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:
- Don't substantially overpay taxes.
- Don't get reamed on underpayment penalties.
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:
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:
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.)
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.
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.