Keeping up With Estimated Taxes
Even the most skilled craftsmen can only earn so much money working for others. Once they’ve hit the ceiling with employers, most have essentially two options if they want to earn more with their construction skills. They can take side jobs in their free time or start their own contracting businesses.
Frequently, the first leads to the second, which can lead to choppy income and more complicated tax returns. This is because in both instances, the craftsmen operate as sole proprietors, which makes them solely responsible for keeping up with federal and state taxes on those earnings.
Income and self-employment taxes are pay-as-you-go, which means you must pay the tax as you earn or receive income during the year or risk being fined by state and federal tax authorities for underpayment. Employers do this by withholding taxes from their employees’ paychecks based on their Form W-4 elections. When you work for yourself, you must make estimated tax payments every quarter.
As reported in the tax consequences of being a sole proprietor, many sole proprietors struggle to keep up with these taxes. In 2016, sole proprietorships accounted for about 27 percent of underpaid federal taxes, or more than $125 billion, according to IRS estimates.
Individuals — including sole proprietors, partners and S corporation shareholders — generally must pay estimated taxes, which are also used to pay the self-employment tax and alternative minimum tax, if they expect to owe the Internal Revenue Service $1,000 or more in a tax year.
If your 2018 adjusted gross income was $150,000 or less, you could likely avoid IRS underpayment penalties if you paid the lesser of either 90 percent of the year’s income tax liability or 100 percent of your income tax liability from 2017.
If your income surges, however, you will want to pay additional estimated taxes to avoid a nasty bill come tax time.
Going part time
As an example, let’s say that after seven years of working as an installer for aluminum siding, gutter, painting and roofing contractors, you decided in late 2017 to start doing handyman work on the side. On Sept. 1, you started working 15 hours a week at $35 an hour and earned $8,925 in the fourth quarter.
To calculate your estimated tax on that income, you downloaded and filled out the IRS Form 1040-ES worksheet (PDF) and made an estimated payment for the final period of the year (Sept. 1 to Dec. 31) by the Jan. 15, 2018 deadline.
After anticipating your earnings from your side business would remain steady in 2018, you knew how much to set aside from your earnings for your four estimated tax payments of the coming year.
Going full time
Now let’s say that by the third quarter of 2018, you were turning down so much work in your side business that you decided to raise your rate to $50 and go full time at the beginning of 2019. You downloaded another 1040-ES worksheet and recalculated your estimated taxes. To be conservative, you doubled your billable hours to 30 hours a week, came up with a quarterly estimated tax payment of $1,750 and begin setting aside money for your first payment for the 2019 tax year, due Apr. 15 with your 2018 tax return.
In the early weeks of 2019, one of your customers asks you to take on maintenance of five single-family detached rental homes she owns. You negotiate a contract, in which you offer her volume pricing of $48 an hour in exchange for her guarantee of 40 hours a month of work, plus your full rate for any hours beyond that, starting May 1.
Assuming you take on this work in addition to your existing work and do it yourself, you can now expect to earn an additional $1,920 per month through the balance of the year. You fill in the 1040-ES worksheet again and decide to increase your second estimated tax payment of the year, due June 17, to $2,400 to avoid owing a lot of money on your 2019 tax return. You also raise your third- and fourth-quarter estimated tax payments, due Sept. 16 and Jan. 15, 2020, to $2,500.
The bottom line
The example above is intended to show that the more irregular a sole proprietor’s income is, the more regularly he or she needs to check estimated tax payments.
The numbers cited in the example are rough estimates based on multiple assumptions about personal and business deductions that will vary widely between sole proprietors. Sole proprietors, and particularly solo contractors, should always calculate estimated tax payments in collaboration with their accountants and/or tax advisers. This is particularly true in 2018 and 2019 in light of new rules and limitations for depreciation and expensing under the 2017 Tax Cuts and Jobs Act.