How to set up an escrow account for paying business taxes.

Setting up an escrow account can be necessary when one party is holding funds for another party. Usually the actual account is held by a neutral third party. An example is an employer who is withholding taxes for an employee and depositing them into an escrow account at the bank until the taxes are paid to the IRS. Following are considerations for setting up your account and examples of scenarios that may involve your escrow account.

Who do you set your escrow account up with? Generally business owners set up an escrow account with the bank that they have their business checking account with for convenience. However, your accountant or payroll company may manage an account. There are also numerous online companies that manage escrow accounts in addition to many local financial institutions that may offer the service. Who you work with may depend on the services that you're looking for.

What services do you want as part of your escrow account and how is your account managed? That depends on who you set up your account with and what your agreement for service is. Before setting up your account, call around. Do you want the account totally managed by a third party that will record all incoming deposits by employee, cut checks to the IRS quarterly, and send you an itemized monthly, quarterly, or annual statement? Do you want an account to deposit the funds in and then you manage all the numbers yourself? How much money will be held in the account? If a lot of money is going to be in the account on a regular basis, you may want an account that pays interest. You may also want to find out what charges are for online transfers, especially if you're going to be moving a lot of money around.

When you've determined the level of service you want, you can then contact different banks and financial institutions, including accountants and payroll companies, and shop for what you need. The cost will be dependant on the services you require. Typically, the escrow account is nothing more than a basic checking account at a bank which has been designated as an escrow account and you or your accountant will manage the deposits, payments, and itemization. However, if you're collecting taxes for a lot of employees or depositing large sums based on your business income, your account may require a few more of the perks designed for working with larger numbers. You will also want to know if the bank's online software is compatible with the program that you are using for your accounting.

When you set up an escrow account you will need the same forms of documentation required to set up a business checking account. The documentation that is required may vary from state to state, but in general you will need proof of your business, i.e. business license and photo id for anyone who may sign on the account. It's as simple as that.

Example #1 - Lets say that you're a small business owner. For the first year or two you've been working night and day trying to get things going. Withholding tax? For who? You've been working round the clock and haven't been able to afford employees. But now things are going well. The business is rolling in and you need to hire some employees. Employees mean withholding taxes. If you're great with QuickBooks and really tax savvy you may decide to do it all on your own. You may just need to walk into a bank with your documentation and set up a basic checking account titled "withholdings" or "escrow" to mark it as separate from your regular accounts. Now you take the withholdings from each employee's check, be sure to note how much and for whom in your accounting software, and deposit it into your account. Quarterly you'll total up the numbers, fill out the forms, and write a check to the IRS from your escrow account. If you're using an accountant or payroll service, you may set up one escrow account that covers all monthly expenses. They calculate the numbers and write out the checks, you deposit one lump sum. Then quarterly they send off a payment to the IRS at the required time.

Example #2 - You're that same small business owner. Now that the business is booming you're actually making some money. That, of course, means that the IRS wants their cut. Maybe before you didn't pay anything until the accountant totaled up at the end of the year because there was so little income that the penalties were not much. Now it matters and you want to start paying quarterly to avoid those penalties and back interest. You set up the same type account and as you balance the books monthly, you put your business taxes into the account to be paid out as required by the IRS. And as before, if you're working with an accountant, they will keep track of the numbers and send off your regular payment.

Example #3 - You were a small business owner, but now you've really done well, your business has expanded, and you're depositing a lot of money into that employee withholding account or business tax escrow account. Now you make the calls to the financial institutions and you start checking on fees and interest. This is where it becomes important how they pay interest and who pays the most. This account is going to be growing monthly or bi-weekly, but then it's going to be emptied on a regular basis. You want a financial institution that will pay a good interest on all that money, but not charge penalties for going below a certain balance. Additionally, you don't want penalties or charges for the deposits or withdrawals. You may want to do more of your banking for this account electronically and you don't want extra charges for that option.

Remember, before setting up your escrow account determine the services that you need with it. Determine when your tax payments are due and how payments will be handled before setting up the account. Also, talk to an accountant or someone at the bank and find out if your state has any regulations that you need to know about. Setting up an escrow account isn't hard, just be sure to do your homework first.