How to head off under-withholding penalties
Let’s say you run a business, and take a small salary. And let’s say you had a great year! If your business is an LLC or S Corp, or even a sole proprietorship, that great year is going to find its way to your personal 1040, and you’re going to have to pay tax on it.
But you’re already contributing with withholding from your small salary, right? Isn’t that good enough? Well, if it’s been enough in prior years, and this year is especially good, then probably not. And not only will you owe income tax and self-employment tax, but you may be subject to underpayment penalties.
The IRS (and the State of New Jersey, as well as most other taxing jurisdictions) expects you to contribute “ratably” throughout the year, just like a W2 employee. It goes like this: a W2 worker has taxes withheld every time he or she gets paid. If the paycheck is large, the government gets more. If the paycheck is tiny, the government gets less. But either way, the government gets its cut way before April 15. And they want this from the self-employed community, too.
A rough calculation works like this:
Final tax liability – total withholdings = amount you should have sent quarterly.
Then do one more calculation:
Amount you should have sent – Amount you sent = Trouble.
“Trouble” is the amount they will focus on. If it is only a couple hundred dollars, you are probably okay. But the larger this number gets, the more “trouble” you will be in. First, of course, there could be penalties for not having sent in enough money. Then, there could be penalties for not having sent the money in fast enough, aka, via quarterly estimated payments. And finally, if this number is large enough, the IRS (and the states) can retroactively deny your extension, and among other things, back-charge you interest on the entire amount, beginning at April 15. (If you make a habit of doing this year after year, yes, they notice. But we aren’t talking about such dire straits today.)
What can you do? Take a year-end bonus! But that’s not all: talk with your payroll provider and weight as much of the check as possible toward income taxes. Usually, you can do this with a new W4. Put a nice big number in Box 6, Other Amount You Want Withheld. Then redo the math above, and heave a sigh of relief. Don’t be shy about asking your CPA to help you with this!
P.S. Once you do the big bonus check, you might need to redo your W4 back to whatever it was before.