Quarterly taxes and the one rule that ends the April ambush

Quick answer: If you expect to owe $1,000 or more in federal tax for the year, the IRS wants it in four payments, not one lump in April. The simplest way to avoid a penalty is to pay 100 percent of last year's total tax, split four ways, on time. Make that 110 percent if last year's adjusted gross income was over $150,000.

Picture a drywall guy in his first full year on his own. This is an example, not a real client. He nets $80,000 after expenses, the best year he's ever had. Nobody withheld a dime. In April his preparer slides a sheet across the desk, and the federal number alone is north of $15,000. Then there's a penalty on top for not paying during the year. And there's a state bill too, depending on where he lives.

He didn't do anything crooked. He just didn't know the government expected to be paid as he went. Most guys learn this exactly once. You can skip the lesson.

You're the payroll department now

When you worked for somebody else, the office took tax out of every check and sent it in for you. You never saw it, so it never hurt.

Now there's no office. The IRS runs on pay-as-you-go, and it treats you like any other earner who's supposed to pay through the year. The mechanism is called estimated tax, filed on Form 1040-ES, and it's due four times a year.

Stop thinking of it as a bill. Think of it as withholding you do yourself.

What you're actually paying

Two taxes, not one.

Income tax, same as everybody.

Self-employment tax, which is Social Security and Medicare. As an employee you paid half and your boss quietly paid the other half. Now you're both. It's 15.3 percent, figured on 92.35 percent of your net profit. The Social Security portion stops at a yearly wage cap, but most tradesmen won't hit it.

Run the drywall example: $80,000 net, times 0.9235, times 0.153. That's about $11,300 in self-employment tax before a single dollar of income tax. You do get to deduct half of it when figuring income tax, which softens it a little. Only a little.

This is the number that catches people. It's also why the hourly rate that felt generous when you quoted it usually isn't. If you haven't run that math, read why $45 an hour is a pay cut when it's your own truck before you quote your next job.

The four dates, and the annoying part

For most years the deadlines are:

• April 15 covers income from January through March
• June 15 covers April and May
• September 15 covers June through August
• January 15 of the next year covers September through December

When a date lands on a weekend or holiday, it slides to the next business day.

Look at those periods again. They aren't quarters. The second one is two months long, which means your June payment comes due eight weeks after your April one. The fourth one is four months long and lands in January, right after you've spent December buying presents and paying for the Christmas party.

Nobody explains this until you've missed one. Put all four dates in your phone now, with a reminder one week early. Paying early costs you nothing.

The safe harbor rule is the whole game

Most guys don't make quarterly payments because they have no idea what they'll earn this year. Fair enough. A landscaper doesn't know if it's going to rain all of May.

You don't have to guess. The IRS gives you a safe harbor: if your payments during the year add up to at least 100 percent of last year's total tax, you owe no underpayment penalty, even if this year turns out bigger. (The other route is paying 90 percent of this year's tax, but that requires knowing this year's tax, which is the whole problem.)

Pull out last year's Form 1040 and find the line labeled "total tax." Say it was $14,000. That's an example. Divide by four. Pay $3,500 on each of the four dates, and you're protected from the penalty no matter how good the year gets.

If last year's adjusted gross income was over $150,000, the bar is 110 percent. In the same example that's $15,400, or $3,850 a payment.

The catch nobody mentions: safe harbor protects you from the penalty, not from the bill. If you earn a lot more this year, you'll still owe the difference in April. Which brings us to the account.

Open a second bank account this week

Open a separate savings account, ideally at a different bank from your operating account so it's a little inconvenient to raid.

Every time a customer pays you, move a percentage into it. Same day. The usual rule of thumb is 25 to 30 percent of what's left after business expenses, higher if your state has a hefty income tax or you're having a big year. Your preparer can give you a sharper number once they've seen a year of your books.

Your four estimated payments come out of that account. Whatever's left in April covers the balance. If there's still money after that, congratulations. That's a real bonus, and it's yours.

Now the hard part. The money in that account was never yours. You're holding it for somebody else. When your buddy tells you about a trailer at a great price, or your brother-in-law needs a loan till Friday, the answer is no. Taking care of your family includes not handing them a five-figure surprise next spring. Say no, and don't feel bad about it.

When the rules bend

Your wife has a W-2 job. Filing jointly? You can have extra tax withheld from her paycheck with a new W-4 instead of mailing estimated payments. The IRS treats withholding as paid evenly through the year, even if you bump it up in October. That can rescue a year where you fell behind. It also pinches her take-home pay, so talk it over before somebody finds out at the kitchen table.

Your work is seasonal. If you make most of your money in summer, equal payments mean paying ahead of income you haven't earned yet. The annualized income installment method, filed with Form 2210, lets payments track when the money actually came in. It's more paperwork, and it's worth it for landscapers, roofers and pool guys.

You file early. If you file your return and pay everything you owe by January 31, you can skip the January 15 payment.

Your state wants its cut. Most states with an income tax run their own estimated payment system with their own forms. A handful of states have no income tax at all. Check yours.

You're in Canada. The CRA runs its own installment system with different dates and thresholds. Ask your accountant.

How to pay

Use IRS Direct Pay, EFTPS or your IRS online account. All three are free and take a few minutes. Choose "estimated tax" and the correct tax year, which matters most on the January payment, since it belongs to the previous year. Save every confirmation number in one folder. You'll want them when you file.

A mailed check with the 1040-ES voucher still works. It's just slower, and you've got no proof until it clears.

What skipping costs

The underpayment penalty works like interest. It's based on the federal short-term rate plus three percentage points, figured separately for each late payment for as long as it's late. It won't bankrupt you.

The penalty isn't the real damage, though. The real damage is getting to April with nothing set aside and a bill you can't cover. Then you're on a payment plan with the IRS, paying more penalties and interest, all while trying to keep your business running.

Every situation has wrinkles, from a spouse's income to a big equipment purchase to a year that doubled. This is general education, not tax advice. A CPA or enrolled agent who works with tradesmen can set your numbers once, and you can run the system yourself after that.

Pay what you owe before anybody has to ask for it. It's how you'd treat a buddy who lent you a tool, and it works on Uncle Sam too.