– By Mark E. Battersby – Can you guess how well your rural building operation will do in the coming months? It should come as no surprise that Uncle Sam wants taxes paid in full during the course of the year.
Fortunately anyone, including any building business, large or small, can usually avoid penalties by basing its estimated tax payments on its previous year’s tax bill.
Unfortunately, if the coming year turns out to be a bad one financially, basing estimated tax payments on the previous year can mean the government, not the business, gets to use those funds, interest free, for as long as a year. If the coming year turns out to be a good one, basing estimated tax payments on the previous year may avoid a penalty but mean a whopping tax bill when the tax return is filed, along with the first estimated tax installment for the upcoming tax year.
Estimating the income – and the tax bill – of any building business can be a nightmare, especially when compounded by the economy, our battling lawmakers and the uncertainty over Obamacare and tax reform. While most self-employed and businesses use software programs or a professional to help with estimated tax payments, few are aware of how to anticipate – or handle – changes.
Think of estimated taxes as a pay-as-you-go tax. Four times a year (quarterly), every builder and contractor is required to send Uncle Sam enough of his or her revenue to cover income tax as well as their self-employment tax (Social Security and Medicare) obligations. If enough taxes are not paid throughout the year, either through payroll withholding or by making estimated tax payments, the builder or contractor and/or his or her business may face a penalty for underpayment of estimated tax. Because calculating earnings isn’t easy, the IRS offers a safe harbor rule. By paying at least as much as the previous year’s liability or paying within 90 percent of the actual liability, there’s no penalty for underpayment.
Anyone filing as a sole proprietor, partner, S corporation shareholder and/or a self-employed individual, is generally required to make estimated tax payments if they expect to owe tax of $1,000 or more. If it’s not through withholding, then it has to be done by quarterly estimated taxes. If the building business is structured as a corporation, estimated tax payments are required if a final tax bill of $500 or more is expected.
For estimated tax purposes, the year is divided into four payment periods. If not enough estimated tax is paid at the end of each payment period, a penalty may be charged, even if a refund is due at year’s end. That underpayment penalty usually consists of a non-deductible interest charge – currently the federal short-term interest rate plus 3 percent – accruing from the date the payment was due.
Fortunately, if income is received unevenly during the year, penalties can be avoided or lowered by annualizing income and making unequal payments. The annualized income installment method annualizes tax at the end of each period based on a reasonable estimate of income, deductions and other items relating to events that occurred from the beginning of the tax year through the end of the period. Form 2110, Underpayment of Estimated Tax by Individuals, Estates and Trusts, is used.
The penalty may also be waived if the failure to make estimated payments was caused by a casualty, disaster or other unusual circumstance and it would be inequitable to impose the penalty, or if a builder or contractor retires (after reaching age 62) or becomes disabled.
Those filing as a sole proprietor, partner, S corporation shareholder and/or as self-employed, should use Form 1040-ES, Estimated Tax for Individuals, to both figure and pay estimated tax. Incorporated building businesses are required to pay their estimated income tax bill in quarterly installments.
When filing as a corporation, Form 1120-W, Estimated Tax for Corporations is used to figure the estimated tax. In general, each quarterly federal tax payment is 25 percent of the corporation’s required annual payment, which is the lesser of two amounts:
1. Current-year tax liability – 100 percent of federal income tax reported on return for the year of the payment
2. Prior-year safe harbor – 100 percent of a corporation’s federal income tax reported on return for the preceding year.
Corporations with no tax liability in the preceding year obviously cannot use the 100 percent prior-year safe harbor amount to determine their required estimated tax payment.
And certain large corporations – those with taxable income of $1 million or more in any of the three preceding tax years – can only use the prior-year safe harbor amount when calculating their first-quarter payment.
All incorporated building businesses are generally required to use EFTPS to pay their taxes, while Form 2220, Underpayment of Estimated Tax by Corporations, is used to determine if a corporation is subject to the penalty for underpayment of estimated tax and to figure the amount of the penalty.
Much as is the case with individuals, if a corporation does not pay a required estimated tax installment by its due date, it may be subject to a penalty. That penalty is figured separately for each installment due date.
Don’t forget the special Quick Refunds for some estimated tax overpayments. An incorporated building business that has overpaid its estimated tax for the year may be able to apply for a quick refund by using Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax. A corporation can apply for a quick refund if the overpayment is:
– At least 10 percent of its expected tax liability, and
– At least $500.
In general, incorporated building businesses estimate their annual depreciation deductions by taking into account purchases, sales or other dispositions, changes in use, additional first-year depreciation and similar events, based on information available as of the last day of the quarter. The tax regulations contain two safe harbor methods that can be used when determining an incorporated business’s estimated tax depreciation deduction: a proportionate depreciation allowance or 90 percent of the preceding year’s depreciation.
Under the proportionate depreciation allowance method, corporations estimate their depreciation deduction based on assets placed in service as of the end of the previous year and by the end of the installment period. Using 90 percent of the preceding year’s depreciation to calculate estimated tax payments may provide a tremendous benefit to taxpayers reporting substantial tax depreciation under 2013’s favorable bonus depreciation rules.
An individual or building business that does not receive income evenly throughout the year will often find that the required estimated tax payments may vary. Failure to make timely payments accurately reflecting the tax liability of the building business – or that of its owner – can result in penalties.
Obviously, every builder, contractor and business owner should give careful consideration to their estimated tax payment calculations. Fortunately, our tax rules contain clear guidelines that can not only help in figuring those estimated tax bills but provide so-called safe harbors that can substantially reduce or even avoid those penalties. Obviously, professional assistance may be necessary not only when first computing the estimated tax bill for the year ahead, but also should events dictate change.
Mark Battersby, a regular Rural Builder columnist, has more than 30 years experience in small business issues, tax and financial matters. He writes extensively on business topics. Contact him at MCBatt12@Earthlink.