Help for Self-Employed Clients Who Owe Taxes They Cannot Pay

Editor: Valrie Chambers, Ph.D., CPA

Practice & Procedures

In tax practice, CPAs occasionally encounter self-employed clients who have difficulty keeping up with their quarterly estimated tax payments. The problem of making adequate estimated tax payments is particularly difficult for the self-employed because they generally do not have taxes withheld and remitted to the government, as do most employees with wages reported on Form W-2, Wage and Tax Statement.

Under Sec. 6654, if the tax shown on the current year’s return is $1,000 or greater, required estimated quarterly payments are generally 25% of the required annual payment, which is the lesser of 90% of the income tax, self-employment tax, and net investment income tax shown on the current year’s return or 100% of the previous year’s liability. If a taxpayer’s adjusted gross income (AGI) for the previous year exceeded $150,000, the taxpayer must substitute 110% for the 100% figure in the above formula. As a practical matter, taxpayers may pay estimated income taxes more frequently than quarterly, but this is not explicit in the Code and might not be obvious on Form 1040-ES, Estimated Tax for Individuals, or its instructions.

Some clients even put themselves on a payroll to take advantage of tax withholding systems, even though the IRS does not recognize self-employed taxpayers as employees.Larry Carlton of Carlton & Duran CPAs in the Boston area has long suggested that the government allow self-employed individuals to voluntarily treat themselves as employees to assist taxpayers, tax preparers, and tax administrators in collecting income tax in timely increments. Until legislation allows this, however, other tax strategies might be preferable.

Danny Snow of CBIZ MHM LLC in Memphis, Tenn., suggests that limited liability company members facing this problem could have funds withheld by the entity from their draws, held in a separate account, and sent to the IRS as estimated payments. Matching the timing of estimated payments with the inflow of taxpayer funds could be the key to helping clients meet this challenge, according to “mental accounting” academics and behavioral economists.

Behavioral economists believe that investing an estimated tax payment that is not immediately due requires self-control. Self-control is difficult, so successful people develop a system of self-controls to avoid the temptation to unnecessarily spend money currently. They do so by deliberately allocating the funds to other, more suitable, accounts, such as a reserve for taxes due. In Portfolios of the Poor (Princeton Univ. Press 2009),authors Daryl Collins, Jonathan Morduch, Stuart Rutherford, and Orlanda Ruthven found that even the very poor can save, most effectively by matching cash outflows as closely as possible with cash inflows. Richard Thaler and H.M. Shefrin also found that “most individuals prefer to have their monthly inflows and outflows roughly balance” (Thaler and Shefrin, “An Economic Theory of Self-Control,” 89 Journal of Political Economy 392 (April 1981)).

Specifically, the authors of this item found that when explicitly offered the opportunity to make smaller, monthly estimated tax payments rather than larger quarterly payments, many taxpayers will opt to make monthly payments, and that adopting this option generally reduces the likelihood of the taxpayers’ incurring a delinquency penalty (Chambers and Curatola, “Could Increasing the Frequency of Estimated Tax Payments Decrease Delinquency Rates Among the Self-Employed?” 20 Advances in Taxation 1 (2012)). More frequent payments are relatively easy now and can be made as frequently as desirable with the IRS’s online payment system.

Having taxes withheld regularly through a W-2 system is often the most convenient way to pay income taxes, and W-2 employees are generally more compliant on average than self-employed taxpayers. Tax reform plans should consider allowing self-employed individuals to be voluntarily treated as employees for withholding purposes. Until then, a strong accounting department within a company may, at the member’s request, withhold taxes concurrently with withdrawals and pay them over on the due dates of the estimated income tax payments. If a CPA is the company’s accounting system, the CPA should consider asking if setting up the client on monthly payments through the IRS online system may help him or her comply with estimated tax payments and avoid an ugly, unaffordable bill—and perhaps an underpayment penalty—at the end of the year.