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I'm running my own business for the first time and I noticed while filing my first quarter's estimated taxes that the instructions ask you to make "four equal payments" throughout the year.
But many people (freelancers, business owners) don't know precisely how much money they'll make throughout the year. How can you be expected to pay exactly x * 0.25 if you don't know what x is?
The heart of the question is: why can't Bill just pay whatever he owes based on his income in that quarter? If Q2 is gang busters, he'll increase his tax payment. Then if Q3 is surprisingly slow, he'll pay less than he paid in Q2.
I think what's most interesting about this question is that the other answers are geared towards how a taxpayer is supposed to estimate taxes. But that's not my objective -- nor is it Bill's objective.
My [his] real objective is:
In other words, the answer to this question either needs to deal with not overpaying, or it needs to deal with mitigating the underpayment penalty.
AFAICT, there are 2 solutions:
Solution 1
Figure your estimated taxes based on last year's tax. You won't owe a penalty if your withholding + estimated tax payments in each quarter are 25% or more of your previous year's tax liability.
Here's the section that I am basing this on:
http://www.irs.gov/publications/p505/ch04.html
Minimum required each period. You will owe a penalty for any 2011 payment period for which your estimated tax payment plus your withholding for the period and overpayments for previous periods was less than the smaller of:
22.5% of your 2011 tax, or
25% of your 2010 tax. (Your 2010 tax return must cover a 12-month period.)
Solution 2
Use the "Annualized Income Installment Method". This is not a method for calculating estimated taxes, per se. It's actually a method for reducing or eliminating your underpayment penalty. It's also intended to assist tax payers with unpredictable incomes.
If you did not receive your income evenly throughout the year (for example, your income from a shop you operated at a marina was much larger in the summer than it was during the rest of the year), you may be able to lower or eliminate your penalty by figuring your underpayment using the annualized income installment method.
Emphasis added.
In order to take advantage of this, you'll need to send in a Schedule AI at the end of the year along with a Form 2210. The downside to this is that you're basically racking up underpayment penalties throughout the year, then at the end of the year you're asking the IRS to rescind your penalty.
The other risk is that you still pay estimated taxes on your Q2 - Q4 earnings in Q1, you just pay much less than 25%. So if you have a windfall later in the year, I think you could get burned on your Q1 underpayment.
You don't actually have to make four equal payments on US federal taxes; you can pay different amounts each quarter. To avoid penalties, you must have paid "enough" at the end of each quarter. If you pay too much in an early quarter, the surplus counts towards the amount due in later quarters. If you have paid too little as of the end of a quarter, that deficit counts against you for interest and penalties until it is made up in later quarters (or at year-end settlement).
How much is "enough"? There are a number of ways of figuring it. You can see the list of exceptions to the penalty in the IRS documentation. Using unequal payments may require more complicated calculation methods to avoid or reduce penalties at year-end. If you have the stomach for it, you may want to study the Annualized Income Installment Method to see how uneven income might affect the penalty.
You can simply use the previous year's tax liability as your basis for payments. Take the amount of tax you owed the previous year, divide by four, and use that amount for your estimated payments.
As long as you're paying 100% of what you owed last year, you won't have any penalty. Except if your AGI is above a certain limit ($150k for married filing jointly in 2011), then you have to pay 110%. See IRS Pub 505 for details (general rule, special rule, under "Higher Income Taxpayers").
(H/T to @Dilip Sarwate for pointing out the 110% exception in a comment below.)
They are four quarterly estimated tax payments. The IRS requires that you pay your taxes throughout the year (withholding in a W-2 job).
You'll need to estimate how much taxes you think you might be owing and then pay roughly 1/4 at each of the 4 deadlines.
How To Figure Estimated Tax
To figure your estimated tax, you must figure your expected AGI, taxable income, taxes, deductions, and credits for the year.
When figuring your 2011 estimated tax, it may be helpful to use your income, deductions, and credits for 2010 as a starting point. Use your 2010 federal tax return as a guide. You can use Form 1040-ES to figure your estimated tax. Nonresident aliens use Form 1040-ES (NR) to figure estimated tax.
You must make adjustments both for changes in your own situation and for recent changes in the tax law. For 2011, there are several changes in the law. Some of these changes are discussed under What's New for 2011 beginning on page 2. For information about these and other changes in the law, visit the IRS website at IRS.gov.
The instructions for Form 1040-ES include a worksheet to help you figure your estimated tax. Keep the worksheet for your records.
You may find some value from hiring a CPA to help you setup your estimated tax payments and amounts.
