one of the biggest mistakes small business owners make is their misunderstanding to pay the estimated tax, especially these who have gotten used to working for an employer. The latter took care of the bulk of your income tax withholding and Social Security and Medicare deductions. Below are some facts from the IRS Estimated Tax Guide to help small business owners understand the estimated tax.

What are Estimated Taxes?

America’s tax system is “pay as you go.” This means you have to pay taxes over the course of the year instead of waiting until April 15. For employees, this is done via wage withholding. If your taxes are not withheld by an employer then you will likely need to pay estimated tax payments each quarter.

Estimated tax payments include both your income tax obligations as well as your self-employment tax (Social Security and Medicare) which will increase the total federal taxes you owe.

Who Must Make Estimated Tax Payments?

For sole proprietors, partnerships, S Corporation shareholders, single member LLCs who elect to be taxed as a sole prop or an S corporation, or multi-member LLCs who elect to be taxed as a partnership or an S corporation: To find out if you are the exception that does not have to make estimated tax payments, take the simple quiz below.

1. Do you expect to owe $1,000 or more in taxes for this year, after subtracting any income tax withholding and credits from your total tax?
   • If the answer is no, you are not required to pay estimated tax.
   • If the answer is yes, go on to the next question.
2. Do you expect your income tax withholding and credits to be at least 90 percent of the tax you’ll owe for this year?
   • If the answer is no, you are not required to pay estimated tax.
   • If the answer is yes, go on to the next question.
3. Do you expect your income tax withholding and credits to be at least 100 percent of the tax shown on your last year’s return? (If your last year’s adjusted gross income was more than $150,000 ($75,000 for married, filing separately), it would be 110 percent.)
   • If the answer is no, you are not required to pay estimated tax.
   • If the answer is yes, you need to pay estimated tax.

For C Corporations and multi-member LLCs who elect to be taxed as a C Corporation: If you operate a corporation, you generally have to make estimated tax payments if you expect to owe tax of $500 or more.

How Much Should You Pay in Estimated Taxes?

Prior year safe harbor

The majority of people who pay estimated tax rely on the prior year safe harbor. You can use the “prior year safe harbor” to determine whether you have to pay estimated tax and how much you have to pay. For example: Your total tax for 2011 was $37,000. Your withholding and credits for 2012 will be $21,000. You can use the prior year safe harbor to determine how much to pay: $16,000, or $4,000 per quarter.

Some people may wonder whether they’re permitted to use the prior year safe harbor even if they know they’re going to owe more tax for the current year. The answer is yes. The prior year safe harbor is a safe way to avoid the penalty for underpayment or estimated tax, no matter how large the underpayment is or how obvious it was that you would end up having an underpayment.

Exception: The prior year safe harbor requires a payment of 110% of the prior year’s tax (not just 100% of the prior year’s tax) if your adjusted gross income for the prior year was over $150,000 ($75,000 if you are married and filed separately).

current year liability

For a self-employed individual or disregarded entity (i.e. single-member LLC, partnership, or S Corp shareholder), you should complete Form 1040-ES: If you have good reason to believe that 90% of your current year’s tax will be significantly lower than your prior year’s tax, you’ll pay a lot more than necessary if you rely on the prior year safe harbor. The best choice then may be to work out an estimate of the current year’s tax liability. You can use Form 1040-ES (the form comes with a worksheet) to estimate how much tax you’ll owe for the current year.

Corporations should use the Worksheet on Form 1120-W to calculate estimated tax payments.

The IRS requires that estimated tax payments be made quarterly. As a result, once you know the total amount of estimated tax payments you’ll have to make during the year,you need to compute the dollar amount you must pay for each quarter.

You can use one of the following two methods to make this computation:

• the regular installment method or
• the annualized income installment method.

The regular installment method works by dividing your total amount of estimated payments for the year by four. On each payment due date, you pay one-fourth of the total tax due for the year. The IRS prefers this method, and it’s by far the simplest to use.

Annualized income method. If your business is of the type that doesn’t receive income evenly throughout the year, you may want to use the annualized income installment method to compute your estimated tax payments for each period. Under this method, your required estimated tax payment for one or more periods may be less than the amount figured using the regular installment method.

If you elect to use this method, you’ll have to file Form 2210, Underpayment of Estimated Tax by Individuals, Estates and Trusts, with your regular individual income tax return.

When are payments due?

Due Dates for Calendar-Year Individuals. If you operate your business on a calendar tax year, your estimated tax payment due dates are:

If the due date falls on a Saturday, Sunday, federal holiday, or holiday in the District of Columbia, the payment is due on the next business day.

There is a special rule in the tax law that excuses you from filing fourth quarter estimated taxes if you file your annual tax return (Form 1040, etc.), and pay any tax due by January 31.

Beware of Estimated Tax Penalties

If you underpay your estimated tax you may be assessed a penalty in the form of interest on the underpayment for the period when the underpayment occurred. Unlike most tax penalties that are assessed based on an annual liability, the underpayment of estimated tax penalty is calculated–and assessed–separately for each payment period. This means that you may owe a penalty for an earlier payment period even if you later paid enough to make up the underpayment.

As a matter of fact, if you didn’t pay enough tax by the due date of each of the payment periods, you may owe a penalty even if you are due a refund from the IRS when you file your income tax return.