Legal Definitions - declaration of estimated tax

A declaration of estimated tax is a formal statement submitted to the Internal Revenue Service (IRS) by individuals or businesses who expect to owe a significant amount of tax that won't be covered by regular payroll withholding. This declaration estimates the total tax liability for the year, and it requires these taxpayers to make regular, periodic payments throughout the year to cover that estimated amount. The purpose is to ensure that taxes are collected as income is earned, rather than waiting until the end of the tax year, especially from sources like self-employment, investment gains, or rental income.

• Example 1: Freelance Graphic Designer

  A graphic designer decides to leave their corporate job to start their own freelance business. They now receive payments directly from clients without any taxes being withheld from their invoices. Since no employer is withholding taxes from their income, the designer must estimate their annual profit and declare this estimated tax to the IRS. They will then make quarterly payments to avoid a large tax bill and potential penalties at year-end. This illustrates the term because they are declaring their estimated tax and making periodic payments to cover their tax liability.

• Example 2: Retiree with Significant Investment Income

  An individual retires and receives a modest pension, but a substantial portion of their annual income comes from dividends, interest, and capital gains from their investment portfolio. While some tax might be withheld from the pension, it is not enough to cover the tax on their significant investment earnings. Because the tax on their investment income is not automatically withheld, this retiree needs to file a declaration of estimated tax. They calculate the tax they expect to owe on their investment gains and make quarterly payments to the IRS, preventing a large, unexpected tax bill when they file their annual return.

• Example 3: Small Business Owner (Sole Proprietor)

  A software consultant operates their business as a sole proprietorship. They invoice clients directly and receive payments into their business account. As the owner and only employee, there is no payroll system to withhold income or self-employment taxes. As a sole proprietor, the consultant's business income is not subject to payroll withholding. Therefore, they are required to estimate their annual business profit and the corresponding tax liability (including income tax and self-employment taxes). They then submit a declaration of estimated tax and make regular quarterly payments to the IRS to fulfill this obligation.