With ownership come certain tax responsibilities. For example, the IRS requires partners, members or shareholders in any firm structured as a “pass-through” entity — a partnership, LLC or S corporation — to calculate and pay quarterly estimated taxes if they expect to owe $1,000 or more. That’s because pass-through entities don’t pay tax at the entity level. Instead, partners personally owe tax on their pro rata share of the firm’s taxable income, regardless of whether income is distributed or not.
Accuracy is critical
Partners need to estimate their tax liabilities as accurately as possible. If you underpay, you’ll be subject to penalties. If you overpay, you’re essentially making an interest-free loan to the IRS.
To calculate your estimated taxes, project your adjusted gross income (AGI), deductions and credits to arrive at your taxable income for the year. Alternatively, you can use last year’s tax liability. Once you’ve arrived at a number, subtract expected withholdings on any wages (yours and, if you file jointly, your spouse’s) and pay the remainder in four equal installments.
If you expect to receive income unevenly throughout the year, you can use the annualized income installment method to match your estimated tax payments to your actual income during each period. Essentially, this is a pay-as-you-go method that calculates each installment based on the payment that would be due if your tax liability through the most recently completed period were annualized.
To avoid underpayment penalties, your estimated tax payments must total at least 90% of your tax liability for the year. Or you can use the IRS’s safe harbor option. This allows you to avoid penalties by paying 110% of last year’s tax liability (or 100% if your 2015 AGI was $150,000 or less). Note that, if you miss or underpay an installment, you’ll still be subject to underpayment penalties even if you end up with a refund for the year.
If your income this year is difficult to predict or it’s expected to be substantially higher this year than last, it could make sense to pay estimates based on last year’s tax liability to minimize your estimated tax payments. But if you use this safe harbor, you’ll need to be prepared for a big tax bill on April 15. Even though you’ll avoid underpayment penalties, you’ll still need to pay your remaining tax liability when you file your return. If, on the other hand, you expect your income to be lower this year, you’re better off using 90% of this year’s tax liability as long as you can estimate it with reasonable certainty.
What happens when partners realize during the year that they haven’t paid enough estimated taxes? It may still be possible to avoid penalties. If you expect your income to be higher in the latter part of the year, use the annualized installment method and increase your remaining estimated tax payments.
Another strategy is to increase withholding from any wages (such as your or your spouse’s wages) to make up the difference. Unlike estimated tax payments, amounts withheld from wages are treated as if they were paid ratably over the year, regardless of when they’re actually withheld. So you can use increased withholdings late in the year to make up for an estimated tax shortfall in the beginning of the year.
Crunch the numbers
To ensure that your estimated tax payments are accurate and timely, project your 2016 taxes as early in the year as possible. You can use your 2015 return as a guide but, if you’re a new partner, last year’s return won’t help much. Ask your firm to provide you with income projections for the year and consider using the safe harbor to reduce your payments and simplify the projection process.