{
  "question_id": "CG-MCE-113",
  "slug": "how-to-work-out-how-much-to-set-aside-for-taxes-from-your-books",
  "display_title": "How do I use my books to work out how much I should be setting aside for taxes?",
  "format": "article-v2",
  "applies_to": {
    "countries": [
      "US"
    ],
    "frameworks": [],
    "tax_year": null,
    "platforms": []
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  "general_concept": false,
  "summary": "Drive the reserve from book profit before income tax, not sales, deposits or the bank balance. Work out whose tax it funds: a C corporation's own, or, for sole proprietors, partnerships and S corporations, mainly the owners'. Apply a proportion from your own filed return or your preparer, move the amount to a separate business account at each monthly close, and record it as a transfer, not an expense. Holding the money pays nothing: estimated payments fall due separately.",
  "body": "## Which figure from your books should drive the reserve?\n\nUse net profit before income tax for the year to date, from your profit and loss report. If any income tax, whether a C corporation's own tax or a payment of an owner's tax made from the business's accounts, has been posted to an expense account, add it back first; how those taxes are recorded belongs with recording estimated tax payments in the books. Federal tax starts from profit, not sales. IRS Publication 334 has a sole proprietor use Schedule C to figure net profit or loss from the business, the IRS's Corporations page says a corporation's profit is taxed to it when earned, and the IRS's Partnerships page says a partnership passes its profits or losses through to its partners.\n\nThe figures people often use instead each go wrong in a predictable way:\n\n- **Sales.** Sales ignore costs, so a reserve built on them rises with sales even when rising costs mean profit, and the tax on it, does not.\n- **Deposits.** Not every deposit is income: IRS Publication 583 says your records identify the source of your receipts so you can separate business from nonbusiness receipts and taxable from nontaxable income. A reserve built on collections ignores costs, so it runs too high in a month heavy with collections and in a month heavy with costs alike.\n- **The bank balance.** It mixes this year's profit with earlier years' cash, loans, money the owner put in and bills not yet paid, and it drops each time you pay a cost, so a reserve built on it runs too low in a month heavy with costs.\n\nYour accounting basis decides what the profit figure measures. IRS Publication 538 says that under the cash method you generally report income in the year you receive it and deduct expenses in the year you pay them, and that under an accrual method you generally report income in the year it is earned and deduct or capitalize expenses in the year incurred. Know which basis your books use; if your return uses the other, that is one of the gaps described below.\n\n## Whose tax is the reserve funding?\n\nHow the business is set up decides whose tax its profit creates, as the IRS's page on each structure sets out.\n\n| If the business is | Whose federal income tax the profit creates |\n|---|---|\n| A sole proprietorship | The owner's. The IRS's Estimated taxes page lists sole proprietors among the individuals who generally have to make estimated tax payments. |\n| A partnership | The partners'. The IRS's Partnerships page says a partnership does not pay income tax and each partner reports their share on their personal return. |\n| An S corporation | Mostly the shareholders'. The IRS's S corporations page says shareholders report the flow-through of income and losses on their personal returns, and that the corporation is responsible for tax on certain built-in gains and passive income at the entity level. |\n| A C corporation | The corporation's. The IRS's Corporations page says it is a separate taxpaying entity whose profit is taxed to it when earned, then taxed to shareholders when distributed as dividends. |\n\nA limited liability company takes one of these rows. The IRS's LLC page says the IRS treats an LLC as a corporation, a partnership or part of its owner's return, depending on its elections and number of members. For federal income tax purposes, by default, the same page says, a single-member LLC is disregarded as separate from its owner (it is still a separate entity for employment tax and certain excise taxes), and a domestic LLC with at least two members is classified as a partnership.\n\nSelf-employed owners owe more than income tax: the IRS's Self-employment tax page describes self-employment tax as Social Security and Medicare taxes primarily for individuals who work for themselves.\n\nWhose tax it is decides what the reserve stands against.\n\n| If the tax is | What the reserve stands against |\n|---|---|\n| The owners' (sole proprietorships, partnerships, S corporations and LLCs taxed like them) | No liability of the business. IRS Publication 583 describes liabilities as the debts of a business, and the owners' tax is not the business's debt, so the books show no liability for it. The reserve is business cash kept back for what the owners will owe. |\n| The business's own (a C corporation, or an S corporation's entity-level tax) | A debt of the business itself. Recording that tax is a separate entry from the transfer. |\n| A mixture of the two | Both. A C corporation's owners also owe their own tax on salary and dividends, which its reserve does not cover, and a state can tax the business where federal law taxes the owners, as the multi-state section below shows. |\n\nWhere several owners share the profit, each owner's tax depends on their own circumstances, so each needs their own figure.\n\n## Why is book profit not the profit that gets taxed?\n\nBook profit is where the calculation starts, not the taxable figure. The gaps fall into three classes, and a fourth item changes what is left to fund; together they can push the reserve either way:\n\n- **Timing.** IRS Publication 538 defines an accounting method as the rules for when and how income and expenses are reported on your return, so if your books and your return use different methods, the same sale or cost lands in different periods.\n- **Items the return treats differently.** Form 1120-S, the IRS's S corporation return, carries a Schedule M-1 reconciling income per books with income per return, with lines for expenses recorded on the books that the return leaves out and for income on the books, such as tax-exempt interest, that the return leaves out.\n- **Items outside the business's books.** The IRS's Estimated taxes page says estimated tax is figured from the year's expected adjusted gross income, taxable income, taxes, deductions and credits, which bring in the owner's other income, deductions and credits.\n- **Tax already being paid.** It is not a gap in profit but in what is left to fund: the same Estimated taxes page says taxes must be paid as you earn or receive income during the year, either through withholding or estimated tax payments, so where the owner has wages, withholding already covers part of the bill.\n\nDo not try to compute these yourself. Take the adjustments for the first two classes from your preparer or last year's return; the proportion carries the third class and tax already being paid.\n\n## Which way of sizing the reserve fits you?\n\nWhich method fits depends on your filing history and how current your books are.\n\n| Method | What it needs | Where it breaks down |\n|---|---|---|\n| A proportion applied to profit as it is earned | Books closed every month, and a proportion from last year's return or your preparer | The proportion is guessed or stale, the books run behind, or large gaps go unadjusted |\n| A proportion from last year's filed outcome | A filed return for the business in its current form, the tax withholding did not cover, and the profit that produced it | A first year, a new structure or election, a sharp change in profit, other income or credits, a new state, or a change in the tax law |\n| A figure from your preparer | Books current enough to share mid-year, and word of each change | Books that are not current, or a change the preparer was not told about |\n\nThe IRS's Estimated taxes page supports starting from last year: it says your income, deductions and credits for the prior year may be a helpful starting point when figuring the current year's estimated tax. The same page says you must make adjustments both for changes in your own situation and for recent changes in the tax law.\n\n## Where does the proportion come from, and why not use a percentage you heard?\n\nThe IRS's Estimated taxes page says estimated tax is used to pay not only income tax but other taxes such as self-employment tax. Take the total tax that last year's filed returns showed, federal and state, including self-employment tax where the owner owes it and not income tax alone, less what withholding covered, and divide it by last year's business profit after the adjustments above. That works when the business is the owner's main income and nothing material has changed; otherwise ask your preparer for a proportion, or an amount per period, for this year.\n\nDo not adopt a percentage heard from a colleague, a forum or a rule of thumb. It was worked out, if at all, for someone else's structure and state, and the IRS's Estimated taxes page says estimated tax is figured from each person's own expected income, deductions and credits for the year.\n\n## Should the reserve sit in its own account or only in the books?\n\n| Trade-off | A separate business account | A book-only earmark |\n|---|---|---|\n| Protection | The money leaves the operating balance, so it is not spent by accident | None: the cash stays in the operating account |\n| Access | One transfer back when a payment is due | Immediate, which is how it gets spent |\n| Effort | One more account to reconcile each month, and one entry per transfer | A figure in your close notes, and no entries |\n\nHold the reserve in a separate account in the business's name, such as a savings account at the same bank, not in a personal account: IRS Publication 583 says to keep your business account separate from your personal checking account. An earmark left in the operating account looks like working capital and is spent in the ordinary course, leaving a reserve that exists only on paper. Rely on one only if you will never let the operating balance fall below it.\n\n## How do you record the transfer without changing profit?\n\nRecord it as a transfer between two of the business's own bank accounts. IRS Publication 583 says you close income and expense accounts at the end of each tax year and keep asset, liability and net worth accounts open permanently. Profit is income less expenses, so an entry between two asset accounts leaves it untouched.\n\n| Account | Debit | Credit |\n|---|---|---|\n| Tax reserve bank account (asset) | 1,750.00 | |\n| Operating bank account (asset) | | 1,750.00 |\n\nRecord the transfer once: if your bank feeds bring in both sides, match them to this single transfer rather than posting it again.\n\nTwo ways of recording it go wrong:\n\n- **Booking it as a tax expense.** Profit falls by the amount moved, next month's reserve is computed from the lower figure, and the error compounds until the method defeats itself.\n- **Booking the owners' tax as a liability of the business.** For a sole proprietorship, partnership or S corporation, that income tax is the owners' debt, not the business's.\n\nIf the reserve ends up above its target, move the excess back with the reverse entry. A book-only earmark takes no entry at all. Recording the tax itself, and each payment made from the reserve, belongs with recording estimated tax payments in the books.\n\n## What does one month's calculation look like?\n\nTake a June close for a single-member LLC operating in one state, with cash-basis books, a return filed on the cash method and an owner who is not on payroll. Step D is your input; suppose it brings E to 13,150.00.\n\n| Step | Figure |\n|---|---|\n| A. Net profit before income tax, January to June, from the books | 62,400.00 |\n| B. Adjustments for items the return treats differently, from your preparer | 1,600.00 |\n| C. Adjusted profit to date, A plus B | 64,000.00 |\n| D. Your proportion, from last year's return or your preparer | Your input |\n| E. Reserve target to date, C times D | 13,150.00 |\n| F. Set aside so far this year: reserve balance of 7,900.00 plus an estimated payment of 3,500.00 already made from it | 11,400.00 |\n| G. Transfer at this close, E minus F | 1,750.00 |\n\nThe transfer is the journal entry above. Counting the payment in F keeps each dollar counted once, because money already paid still covers part of the year's tax. If E comes out below F because profit fell, move the difference back. On accrual books, A would include income invoiced but not yet collected; with a return on the cash method, that timing gap is one of the adjustments your preparer gives you for B.\n\n## How often should you recompute and move it?\n\nEvery month, as part of the close, once the bank accounts are reconciled; IRS Publication 583 says you should reconcile your checking account each month. Recompute from year-to-date figures each time rather than adding up monthly amounts, so a wrong month corrects itself at the next close. The IRS's Estimated taxes page says the year is divided into four payment periods, each with a specific payment due date, so keep the reserve current through every period rather than catching up at year end.\n\n## What should make you revise it during the year?\n\nRevise the proportion, not just the transfer, when any of these happens:\n\n- **Profit moves away from last year's pattern.** The IRS's Estimated taxes page says that if you estimated your earnings too high, you complete another Form 1040-ES worksheet to refigure your estimated tax for the next quarter, and that you do the same to recalculate it if you estimated too low.\n- **The structure or a tax election changes.** The IRS's LLC page ties how an LLC is taxed to its elections and number of members, so a change can move the tax between the owners and the business.\n- **Owner pay starts, stops or changes.** Withholding then covers more or less of the owner's tax.\n- **The business begins operating in another state.** That state may add a tax of its own.\n- **A large one-off item arrives.** Buying or selling major equipment, for example, can open a wide gap between book and taxable profit.\n- **The tax law changes.** Last year's proportion reflects last year's rules; ask your preparer whether the change moves it.\n\n## What does the reserve not do?\n\nA funded reserve neither settles nor pays the tax:\n\n- **It does not decide what is owed.** IRS Publication 538 says every taxpayer must figure taxable income for an annual accounting period called a tax year; the tax follows from that computation, whatever the reserve holds.\n- **It does not meet any payment obligation.** The IRS's Estimated taxes page says that if you don't pay enough tax by the due date of each payment period, you may be charged a penalty even if you are due a refund when you file. IRS Publication 542 says a corporation that does not pay a required installment of estimated tax by its due date may be subject to a penalty.\n\nMake each payment the way the IRS or the state's revenue agency instructs.\n\n## What changes with payroll, several states or seasonal profit?\n\n### What if the owner is on payroll?\n\nFind out what is already being withheld before sizing anything. The IRS's Estimated taxes page says someone who receives salaries and wages can avoid having to pay estimated tax by asking the employer to withhold more, so withholding counts toward the owner's tax. Total the federal and state income tax withheld from the owner's pay so far this year, from this business's payroll records and from any job elsewhere. The owner's salary is already an expense in book profit. Count the withholding once: either your proportion already leaves it out, as the last-year method above does, or you subtract year-to-date withholding from the target, never both.\n\n### What if the business operates in more than one state?\n\nState tax is set state by state and need not follow the federal treatment. The Texas Comptroller's Franchise Tax Overview, for example, says each taxable entity formed in Texas or doing business in Texas must file and pay franchise tax, and its list of taxable entities includes single-member LLCs, which the IRS's LLC page says are by default disregarded as separate from their owners for income tax purposes. For each state where the business operates, or has just begun to, establish from that state's revenue agency or your preparer what the business and each owner owe there and when, and size the reserve for all of it. Wherever a state taxes the business or its owners, a reserve sized for federal tax alone falls short.\n\n### What if profit is seasonal?\n\nRecompute from actual year-to-date profit at every close, never from an early month or quarter scaled up to a year: a strong spring multiplied out overstates a year that tails off, and a slow start understates a year that peaks late. Payment timing is a separate matter. The IRS's Estimated taxes page says that if your income is received unevenly during the year, you may be able to avoid or lower the penalty by annualizing your income and making unequal payments; whether that applies is for your preparer to judge.\n\n## When does the figure have to come from your preparer?\n\nA self-run method works only while last year still describes this year. Get the figure, or at least the proportion, from your preparer when any of these applies:\n\n- There is no filed return for the business in its current form, as in its first year or after a change of structure or election.\n- The business is a C corporation, or an S corporation that may owe tax itself.\n- Several owners share the profit, or an owner has significant income, deductions or credits outside the business.\n- The business has started operating in another state.\n- Profit is far from last year's, or a large one-off item has hit the books.\n- The tax law has changed since last year's return.\n- You cannot tell how large the gaps between your book profit and taxable profit are.",
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    {
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      "url": "https://www.irs.gov/publications/p334",
      "title": "Publication 334 (2025), Tax Guide for Small Business",
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      "title": "S corporations",
      "publisher": "Internal Revenue Service",
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      "slug": "what-your-cpa-or-tax-preparer-needs-from-your-books-at-year-end",
      "display_title": "What does my CPA or tax preparer need from my books at year end, and how do I hand the books over cleanly?"
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  "question_text": "How do I use my books to work out how much I should be setting aside for taxes?",
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