In this year-end tax planning update we review the US estimated tax system and how it applies to US connected businesses.
What Are Estimated Tax Payments?
Estimated tax payments are periodic advance payments made by corporations to the Internal Revenue Service (IRS) throughout the year. These payments are made to cover the corporation’s expected tax liability for the current year. Essentially, instead of paying the entire tax bill at the end of the year, corporations make smaller, regular payments to avoid a large lump sum payment and potential penalties.
Who Must Make Estimated Tax Payments?
Corporation that expects to owe $500 or more in taxes for the year must make estimated tax payments. This includes both domestic and foreign corporations operating in the US. The requirement ensures that the IRS receives tax revenue throughout the year, rather than waiting until the annual tax return is filed.
Methods for Calculating Estimated Tax Payments
There are several methods corporations can use to calculate their estimated tax payments:
- Actual Basis: This method involves calculating the estimated tax payments based on the actual income earned during each quarter. This method is useful for corporations with fluctuating income throughout the year.
- Safe Harbor: The safe harbor method allows corporations to base their estimated tax payments on the previous year’s tax liability. If the corporation’s income is expected to be similar to the previous year, this method can simplify the calculation process and help avoid underpayment penalties.
- Annualised Income Instalment Method: This method involves estimating the corporation’s income for the entire year and then dividing it into quarterly instalments. This method is particularly useful for corporations with seasonal or uneven income, as it allows for adjustments based on actual income earned during each quarter.
How Are Estimated Tax Payments Calculated Under the Actual Basis?
Calculating estimated tax payments involves a few steps:
- Estimate the Corporation’s Taxable Income: This includes all sources of income, minus any deductions and credits the corporation is eligible for.
- Apply the Corporate Tax Rate: The current federal corporate tax rate is 21%. Multiply the estimated taxable income by this rate to determine the estimated tax liability.
- Divide the Estimated Tax Liability: The total estimated tax liability is divided into four equal payments, which are made quarterly.
For example, if a corporation estimates its taxable income to be $1,000,000, the estimated tax liability would be $210,000 (21% of $1,000,000). This amount would then be divided into four quarterly payments of $52,500 each.
How Are Estimated Tax Payments Calculated Under the Safe Harbor Method?
The safe harbor method allows corporations to base their estimated tax payments on the previous year’s tax liability. This method is particularly useful for corporations that expect their income to be similar to the previous year. By using this method, corporations can avoid underpayment penalties as long as they meet certain criteria.
To calculate estimated tax payments under the safe harbor method, follow these steps:
- Determine Last Year’s Tax Liability: Start by looking at the corporation’s total tax liability from the previous year. This includes all taxes owed after applying any credits and deductions.
- Apply the Safe Harbor Percentage: The IRS provides a safe harbor percentage that corporations can use to calculate their estimated tax payments. Generally, corporations must pay at least 100% of the previous year’s tax liability. However, if the corporation’s adjusted gross income for the previous year was more than $150,000, the safe harbor percentage increases to 110%.
- Divide the Total into Quarterly Payments: Once you have the total amount based on the safe harbor percentage, divide this amount into four equal quarterly payments. These payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of the corporation’s tax year.
For example, if a corporation had a tax liability of $200,000 last year and expects similar income this year, it would need to pay at least $200,000 in estimated taxes for the current year. If the corporation’s adjusted gross income was more than $150,000, it would need to pay $220,000 (110% of $200,000). This amount would then be divided into four quarterly payments of $55,000 each.
Using the safe harbor method helps corporations avoid penalties for underpayment of estimated taxes, as long as they meet the required payment thresholds.
How Are Estimated Tax Payments Calculated Under the Annualized Income Instalment Method?
The annualised income instalment method is particularly useful for corporations with seasonal or uneven income throughout the year. This method allows corporations to make estimated tax payments based on their actual income earned during specific periods, rather than spreading the total estimated tax liability evenly across the year.
To calculate estimated tax payments under the annualized income instalment method, follow these steps:
- Estimate Income for Each Period: Divide the tax year into specific periods, such as quarterly or monthly. Estimate the corporation’s income for each of these periods. This helps in reflecting the actual income earned during each period.
- Annualise the Income: Multiply the income for each period by an annualization factor to project the income for the entire year. The annualization factors are provided by the IRS and vary depending on the length of the period. For example, if using quarterly periods, the annualization factor for the first quarter is 4, for the second quarter is 2, for the third quarter is 1.333, and for the fourth quarter is 1.
- Calculate the Tax Liability: Apply the corporate tax rate to the annualized income to determine the estimated tax liability for each period. The current federal corporate tax rate is 21%.
- Determine the Required Instalment: Subtract any previous estimated tax payments made during the year from the total estimated tax liability. Divide the remaining tax liability into the required instalments for the remaining periods.
For example, if a corporation estimates its income for the first quarter to be $250,000, the annualized income would be $1,000,000 (250,000 x 4). The estimated tax liability for the first quarter would be $210,000 (21% of $1,000,000). If the corporation has already made a payment of $50,000, the remaining tax liability would be $160,000, which would be divided into the remaining instalments.
Using the annualized income instalment method helps corporations align their estimated tax payments with their actual income, reducing the risk of underpayment penalties.
When Are Estimated Tax Payments Due?
Estimated tax payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of the corporation’s tax year. For a calendar year corporation, this means payments are due on April 15, June 15, September 15, and December 15. It’s important to mark these dates on your calendar to avoid missing a payment.
Consequences of Not Making Estimated Tax Payments on Time
Failing to make estimated tax payments on time can result in penalties and interest charges. The IRS imposes a penalty for underpayment of estimated taxes if the corporation does not pay enough tax throughout the year. This penalty is calculated based on the amount of underpayment and the length of time the payment is late.
Additionally, interest is charged on any unpaid tax from the due date of the payment until the date the payment is made. This can add up quickly, increasing the corporation’s overall tax liability.
Year-End Accruals
A business that is required to share management information with directors& shareholders, a wider group or external regulators may be required to make a tax accrual at year-end. The purpose of the year-end tax accrual is to include in the financials a fair and true representation of the business’ federal and state tax liabilities. Alternatively, loss making businesses may want to include details of any tax assets, such as net operating losses, excess charitable contributions or excess foreign tax credit balances on their balance sheet in order to better reflect the tax position of the business.
Conclusion
Understanding and complying with the estimated tax payments system is essential for any US corporation. By making timely and accurate estimated tax payments, corporations can avoid penalties and interest charges, ensuring a smoother tax filing process at the end of the year. Remember, the key is to estimate your taxable income accurately, apply the correct tax rate, and make your payments on time.
