Small Business Taxes - What Happens If You Don't Make Quarterly Estimated Tax Payments?

How about a quick multiple-choice question on the world's most complicated subject: taxes.

Here's the question: As a sole proprietor or self-employed person, what will the IRS do to you if you don't make federal quarterly estimated tax payments?

Here's the possible answers:

a. Carry you off to prison
b. Fifty lashes with a wet noodle
c. Nothing
d. Assess a penalty

Depending on your particular tax situation, the correct answer is either "c" or "d".

Yes, it is possible that nothing will happen. According to the instructions for Form 1040-ES (the form that's used to accompany federal quarterly estimated tax payments), you do not have to make quarterly estimated tax payments if you were a U.S. citizen or resident alien for all of the previous year, and you had no tax liability for that previous 12-month tax year.

If you've been in business for a while, the above exception to the general rule probably doesn't apply to you. The general rule is this: You must make quarterly estimated tax payments if you have a balance due on your federal income tax return of at least $1,000 and you pay in less than (1) 90% of the current year's tax liability or (2) 100% of the previous year's tax liability (whichever is less).

Hmm. Don't you just love tax rules like that? The above paragraph is convoluted enough to make any sane person's head spin.

Oh, I almost forgot to tell you that in the paragraph above, if your adjusted gross income is more than $150,000, item (2) should read "110% of the previous year's tax liability". Oh boy. Now your head is really spinning.

Here's another, and hopefully simpler way to look at it: During the year, if your tax payments are such that you end up owing more than $1,000 on the return, you can be penalized for underpayment of quarterly estimated taxes, even if you pay the balance due by April 15.

What's the solution to avoiding a penalty for not paying enough estimated tax? Do one of these two things: (1) Make sure your quarterly payments are high enough that you never have a balance due of more than $1,000, or (2) Make sure your quarterly payments are greater than 100% of your previous year's tax liability or 90% of your current year's tax liability. As long as you do that, you won't have to worry.

But if you do have a balance due of more than $1,000, you might have to pay a penalty - not a penalty for late payment of the balance due, but a penalty for underpaying the estimated taxes during the year.