are available.
For example, if one of his clients plans to buy three trucks, he may advise them to buy two in one calendar year and the third in the next calendar year. Buying all three trucks in one calendar year could reduce the client’s taxable income to near zero, and this could prevent them from taking advantage of all possible tax deductions. It also leaves them with fewer deductions in the following calendar year.
“When people buy equipment and bring themselves down to no taxable income, I say, ‘Well, you just threw away some tax deductions because you can’t benefit from them because you’re paying no tax,” said Dowen. “It’s not a matter of managing that you pay the least amount of estimated tax. I try to discourage people from looking at it that way and really look at managing and trying to keep yourself in that 22 to 24 tax bracket. That’s not a bad tax bracket. So if you’re having a really good year and you jump to 32, let’s try to get you down to the 22 or 24 percent tax bracket. It’s all about managing your tax bracket.”
Kevin Hedley, CPA, of Hedley & Co. CPA’s in Clifton Park, said 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.
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.”
Although the IRS has forms, schedules, and worksheets taxpayers can use to calculate their installments using the annualized income installment method, it is complicated. It is advisable to consult a tax professional on the matter.
Amell advises operators of a pass-through entities to closely monitor their income throughout the year. He said his firm touches base with their larger clients several times a year.
“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 his clients to set aside 30 to 40 percent of their self-employment income for taxes.
For business owners who have spouses who receive income, Dowen said it is important to consider collective income when managing tax brackets. He uses the example of a pass-through entity business owner who has a spouse that collects social security.
“If the spouse is retired and collecting social security and the business is having a really good year, then some of that social security become taxable,” he said. “You are looking at something that was not taxable last year now becoming taxable depending on tax brackets and how much taxable income you have. It’s not just about managing the business. If it’s a flow through, you have to manage the personal tax return.”
In cases where clients are having a down year, Dowen may advise them to reduce their fourth quarter estimated tax payment. In those instances, fourth quarter payments should not be based on the prior year.
“You don’t want them to part with cash if they need it to get themselves through the winter,” he said.
Asked if most pass-through entity business owners would be likely to offset this cost with tax savings, Dowen responded, “Yes, absolutely. If by working with us, I can’t show that I’m saving you enough money, you should go to someone who will just prepare your taxes and not spend the extra money.”