It’s always a pleasure to share these pages with like-minded friends. Adam Ferguson of McCarthy Ferguson CPA is a respected accountant and friend. When he accepted our invitation to share his wisdom with our readers we were thrilled! Adam is a details guy, as meticulousness is paramount to the success of any CPA firm. He's done a great job of highlighting the most important things to consider in your business so that you avoid tax time surprises.
Below is a brief tax Q&A by Adam for business owners and workers who are self-employed.
Each year, my colleagues and I at McCarthy Ferguson meet entrepreneurs who have shed their comfort blanket of a weekly paycheck or are burning the midnight oil while working full time and trying to get their business off the ground. Their unifying qualities are excitement and optimism. They have business plans, newly opened bank accounts, and some have even figured out how to start making money right at the start. But a common misstep is to underestimate or disregard the tax implications derived from their new source of income which often leads to a tax bill that they weren’t expecting.
Q. Am I on the hook for paying income and self-employment taxes?
A. When you were a W2 employee, you didn’t have to worry about withholding federal and state income taxes, as well as social security and Medicare taxes. Your employer did it for you. Whether or not you under or over-withheld from your W2 income, and whether you would get a refund or owe at the end of the year, would be largely dependent on how you filled out your W4 (withholding certificate), but at least some taxes were being taken out when you were an employee. When you are self-employed and paid as a 1099 independent contractor (or receive income from a pass-through entity, shown on a K-1), no tax is withheld in most cases, and you are responsible for paying tax throughout the year.
Q. How do I determine whether I should be making quarterly estimated tax payments?
A. Whether you are the owner of a sole proprietorship, a member of an LLC, a partner in a partnership, or a shareholder in an S-corp, the IRS requires you to pay quarterly estimated taxes (often referred to as paying “estimates”) on your income based on certain criteria. So, how do you know if you need to make these estimated tax payments?
Q. I need to pay estimates, but how much should you pay?
A. This question isn’t always easily answered. After all, these tax payments are in estimates of the tax owed, and there are a lot of moving parts that contribute to an individual (or couple’s) end of year tax bill. First, the amount of estimated taxes to pay is typically a function of the following:
You can make a sufficient estimate based on your highest income tax brackets (which have recently changed with the 2018 Tax Cuts and Jobs Act), the federal self employment tax rates (roughly 15% -- as a business owner or recipient of 1099 income, you are responsible for both the “employer” and “employee” portion of self-employment and Medicare tax), and your state income tax rate. While it is impossible to offer a sweeping, standard federal tax rate percentage from which to make estimates, we tend to suggest a range of 25-40% of your income.
Determining how much should you pay isn’t cut and dry. While it is steeped in objectivity, it is still hard to estimate your tax liability before the year is done because you do not know how much money you will ultimately earn! Often, the exercise is more art than science.
With that said, having your accountant weigh in will help to alleviate the pressure of making the right choice. After all, you do not want to underpay and be subject to frustrating underpayment penalties. But, you also do not want to overpay and essentially provide the IRS with an interest-free loan.
Ultimately, your year-end tax liability is based on your business income, but you’ll also need to consider other factors, such as:
This information can be used in conjunction with the guidance of your accountant and/or tax professional, but it should not be used as an authoritative source of tax advice. McCarthy Ferguson welcomes follow up questions on estimated tax, as well as other tax, accounting, and general business topics which may warrant further clarification.
Adam Ferguson, C.P.A. is a partner at McCarthy Ferguson CPA and focuses on small- to mid-sized business strategy and development. You can reach Adam at firstname.lastname@example.org and learn more about his firm at kmfcpa.com.