How much to hold in a tax reserve

Contractors pay their own income and self-employment tax. That is part of why companies hire them. But the company paying them still owes taxes of its own — estimated federal and state income tax, sales tax in some states, payroll tax for any employees — and the money for those has to be somewhere when the quarter ends.

In most of the companies we talk to, that somewhere is “the operating account, and we'll see.” It works until a quarter where revenue spikes, the estimated payment is larger than anyone expected, and the payout run due the same week has to wait.

A rule that holds up

The rule we suggest to new customers is simple enough to set once and forget. Each time money arrives, set aside a fixed share of it in a separate account. The share is your effective tax rate on revenue from last year, rounded up to the next whole percent, plus two points of cushion.

For a company that paid $410,000 in total taxes on $6.8 million of revenue, the effective rate is about 6.03%. Rounded up and cushioned, that is 9%. Every dollar that lands, nine cents moves to the reserve.

• It scales with revenue automatically, so a big quarter funds its own bill.
• It is easy to explain to a founder who asks where the money went.
• The cushion covers a rate that creeps up, and it is visible, so it can be spent deliberately.

Why a separate account

A reserve that lives in the operating account is a reserve in name only. It shows up in every balance anybody looks at, and it is spent the first time the balance is tight. Money in its own account, with its own name and number, is much harder to borrow from without noticing.

Pinnacle lets you open a Tax reserve account in the same treasury and fill it with a sweep rule — a share of every deposit, or everything over a ceiling in Operating, swept every Friday. The account is still yours, in FDIC-insured accounts at our partner banks, and you can move money out of it at any time. You just have to do it on purpose.

Federal and state on different calendars

Estimated federal payments are due in April, June, September and January. Most states follow the same dates, but not all of them, and a few want payments from companies that have no office there at all once revenue from the state passes a threshold. If you sell into a dozen states, the reserve is paying a dozen calendars.

That is one more reason to keep it in its own account. When a state notice arrives in an unfamiliar month, the money is already sitting somewhere labeled for it, and paying it is a transfer rather than a conversation.

How big is too big

A reserve can also grow larger than it needs to be, and cash sitting idle in a tax account is cash not paying anyone. Once a year, after you file, compare the reserve's balance to what you actually paid. If it has grown more than a quarter's worth above that, lower the share by a point and sweep the excess back to Operating.

The point of a reserve is not to be conservative. It is to make the quarterly payment boring.

That is the whole method. One account, one percentage, one check each spring. The quarters stop being events, and the payout run never waits for the IRS.