estimated taxes and late penalties on highly "bursty" side income

Question

I have a full time job where I get a W-2. In addition I occasionally freelance on the side as a contractor and receive a 1099-MISC.

The freelance work is very irregular and hard to predict. It's possible that I'll do zero freelancing one quarter and then some amount of freelancing the next. I am sure to do a reasonable amount of freelancing work this year, but the net revenue I receive could vary by as much as 2-4x.

Last year I did not file any estimated taxes (it was my first year freelancing). Turbotax was kind enough to provide an estimate (presumably based on similar/identical income for 2015) for estimated taxes and the quarterly schedule for when I need to pay said taxes.

My understanding is that late payments are subject to penalties. This year, to date, I have had almost zero freelancing income (maybe ~$400), but I expect that this quarter I will have substantial freelancing income.

Additionally I did not pay any estimated taxes by April 15th (I didn't make nearly the amount of money freelancing required to pay the estimated taxes that turbotax suggested).

What's the best strategy for someone in my position?

Can I simply pay estimated taxes on the money that I earn (or will earn) in a given quarter (e.g. estimate the tax liability on the money I earned that quarter and pay just that so some quarters I might pay zero and other quarters I might pay a few thousand dollars)?

Am I subject to a late penalty because I didn't pay estimated taxes in April even though by income by April was negligible? How do people handle highly bursty/irregular freelancing income?

Answer 1

See Publication 505, specifically the section on "Annualized Income Installment Method", which says:

If you do not receive your income evenly throughout the year (for example, your income from a repair shop you operate is much larger in the summer than it is during the rest of the year), your required estimated tax payment for one or more periods may be less than the amount figured using the regular installment method.

The publication includes a worksheet and explanation of how to calculate the estimated tax due for each period when you have unequal income. If you had no freelance income during a period, you shouldn't owe any estimated tax for that period.

However, the process for calculating the estimated tax using this method is a good bit more complex and confusing than using the "short" method (in which you just estimate how much tax you will owe for the year and divide it into four equal pieces). Therefore, in future years you might want to still use the equal-payments method if you can swing it. (It's too late for this year since you missed the April deadline for the first payment.) If you can estimate the total amount of freelance income you'll receive (even though you might not be able to estimate when you'll receive it), you can probably still use the simpler method. If you really have no idea how much money you'll make over the year, you could either use the more complex computation, or you could use a very high estimate to ensure you pay enough tax, and you'll get a refund if you pay too much.

Answer 2

The key for you this year (2015) be aggressive in paying the taxes quarterly so that you do not have to do the quarterly filings or pay penalties for owing too much in taxes in future years.

The tax system has a safe harbor provision. If you have withheld or sent via the estimated quarterly taxes an amount equal to 100% of the previous years taxes then you are safe. That means that if you end to the IRS in 2015 an amount equal to 100% of your 2014 taxes then in April 2016 you can avoid the penalties. You should note that the required percentage is 110% for high income individual.

Because you can never be sure about your side income, use your ability to adjust your W-4 to cover your taxes. You will know early in 2016 how much you need to cover via withholding, so make the adjustments. Yes the risk is what you over pay, but that may be what you need to do to avoid the quarterly filing requirements.

From IRS PUB 17:

If you owe additional tax for 2014, you may have to pay estimated tax for 2015.

You can use the following general rule as a guide during the year to see if you will have enough withholding, or if you should increase your withholding or make estimated tax payments.

General rule. In most cases, you must pay estimated tax for 2015 if both of the following apply.

• You expect to owe at least $1,000 in tax for 2015, after subtracting your withholding and refundable credits.

• You expect your withholding plus your refundable credits to be less than the smaller of:

  • 90% of the tax to be shown on your 2015 tax return, or

  • 100% of the tax shown on your 2014 tax return (but see Special rules for farmers, fishermen, and higher income taxpayers , later). Your 2014 tax return must cover all 12 months.

and

Estimated tax safe harbor for higher income taxpayers. If your 2014 adjusted gross income was more than $150,000 ($75,000 if you are married filing a separate return), you must pay the smaller of 90% of your expected tax for 2015 or 110% of the tax shown on your 2014 return to avoid an estimated tax penalty.