If you own a business or are an active investor, tax planning can help you eliminate surprise tax bills. Over the last 25 years I have met dozens of investors and business owners who tell me stories of large, unexpected tax bills. The story is always the same, the person met with their CPA and found out they had a huge tax bill due from the prior year. People are always shocked to get this news!
Large, unexpected tax bills are simple to explain. You get a large, unexpected tax bill because your income throughout the year was greater than the prior year and you did not pay enough tax throughout the year. Either your tax withholding was too low, your estimated payments were too low, or both.
If you are running into surprise tax bills, there is a simple planning process you can use to end surprise tax bills.
Step 1. In August, Estimate Annual Income from All Sources
By August you should have a good idea of what your total income will be for the year. If not, you can complete this step in November or December. What you are looking for is a change from the previous year. Use the prior year’s income as your baseline and look for increases. Remember to add up all sources of income. Sources of income will be capital gains from stock sales, real estate sales, business income, rental income, royalties, stock dividends, limited partnership income, money market interest, bond interest, CD interest, etc. If your income is larger than the previous year you will need to make an estimated payment.
If you are a business owner, common sense should tell you that if your profits are way up, you are going to need to increase your estimated tax payments! For example, if you are the sole owner of an S-Corp and your business profits are up $300,000, you are going to owe an additional $100,000 in taxes. Tracking your income throughout the year will help eliminate surprise tax bills when you file your tax returns.
Step 2. Report Your Income Increases to Your Tax Advisor
Your tax advisor can help you by preparing a tax projection. The tax advisor will give you advice on what changes you need to make to estimated payments and tax withholding. If you do your taxes on your own, you are simply looking at the increase in income from the prior year and estimate as best you can how much in additional tax you will owe. Then make an estimated payment.
Step 3. Over Withhold Taxes Through Payroll and 1099R Payments
If you had a big increase in income from the prior year, over withholding taxes through payroll and 1099R Payments will help reduce penalties from being short on estimated tax payments.
Following the three steps listed above should eliminate tax surprises. With proper planning and income tracking, you should know your tax bill at the end of the year.
Ethan S. Braid, CFA
President
HighPass Asset Management