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Taxes for the self-employed – plan for the April surprise

Taxes for the self-employed – plan for the April surprise

As business owners, my wife and I know that we need to make quarterly payments to the IRS.  Our CPA (Certified Public Accountant) tells us how much to pay, and we pay it.  Yet, nearly every April, our CPA delivers a second message that feels like a kick to the ribs – you need to pay more to the IRS.

Huh?  We owe more?  Didn’t we already pay a bunch all year long?  We have to pay AGAIN??!!

It is a frustration voiced by many of my self-employed friends and clients.  I call it the April surprise.  

This post is NOT a rant against taxes, or whether taxes are too high (or low).  I appreciate the many benefits that taxes pay for – the safety net of social security and medicare, the ease of living within a robust public infrastructure, the security of a defended homeland, the pride of my children finding their voice through schools.  Nevertheless, paying Uncle Sam is never fun.   

This post is intended for business owners and those contemplating self-employment.   It could be summed up as:

“Why do I keep owing more in taxes every April?” AND “What can be done about it?”

There is a cut to the chase message for the busy reader, who isn’t interested in details.  It’s budgeting advice:  As a business owner, save $1 out of every $4 of business revenue (25%) in a dedicated “pay for taxes account.”  Pay quarterly taxes from the account.  Come April, you will have money saved to cover any bad news.  If the money isn’t needed, then your surprise in April will be a pleasant one.      

This post is the second in my series about transitioning to self-employment.  The first post was about cash flows:

Transition to self-employment – where is the water?

First, a disclaimer.  Taxes are complicated, especially when you add in business or real estate income.  In this post, I will use a fictional case study to help explain the math.  The case study is simplified to aid in understanding.  Please do not use my numbers as any sort of proper tax projection.  Consult your CPA or tax professional for advice that pertains to your situation.

What’s the problem?

The April surprise is the unexpected message from your CPA that you owe money with the filing of your return.  Sometimes, the surprise is small and benign, sometimes it can be nasty and a threat to your business or household if not budgeted for.  

Four years ago, our April surprise was about the size of another mortgage payment.  That’s an annoying “startle scare,” but we could easily pay it from our savings (or emergency fund).   We could just wing it. 

Last year, as we underwent a more dramatic transition to self-employed income (I went to halftime as a teacher), the April surprise turned spooky.  It was more like 3 mortgage payments, due all at once.  We were caught off guard, and had to scramble to pay. 

This year, I anticipated a much larger April surprise, more like the cost of a decent used car.  We need to budget.  

What is going on?

The core reason a small business owner might receive a big April tax surprise is that the business is growing.  For most business owners, growth is a welcome scenario.  Nonetheless, as taxes are such a large bill, the surprise can turn into a real problem if not planned for.  I call it “April” because that is the normal deadline to file one’s personal taxes.  If you file for an extension, your surprise will come the day you file your tax return. 

There are two primary drivers: 

A. If you end up owing more than you paid, you must pay the difference by April 15.

B. You must pay the first quarterly tax payment for the current tax year on April 15.

I will examine each in turn.

A. If you end up owing more than you paid, the difference is due on April 15.  

Small business owners pay their taxes through quarterly, estimated tax payments.  The amount of quarterly tax payment is a projection of taxes owed for the year.  There are IRS rules for a minimum amount.  One such rule is that you should pay quarterly estimated taxes of at least 100% of the amount of taxes owed in the previous year.  Even if you end up owing more in taxes, as long as you paid the same amount as you owed the previous year, the IRS does not penalize you for underpayment in most situations.  That is a friendly rule.  It recognizes that business owners should be conservative, and not count their chickens before they hatch.  The downside is, of course, that a growing business will owe more in taxes than were paid through minimum quarterly estimated taxes.

B. The first quarterly tax payment for the current tax year will be due on April 15.

Quarterly estimated tax payments are determined based on what you owed last year.  A payment is due about once every 3 months.  If your business is growing, the new quarterly payment will be more than it was last year.  The first payment is due on April 15 (regardless of when you file your return).   

Put together – paying the balance of last year’s tax owed, plus the first installment of a new quarterly bill, on the same day can turn into a “double whammy.”  In some senses, the problem is really a timing one.  The deadlines for making quarterly tax payments are April 15, June 15, September 15 and January 15.  Notice that there are actually four months between the Sept and Jan deadlines (to account for the holidays?), but there only two months between the April and June dates.  In theory, a business owner could pay their last estimated tax payment in January, file their return in February and pay any excess tax owed.  A new quarterly tax payment would be established, and the owner would make the first payment two months later (on April 15), thereby removing the double whammy.  However, I don’t know anyone who works that way.  Another option is to file for an extension to file your return (which many business owners do).  However, the deadline for estimated tax payments does not extend, so this strategy is just kicking the can down the road.   

Storytime – a case study

The math is pretty simple – some addition, a bit of division, followed by subtracting some big sum from your bank account.  However, understanding which numbers to add and divide and subtract can get confusing.  To illustrate, I will create an example.  

Leah Goh and her business, EverythingIsAwesome LLC.

Leah Goh was working as a bricklayer, but her dream was to own her own business.  In 2017, she started a life coaching business called EverythingIsAwesome LLC, while still working as a bricklayer.

In the first year, she worked her tail off marketing and building a clientele;  she made a modest business profit of $20,000 (after expenses).  As a new entrepreneur, she vaguely knew that she needed to pay some taxes on her business income, but she didn’t really know how to do so.  At the end of the year, she found a highly recommended CPA (Certified Public Accountant), named Bee Encownter.   

Bee asked Leah if she had paid any quarterly estimated taxes.  Since Leah had always done taxes herself, based on a pretty simple paycheck income, she had never heard of quarterly estimated taxes. 

“Nope,” Leah responded, slightly abashed.   

“Not to worry,” Bee re-assured her.  “We will fix this right up, you’ve just started a business.  This type of thing happens all the time!” 

Bee asked Leah if she anticipated big changes to her business for the upcoming year.  Leah hoped so, but she knew that hope was not a strategy.  So, she modestly told Bee, “I hope EverythingIsAwesome will grow, but I don’t want to count on it.” 

Bee prepared Leah’s return, and in the nicest way possible, informed her that she needed to pay $3,750 to the IRS by April 15.  The payment was due to the following:

A – She owed $3,000 of income+self-employment tax for 2017.

B – She needed to make a 2018 1st quarter estimated tax payment for the next year of $750 ($3,000 divided by 4) (see Endnote [1] for a comment about this calculation)

That was a tough pill to swallow for Leah.  But, she realized her error – of course she needed to pay taxes as she went!  She also owed a penalty for “under-payment” of tax.  The penalty wasn’t too much, but it was annoying.  Leah wondered why her tax bill was so high, $3,000 seemed like a lot compared to what she paid as a bricklayer.  She was glad to have a CPA on her side, so she asked Bee,

“Why were my taxes so high?” 

Bee explained,

“Overall, your effective tax rate was 15%, which, compared to others, is quite reasonable.  But, you are paying it all at once, so it looks like a much bigger number.  As a paycheck employee, you paid taxes as you went through monthly deductions.  In addition, small business owners do pay slightly more in taxes than paycheck employees.  Here is how it works:

There are two primary components to federal income tax as a self-employed person:  ordinary income tax and self-employed taxes.  Ordinary income tax is what everyone who earns money must pay.  It is similar to what you paid when you earned a paycheck.  The rate varies from 12% to 37.6% depending on how much money you make.  The other component is self-employed taxes.  They are another 15.3% of business profits.  It is important to note, however, that self-employed taxes are not really a tax expense.  They are really a payment for your access to Social Security and Medicare.  Paycheck employees also pay Social Security and Medicare taxes, but employees and employers split the bill 50-50.  Self-employed individuals are both employee and employer, so they must pay 100% of the Social Security/Medicare ‘taxes.’

For your bricklayer income, the federal income, Social Security and Medicare taxes were deducted from your paycheck, you likely never even noticed that you were paying. Now, as a self-employed person, you are responsible to pay for all of your taxes – ordinary income tax AND self-employed tax.  Although it may look like you are paying more, you aren’t.  You are just made aware of how much you are paying, because you have to write the check.”  

Bee told Leah to make the rest of her $750 tax quarterly estimated tax payments.  Leah thanked Bee for the help and the information, and vowed to not get stung next April.  In 2018, Leah was going to pay all her taxes as she went, yay for quarterly tax payments!

In 2018, Leah quit her bricklayer job to focus on running EverythingIsAwesome.  Her business did amazingly well, with rave reviews from her clients.  Her business earned $60,000 in profits for the year, nearly matching Leah’s paycheck earnings.  All year, she diligently saved for and paid her quarterly tax payments.  She expected that her tax bill would grow.  She even budgeted for it.  Since her business profits were three times what they were in 2018, she saved $2,250 (three times the quarterly tax payment she had been paying in 2018) to be at the ready come April tax time.  She proudly marched into Bee’s office.

“Look at me!” she proclaimed.  “EverythingIsAwesome is doing awesome!  This business I have built is earning as much as my old job!  And, this year, I paid all my taxes!”

Bee was thrilled for Leah, however, she cautioned Leah that her taxes owed would probably be higher.  “You are doing great Bee, but when you earn more money, you know that you will owe more in taxes.” 

Leah responded confidently, “I figured as much.  This year, I am ready to pay three times the quarterly payment we made last year!”  Bee gave Leah a thumbs-up, but the look on Bee’s face worried Leah.  

As she left Bee’s office, doubt crept into Leah’s mind, followed by anxious questions.

“What was that look?  How bad could it be?” 

A month later, Bee delivered the “April surprise.”  Leah needed to pay the IRS $9,500.  The payment was broken down into:

A – $7,000 additional taxes owed (2018 ordinary income+self-employment taxes owed were $10,000 less the $3,000 paid in quarterly tax payments).

B – $2,500 for the first quarterly tax payment for 2019. 

Leah stared at the paper, panic creeping in her throat.  Bee started talking, explaining, but all Leah could focus on was $9,500.   

Bee knew this would be painful news for Leah.  Bee was empathetic, and she took the time to explain that the underlying reason for her new bill – EverythingIsAwesome was growing!  In addition, Bee pointed out that Leah’s effective tax rate was still reasonable – at about 17%. 

None of that mattered to Leah.  All she saw was a need to pay $9,500 when she had only budgeted $2,250.  Although her business WAS doing well, she didn’t have piles of cash laying around.  She wasn’t living extravagantly.   An unexpected $9,500 bill would devour all of the stored cash in her business, plus the funds she was saving to buy a new car.  She left Bee’s office in tears.

Leah went back to work, determined to dig herself out of this hole.  Her business continued to do great.  In 2019, it earned $100,000 in profits!  EverythingIsAwesome was the talk of the town.  By now, Leah was catching onto the upcoming “April surprise.”  Throughout the year, she aimed to save 25% of her revenue.  Her car finally died.  Rather than buy the new Subaru Outback her heart sung for, she bought a five-year-old model for half the cost.  By December, she had saved $20,000 saved for taxes   

In April 2020, Leah was prepared.  The April surprise turned out to be around $18,000.  Leah was proud, she had tamed the wild April surprise.   

Shouldn’t our CPA help prepare us for the April surprise?

I have heard many small business owner friends tell me a similar story to Leah’s, then wonder why their CPA wasn’t helping them figure this out.  I’ve wondered the same.  But, as I think more deeply about the situation, I think I understand some of the reasons why.

  1. First of all, taxes are incredibly complicated.  The example I illustrated above is “more or less correct,” but I stripped away all complexities from Leah’s life like marriage, kids, paying for college, owning real estate, depreciation, carry-forward losses from start-up costs, etc.  In reality, most small business owners have tax situations that are much more complicated than Leah’s.  For a CPA to do a proper tax projection, they need all of your information.  
  2. Secondly, in order to properly prepare for the “April surprise,” your CPA would have to know your future income before your business earns the income.  Quarterly estimated tax payments are typically created based on the business that is known, not the business that might come to pass.  Why pay taxes on fictional income, it would not make sense.
  3. It is a good financial move to not overpay estimated taxes.  It is better to hold onto the money and earn some amount of interest.  Thus, a CPA may be acting in your best interest by suggesting the minimum quarterly estimated tax payment.

The final reason is psychological.  CPAs are known for their knowledge of the tax code, and for their careful attention to accuracy.  They like to be correct down to the nearest penny.  They don’t like to live in a world of “estimates, projections and uncertainty.” 

If “paying your way to be a US citizen through taxes” was a sporting event, CPAs would be like the referees.  They are responsible to make sure that the score is counted properly, and that the game is played fairly.  They are responsible for knowing the rules, informing you if you have stepped over a line.  Without good referees, sporting events devolve into anarchy.  Without good CPAs, and fair tax collection, societies become corrupt. 

Planning for taxes is a much more amorphous game than preparing a tax return.  Planning is designing a strategy.  Sports teams don’t ask the referees to come up with a game strategy.  That is what a coach is for.  To be fair, there ARE some CPAs who do tax planning, or advising.  However, it is a different service than tax preparation.   

We have a CPA who prepares our taxes.  I adore her.  She is smart, fair, and diligent.  I love gathering my papers, organizing them as best I can, then handing the whole lot off to her to prepare our returns correctly.  Nearly every April, she makes sure that I understand why our surprise is the number it turns out to be.  However, I do not expect her to plan for next year’s surprise (unless I had all of the information in October for her to do a proper projection).  

Is there anything you can do?

Yes. 

If you are transitioning into self-employment, be aware of the possibility of the “April tax surprise.”  Hire a CPA early to be sure that you are following the tax code properly.  Many people self-prepare their returns, using tax preparation software.  If your situation is simple, that often works fine (although I still find many errors even on self-prepared returns).  Once your situation gets complicated, including opening a business, hire a competent CPA.

If your business is growing, try to take the “surprise” out of play.  Once your current year tax return is complete, ask your CPA for a simple projection for next year.  Here is an example question you could ask,

“If I pay all my quarterly tax payments, and nothing else changed in my tax situation except that my business profits grow by __next year,  how much do you think I would need to pay the IRS next April?” 

I’d speculate that your CPA could get you an answer that would be reasonably accurate.  Unfortunately, there is no way to be perfectly accurate, because you don’t really know what your business will earn!  Plus, your personal situation likely WILL change somewhat, AND all of the numbers, reference points, tax brackets, etc. change from year to year.  But, it will give you a ballpark number to budget for.  Let your CPA that you are ok with the uncertainty.  If you can’t get a better number, save 25% of revenues.  

Are there ways to reduce the taxes I owe?

Yes, there are.  As a small business owner, there are many ethical and legal tax planning strategies you can take to reduce your tax bill.   Just Google, “How can I lower my tax bill?”  You will find lots of information.  Personally, I find that most information tends to be fairly generic, and the strategies you will work for you are highly dependent on your individual tax situation.  So, you might be back to asking your CPA, or your financial planner for advice.

As a comprehensive financial planner, I do tax planning with my clients.  However, I can’t just look at a return and find tricks and tips.   I need to know a LOT about their financial situation.  Taxes are one area of a household’s financial life, the taxes are often affected by your investments, your goals, your savings, and of course your income.  In essence, tax planning is complex!  Also, I am not a CPA.  I am a student of the US tax code, but not a referee.  Whenever I develop a recommendation, we consult with my client’s CPA to ensure that I am not missing something.  Thus, I do not advise you to take my thoughts/words/advice into your own tax situation without first consulting a tax professional (like a Certified Professional Accountant, or CPA).    


Look there!  You’ve read an entire blog-post on tax planning!  If you enjoyed this article, or think you know someone who would, please share!  You can select one of the social share buttons below. 

Are you hungry for more?   Last year I wrote a couple of posts about taxes over the long term.  Here is a link to one of those articles:  

How about them Tax apples? Using your tax bracket and tax-diversified savings to harvest tax savings.


Endnotes

[1] Yes, yes, I know that this number is not exactly correct and does not account for other income, deductions, etc.  But, it is close.  And, bear with me for simplicity!

John Chesbrough
john@trailfp.com

I am a financial planner and investment manager. I also am the owner of a fee-only, independent financial advisory firm called Trail Financial Planning. I enjoy working with people who care for others and their community – parents, firefighters, therapists, doctors, nurses, and teachers. I may be spotted at through my blog or on the many winding trails of Whatcom County. To learn more, or contact me directly, please visit my firm's website: www.trailfp.com.