Tax Planning: Payroll Withholding vs. Quarterly Estimated Tax Payments
Employees can use a W4 to help determine the amount of taxes to withhold so that at the end of the year sufficient taxes had been withheld. However, that isn't the case for shareholder(s) of corporations including those of an LLC taxed as an s-corp. Shareholders receive income from their W2 salary/wage and from the passed through K1 income generated to them as shareholders of the entity. For this reason, relying on a W4 alone for tax planning is flawed.
How to do tax planning? As your payroll service provider we would love to help, but this area of accounting is more suitable to handle with your CPA or other certified tax advisor. In a perfect world, you would work with them after completing your prior year returns to help guide your tax strategy for the current year. They may instruct you to make quarterly estimated tax payments outside of the withholding we deduct from your W2 wages. In the fall, they may ask for an update of the businesses YTD performance and your expectations to evaluate if additional withholding should be required prior to year end. If perfection isn't possible, you may need to review your prior year returns to see how much Fed/State income taxes you paid, compare that to your YTD W2 Fed/State income withholding & any quarterly estimated tax payments made to determine a preferred amount of Fed/State income tax to withholding prior to year end. Doing this at the end of the year can be challenging in particular while insuring adequate cash flow for the business & yourself.
Do I still need to make quarterly estimated tax payments? Possibly. Quarterly estimated tax payments are individual tax payments that the IRS instructs taxpayers to make to avoid penalties for underpayment of taxes. The IRS is okay with those estimated income tax payments being made via mail with a 1040-ES coupon or you can set yourself up to pay online. However, payroll income tax withholding which is reported on a W2 also is allowed to offset those estimated tax payments. You can instruct ASAP to withhold a specific target amount for Fed and similarly State income taxes out of your salary payments to accommodate this.
What if I don't think I'll owe as much as last year? While most tax return software and CPA's will give taxpayers coupons & instructions to make payments based on the prior year return to avoid penalties, if your income is expected to be significantly lower you may not owe as much as in year's past. However, to calculate your estimated tax, you must figure your expected adjusted gross income, taxable income, taxes, deductions, and credits for the year. The IRS provides a worksheet in the 1040-ES packet to assist in this, but often this turns into work a CPA would provide for their clients. ASAP isn't your income tax preparer or CPA, so we can't really assist in this type of estimation. You can give us your prior year income tax figures from your 1040 to use as your target, but that is the simplest method and doesn't take into consideration your actual current year situation. Estimated state income tax payments follow a similar methodology.