We are expected to pay taxes at the time we earn income, so we need to make tax payments during the year. This avoids penalties for underpayment of estimated taxes, and reduces the chance of being slammed with a huge bill at tax time.
To avoid a penalty, you need to pay either 100% of last year’s tax or 90% of the current year’s tax. If your income was over $150,000 last year, you need to pay 110% of last year’s tax or 90% of this year’s. Unless you miss by a wide margin, the estimated tax penalty probably won’t freak you out, but a big bill can cause troublesome cash flow problems.
If you have an S Corporation, you may not be doing it effectively
Payment Methods
There are 2 basic ways to pay your taxes during the year.
- Withholdings from W-2 salaries, retirement income or other 1099s
- Quarterly payments based on estimated self-employment, investment or other income
Quarterly payments must be made by specific dates – April 15, June 15, September 15 and January 15 – so you need to make each payment on time to avoid a penalty. (California has a slightly different schedule)… But salary withholdings can be made at any time during the year without penalty.
A Quick S Corp Lesson
As you know, an S Corp is a “passthrough entity”, which means that the company doesn’t pay tax, but rather its income passes through to you, and is reported on your personal tax return.
The company’s income passes through to you in two ways:
- Your W-2 salary – You are an employee, so the company is required to pay you a “reasonable” salary, and to withhold both payroll taxes (social security and medicare) and income taxes. The company pays these taxes to the IRS and the state on your behalf.
- Form K-1 passes the company’s net income (after deducting your salary) to your personal tax return. Although you don’t pay payroll tax on this income, you will pay income tax… but there is no automatic deduction, as there is for your W-2 income.
You are probably trying to keep your salary low, in order to reduce your payroll tax payments. That’s one of the classic selling points for forming an S Corp. You will want to pay enough salary to achieve your retirement contribution goals, but generally, a large portion of your income passes through to your personal tax return with no tax withheld.
Here’s the Problem
Your payroll service is probably withholding payroll tax correctly, but your income tax withholdings may be a different story. The payroll service probably assumes your salary is your entire income for the year, and uses Form W-4 to calculate income tax only on that income.
There will be no withholdings on your company passthrough income, because the payroll service doesn’t know about it. And you may have other income unrelated to your business. If you don’t address this, you will be in for an unpleasant surprise at tax time.
The Solution
You need to be sure you are paying 100% (or maybe 110%) of last year’s total tax. Everyone has their own way of handling their finances, so here are some thoughts:
Payroll Withholding:
Remember that you don’t have to actually write yourself a check for every payroll. You just need to pay the taxes… and 401(k) contributions, if any.
Also remember that you can generally take cash out of the business as a tax-free distribution at any time. You don’t need to use payroll to take money out of the business.
If you choose to have income taxes withheld from your salary, be sure to tell the payroll service how much to withhold for federal and state tax. Otherwise, they will go by your Form W-4, and withhold too little
- You can take your salary monthly, quarterly or annually, and have payroll and income taxes deducted from each payroll.
- Monthly payroll divides your tax payments into smaller, manageable bites, but your payroll service fees will be higher. The same can apply to 401(k) contributions
- Annual payments reduce your processing cost, but result in a very large payment at the end of the year, especially if you are making a personal 401(k) contribution
- Many of my clients like to take their salary quarterly
Quarterly Payments:
- You can take your salary, and let the payroll service calculate taxes, but make quarterly income tax payments to make up the difference
- You can take your salary once at the end of the year, but make quarterly income tax payments to reduce the sudden cash requirement at the end of the year. You can also spread out your retirement contributions.
If you are interested, I take my salary annually, and make quarterly payments… It reduces the annoyance of payroll processing, but I do need to have enough cash at the end of the year to pay my payroll taxes and my 401(k) contribution
Bruce Critchley Tax 