How Much to Set Aside for Small Business Taxes
Heads up: this article is only relevant for U.S. businesses.
Not sure how much money you should save for small business taxes? There are a few ways to go about calculating what you owe and saving the right amount.
The best method to use will depend on how long you’ve been in business, how stable your income is, and how willing you are to roll up your sleeves and crunch some numbers on a regular basis.
Here’s how to set money aside for your small business taxes.
Step 1: Get Clear on Tax Obligations
In this guide, we’re outlining methods that help you set money aside for the federal taxes your business owes. This means your self-employment tax and your income tax, which you and your business, respectively, will most likely pay the IRS on a quarterly basis.
If you hire employees, you’ll also need to deal with employment tax (aka payroll tax).
Unfortunately, federal taxes are only one piece of the tax pie. Depending on the nature of your business, you may also have to pay a variety of state and local taxes. Examples include:
- Sales Tax: Most states charge sales tax, which you collect at the time of making a sale.
- Franchise Tax: If you have sales tax nexus in a state, that state may charge you a franchise tax. How franchise tax is calculated and applied differs from state to state.
- Property Tax: Charged on real estate you or your business owns, property tax varies state-by-state—from 0.28% in Hawaii, to 2.38% in New Jersey.
- Excise taxes: As indirect taxes on goods sold by a business, excise taxes sometimes take the place of corporate income or sales tax. The Gross Receipts tax is a common example of an excise tax.
We wish we could say this list was comprehensive, but it’s not.
You can learn more about state-specific taxes by visiting the website for your state’s tax authority.
The only surefire way to determine your business’s tax obligations is to work with a CPA. A qualified accountant can outline what the taxes your business will owe, and show you how and when to pay.
Just remember: It will be your responsibility to set money aside for all of the taxes your business is obliged to pay—federal and otherwise—throughout the year.
Step 2: Use the 30% Rule to Save for Taxes
To cover your federal taxes, saving 30% of your business income is a solid rule of thumb.
According to John Hewitt, founder of Liberty Tax Service, the total amount you should set aside to cover both federal and state taxes should be 30-40% of what you earn.
Land somewhere between the 30-40% mark and you should have enough saved to cover your small business taxes each quarter.
Tax obligations differ from business to business. If you’d like to get granular, or see if you can get away with saving less than 30%, ask your CPA to determine what percentage of your business income you should be saving to cover taxes.
Step 3: Choose a Saving Method
You can set aside money for your small business taxes as often as you like. The best savings method for your needs will depend on what kind of business you run, and how long it has been operating.
The Per-Payment Method
When to Use It
The per-payment method makes sense if you haven’t been in business for long, or if this is your first year filing a tax return for your business.
Reason being, when your business is relatively new, it can be difficult to estimate its total income (and therefore your total taxes owed) for the current year. You have no financial records from previous years to use as a guide. And it’s likely your business’s monthly income is unstable or growing.
Also, if your business is affected by seasonality, predicting income for your first year can be especially difficult.
How It Works
Every time you receive a payment from a client or customer, put 30% of it into a business savings account.
This is easy to do if your incoming funds are low-frequency but high-value. For example, if clients pay you for project work only a few times a month, you won’t have to manually set aside money for tax too often.
But if, for example, you sell high volumes of merchandise via ecommerce, it becomes impractical to take 30% off after every transaction. In this case, add up your income for one week or one month, and then make the 30% deduction.
A Pro Tip for the Super Organized
If you receive low-frequency/high-value payments, and you have a solid financial cushion in your bank, consider using the sum total of one or more payment to cover the current quarter’s estimated taxes.
You’ll get the satisfaction of ticking that tax payment off your to-do list in one fell swoop. And it will save you the trouble of squirreling away 30% from every paycheck that comes in.
The Monthly Method
When to Use It
It’s best to use the monthly method if this is the first year your business has turned a profit.
This method is also helpful if your business income has changed so much that profits from previous years aren’t a good indicator of the income you can expect to bring in this year.
For instance, if you earned an average of $2,000 per month in 2016, but so far in 2017 you’ve been earning an average of $3,000 per month, using last year’s numbers probably won’t help you anticipate how much you owe this year.
If your monthly business income hasn’t changed since last year, you can use the yearly method to calculate your tax deductions.
How It Works
First, calculate your average monthly income.
Add up your business income from each month that has passed between the beginning of the financial year and the present month. Then, divide it by the number of months that have passed.
As an example, let’s say it’s the middle of June. Add up all your income from January, February, March, April, and May. Then divide that number by five.
The result is your average monthly income.
Second, calculate 30% of your average monthly income.
From now on, at the end of every month, put aside that amount for taxes.
The Yearly Method
When to Use It
If you filed a tax return for your business last year, and you don’t expect your business income to drastically change this year, use the yearly method.
One of the benefits of this method is that you only need to do the math once, for the entire year.
How It Works
Take last year’s business total income, and divide it by four.
Then calculate 30% of that amount.
The result is how much you need to save (and pay) for your quarterly estimated tax payments.
What happens if you underestimate your taxes owed?
According to rules set out by the IRS, so long as you pay 100% in the present year of what you paid the previous year in quarterly estimated taxes, you can’t be penalized for underpaying—even if that amount turns out to be too low. This is sometimes called the safe harbor rule. If your income is over $150,000, however, you must pay 110% of last year’s income—or 90% of the current year’s income—in order to qualify for safe harbor.
If you underpay your quarterly estimated taxes, you’ll know at tax time. In order to file your tax return, you’ll be adding up your income for the year—taking into account deductible expenses and other factors—and determining your tax liability.
You can also determine whether you’ve underpaid, and how much you will be penalized, by filling out Form 2210 (Underpayment of Estimated Tax by Individuals, Estates, and Trusts)
What Happens If You Pay Too Much?
With the 30% method, you may end up overpaying your taxes owed. While overpaying isn’t ideal—it ties up funds that could otherwise be used productively—you will nonetheless get back as a tax refund whatever you overpay. And that money can be put to good use.
Save for Next Year
A good way to lessen the burden of saving for taxes next year (and to avoid the temptation to splurge) is to save your tax refund and put it toward future tax payments.
If you’re filing a Form 1040 or 1040A for your business, you can opt to leave some or all of your tax refund in the hands of the IRS and have them put it towards next year’s taxes.
On the one hand, this can help if you’re anticipating your tax liability will increase next year. It also saves you the busywork of depositing the money from the IRS and putting it aside in a savings account, which might not be worth the time or energy if your refund is small.
On the other hand, if it’s a large refund, that money could otherwise be put to work—as an investment that accrues interest, for instance, or as an investment back into your business. While the IRS is holding your money, it doesn’t gain any interest. These are just some of the arguments against carrying forward your refund balance.
If having enough funds to cover your quarterly estimated tax payments is a source of stress for you, we recommend putting your tax refund towards them. Whether or not you leave your refund in the pocket of the IRS is ultimately up to you.
How to Manage Your Savings
Set money aside for taxes in a separate business bank account. This is the best way to keep it removed from your day-to-day financial goings-on, and avoid the temptation to tap into it for regular operating expenses.
If you budget money for taxes on a monthly or quarterly basis, consider setting up automatic bank transfers from your regular business income account to your tax savings account.
Budgeting money for your small business taxes is only half the battle. Ideally, you want to pay as little in taxes as possible. Learn more about small business tax deductions and how to claim them, and reduce your next tax bill.
Then, hire a CPA. A qualified accountant can use your financial data to help you strategize and grow your business.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.