Estimated taxes for contract workers

[Mike E 11,727]

I was asked in another thread and forum about this. Rather than hijack that topic, I am posting here.

 

@MIRN

 

This question comes up on VJ, because sometimes a new immigrant has the opportunity to continue to work for a foreign employer as a contractor. Contractors will not have taxes deducted from their pay, and so it is up them to pay their taxes. It would be simpler if contractors could just pay their entire tax liability in the April following each tax year, but doing so risks penalties as the IRS wants to be paid at least once per quarter. 
 

Quarterly estimated taxes are complicated because:

 

* even if you pay what you owe each quarter, you can still be hit with an underpayment penalty if your income is highly variable. So for example you are in the 10 percent tax bracket for the first 3 quarters of the year, and then on the four quarter you get a large payment that puts you in the 37 percent tax bracket. Technically you under paid for those first 3 quarters though the IRS gives you the option of breaking down your revenue and expenses by quarter to avoid the penalty. It is basically  5 + 4 = 9 tax returns. That’s complex.

 

* the “quarters” are not each exactly 3 months. Quoting from the IRS:

 

Estimated tax payments are due as follows:

• January 1 to March 31 – April 15
• April 1 to May 31 – June 15
• June 1 to August 31 - September 15
• September 1 to December 31 – January 15 of the following year

 

So one quarter is 2 months and another is 4 months. 

While most of my income has been W-2 income, I have had years with high percentages of variable pay whether from contracting or bonuses (bonuses have  lower tax with holding than their actual tax liability). Over the years I have learned the following tips:

 

* Assume that contractor income will be taxed at 35 percent. Even if your  tax bracket is as low as 10 percent, you still owe 15.3 percent SE tax. Even if your marginal tax rate is high as 37 percent, you won’t owe the full 37 percent on all income because of the progressive tax brackets. And SE tax drops from 15.3 percent to 2.9 percent well before you hit the 37 percent tax bracket. Of course, earn enough money and you will be hit with the 0.9 percent medicare surtax. So generally the 35 percent rule keeps most contractors safe. So each time you get revenue, put 35 percent of it in a separate bank account and do not touch it until you make  a quarterly payment, or pay any taxes owed in April

 

* If over the course of say tax year 2023 you pay 110 percent of tax year 2022’s tax liability you will not in April 2024 owe any penalties, provided you make 4 equal estimated tax payments in 2023. So if in 2022 you had a tax liability of $20,000, then 1.1 * 20,000 / 4 = quarterly payments of $5500 per quarter in 2023.

 

* you can avoid underpayment penalties if you or your joint filer spouse have a W-2 job and 110 percent of your tax liability from the previous tax year is paid from the W-2 job’s tax with holdings. You can do this by filing a W-4 with your employer to request additional taxes to be with held. This is my preferred way to do this, because this way I do not have to remember my quarterly tax payments  

 

So let’s try some examples:

 

You work in the U.S. remotely in 2023, and did not work in U.S. in 2022. You expect to gross $100,000 as a contractor in 2023.

 

Since your 2022 tax liability was zero dollars. the 110 percent rule says you are excused from making quarterly tax payments. You still reserve $35,000 in a separate bank account for paying taxes. In April 2024, you determine your tax liability is $30,000. You pay the IRS $30,000 out of your reserve fund. 
 

110 percent of $30,000 is $33,000. $33,000 / 4 = $8250. You make an estimated tax payment for tax year 2024 on April 15, 2024. And again on June 15, Sept 15, and Jan 15, 2025.

 

Continuing from the above, in 2024 your income was $103,000. The tax liability is $31,000. You paid $33,000 over year.

 

You are due a refund of $2000. However, you might instead apply that to 2025 estimated taxes. So:

$31,000 * 1.1 / 4 = $8525. So for April 15, 2025, you make an estimated tax payment of $6525. For the other quarters you pay $8525.

 

As above but your spouse decides to change the W-4 instead of you making estimated tax payments.

 

There are say 16 pay periods left in 2025, so your spouse files a W-4 requesting 31,000 * 1.1 / 16 = $2133 extra with held from each paycheck. To make up for the short falls in household cash flow, each time your spouse is paid, you transfer $2133 from your reserve account to your joint account. You let the IRS send you the $2000 refund.

 

Continuing with the above, April 2026 arrives. Your spouse had gross W-2 income of $150,000 and the W-2 shows $60,000 in income tax with held. You had $125,000 in contractor income. 
 

Your joint tax liability on a combined $275,000 income is $56,000. You take the $4000 refund. Your spouse has paid $25,000 to date.

 

110 percent of $56,000 is $62,000. $62,000 - $25,000 = $37,000. $37,000 / 16 = $2312. Your spouse files a new W-4 changing the extra with holding from $2133 per pay period to $2312.

 

 

 

 

 

 

[Bill Oxner 18]

Interesting post.

 

But don't most CPA suggest once you start making close to 100K or more as self employment that you set up a LLC / S-Corp and let the Corportion take about 70% of the revenue and cut a yearly check for like 30k and take out FICA/FUTA/etc..

 

I was always told Self Employment pays around 15% tax and corporate tax is like 7%.  I know you business tax returns are due March 15th and personal tax returns are due April 15th. And you have to file two seperate returns in this scenario.

 

 

 

 

[Mike E 11,727]

1 hour ago, Bill Oxner said:

But don't most CPA

If people want to use a CPA, they should not read any of content. 😀

 

It is a running joke on VJ that CPAs are those folks who make you evade taxes by filing a single when married to a NRA who does not have a TIN.

Quote

suggest once you start making close to 100K or more as self employment that you set up a LLC

IMO, most LLCs are pass through entities and so taxes are paid on a personal 1040.  But yes my understanding is one can opt to treat LLC as separate entity and pay corporate income tax. 

 

Corporate income tax today is 21 percent.

 

Personal income tax on $100,000 for a MFS filer is $14,000. 14 percent is cheaper than $21,000.

 

In my last example the contractor was earning 125K and filed jointly with a W-2 spouse earning $150,000. The income taxes on the couple ob $275,000 are $46,000. That is a rate of 16.7 percent.
 

There there are costs of setting of LLC/S-corp and the costs for a CPA. It amazes me that people balk at paying a lawyer a one time life fee of $5000 to get a gc, and do not flinch at paying $2000 or more each year to a CPA. At least one state has a punishingly high flat LLC surtax even if the LLC generated zero revenue. Some cities will go after you to get a business license.

 

US corporations pay hideously high taxes compared to most other countries.

 

 

 

 

 

Edited March 23, 2023 by Mike E

[Bill Oxner 18]

I paid 1k for a lawyer to set up my LLC/S-Corp

 

I just did my taxes since business taxes are due March 15th. Paid $662  for doing Form 1120S, Paid $95 for Franchise Tax return, Paid $334 for doing 1040.

 

Pay about $500 yearly for them filing all my quartely stuff and doing payroll.

 

Rather inexpensive in my books for all the money I save

 

 

[Mike E 11,727]

So close to $2500 per year including the $800 annual FTB LLC fee. I would have to have annual revenue over $2M before I would consider those fees. Too many CPA horror stories experienced vicariously. To each their own.

[Bill Oxner 18]

2 hours ago, Mike E said:

US corporations pay hideously high taxes compared to most other countries.

 

That why I use a CPA to try to reduce any thing I have to pay to the IRS

 

I pay taxes on my house to live in like 10K per year, pay taxes when I buy something, pay taxes on anything I earn, it's crazy the taxing that goes on, thankfully no state income tax.

[Bill Oxner 18]

1 minute ago, Mike E said:

So close to $2500 per year including the $800 annual FTB LLC fee. I would have to have annual revenue over $2M before I would consider those fees. Too many CPA horror stories experienced vicariously. To each their own.

I do about 1.5 per year