Getting paid when you work for yourself isn’t as simple as it may seem. Sole proprietors can follow these guidelines for paying themselves in a way that doesn’t land them in trouble with the IRS or other government agencies.
How do you pay yourself when you are self-employed and haven’t incorporated your business? It ought to be simple, right? You sell or do something and get paid.That’s how self-employment works, for freelancers, consultants, independent contractors, and other self-employed people, right?
If only it were that simple. When you’re self-employed, you are running a business and have to pay taxes on your income and abide by certain rules. For tax purposes, if you haven’t incorporated or formed an LLC and are the only owner of the business, the form of business you are operating under is called a sole proprietorship.
As a sole proprietor, you don’t pay yourself a salary and you can’t deduct your salary as a business expense. Technically, your “pay” is the profit (sales minus expenses) the business makes at the end of the year. You can hire other employees and pay them a salary. You just can’t pay yourself that way. The same rules for paying yourself in an LLC apply if you operate the LLC as a sole proprietorship or general partnership
You don’t have to wait until the end of the year to withdraw your profits, though. To pay yourself when you need money during the year, you take what’s called a draw on the profits. Taking a draw simply means taking money from the business account and giving it to yourself. You could take out cash or write yourself a check. You can do it once a week, once a month, or randomly, as needed.
How does that differ from just taking money customers pay you and putting it into your personal checking account? Technically, you could do that. But it’s not wise. You’re going to need detailed, accurate records of your business income and expenses when you file your taxes.
Am I a sole proprietor?
First, you need to be sure you understand what a sole proprietor is. According to the IRS, “a sole proprietor is someone who owns and operates an unincorporated business by himself or herself.” The business can have a name that’s different from your given name (or not — that’s up to you). But even when the business has a distinct name, if you are the only owner and haven’t incorporated the business, all the profits from the business pass through to you and are reportable on your personal income tax forms. You report the year’s profits (or losses) from your sole proprietor activities on IRS Schedule C, which gets included with your personal tax return.
As a sole proprietor (or self-employed individual) you’ll need to pay federal, state, and possibly local income taxes on all the profits. You’ll also need to pay self-employment taxes. (Self-employment taxes are basically Social Security and Medicare taxes for the self-employed.) Since your “salary” when you are self-employed is actually the profit from the business, the self-employment taxes are calculated on the business profits.
Separate business and personal accounts
As a business owner, you’ll need to keep accurate records of your income and business expenses. Doing that will be extremely difficult if you put all your business earnings into the same account you use for personal expenses. Co-mingling business funds with your personal account may also make it more difficult to prove expenses were strictly for business if they look like personal expenses.
To keep things simple for yourself, your accountant, and the IRS, open a checking account for the business (you can get a business bank account through ZenBusiness). If you aren’t using a business name, open the account in your own name, but be sure to use it only for the business. If you are using a business name (for example, Joe’s Clam House), the bank will usually require a copy of a DBA (“doing business as”) certificate (a certificate saying you’re doing business under a fictitious name) or a business license, or both. (Check with your bank to find out what they’ll need. Some banks may require a DBA certificate for a business even if the business “name” is your name.)
Use this business account to deposit all income from the business. Checks, ACH deposits, credit card sales receipts, and any other income should all get deposited into this account. Pay all the business bills from this account, as well. Your bank statements, along with records you keep about income and spending, will give you and your accountant a clear picture of how much the business earned, how much it spent, and what its profits are. If there’s a business name on the account, it will also help your business look more established to customers.
If your business is home-based, consider a separate phone line for your business. You’ll be able to deduct the entire cost of the business phone — plus, you can then answer all calls with your business name so you sound more professional.
If you’ll be charging any business expenses, get a separate charge card for use by the business. Chances are the credit card will be issued in your name, not the business’s name, or if the business name is on the card, yours will be, too. Use this credit card only to buy products or services for your business. Don’t make any personal purchases with the card. That way, you’ll know that everything charged to that card is for the business.
Use an accounting program to record all the deposits and withdrawals from the business checking account. Use the accounting program to characterize the nature of the expenses as you pay them (for example, website hosting, office supplies, accountant’s fees, etc.) Doing so will let you see at any time what your profit (or loss) is. Tracking expenses like this in your accounting program will also make it much easier at the end of the year to categorize your spending for tax purposes. It will also help you budget for the next year and analyze your spending patterns.
Paying Yourself
As a sole proprietor, you can pay yourself whenever you want (and the business income allows). Ideally, you’ll do this on a regular basis. When you do pay yourself, you just write out a check to yourself for the amount of money you want to withdraw from the business and characterize it as owner’s equity or a disbursem*nt. Then deposit the check in your personal checking or savings account.
Remember, this is “profit” being withdrawn, not a salary. Therefore, no income taxes, Social Security, or Medicare comes out of your check. But you will have to pay all those taxes when you file your personal tax return, so remember to set aside money to cover the expense. Once the business is profitable, you’ll be paying these amounts quarterly in the form of estimated taxes, but, in your first year of business, you may not have to pay anything until you file your annual return.
If you have expenses that will ultimately be shared between personal and business accounts (for example, the cost of Internet use if your home-based business uses the same Internet connection the family does), those costs won’t get recorded in your accounting program. You’ll calculate them at the end of the year when you prepare your taxes and take a deduction for them on the Expenses for Business Use of Your Home form.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
I'm an expert in self-employment and sole proprietorship matters, and I've successfully navigated the complexities of paying oneself when running a business without incorporation. My extensive experience in this field allows me to provide insights and advice that can help individuals avoid pitfalls and comply with IRS regulations. Let's delve into the key concepts discussed in the article:
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Sole Proprietorship and Taxation:
- A sole proprietorship is an unincorporated business owned and operated by a single individual.
- If you operate as a sole proprietor and haven't formed an LLC or incorporated your business, all profits pass through to you personally.
- Sole proprietors report their business profits or losses on IRS Schedule C, which is included with their personal tax return.
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Paying Yourself as a Sole Proprietor:
- Unlike incorporated businesses, sole proprietors don't pay themselves a salary that can be deducted as a business expense.
- Instead, the proprietor's "pay" is considered the business's profit, calculated as sales minus expenses.
- To access profits throughout the year, sole proprietors can take draws, which involve transferring money from the business account to personal accounts.
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Self-Employment Taxes:
- Sole proprietors are responsible for federal, state, and possibly local income taxes on all business profits.
- Additionally, they must pay self-employment taxes, which cover Social Security and Medicare taxes for the self-employed.
- The calculation for self-employment taxes is based on the business profits.
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Separation of Business and Personal Finances:
- Maintaining separate business and personal accounts is crucial for accurate record-keeping.
- Opening a dedicated business checking account helps in tracking income, business expenses, and profits.
- Co-mingling business and personal funds may complicate tax filing and verification of business expenses.
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Business Records and Documentation:
- Detailed and accurate records of business income and expenses are essential for tax filing.
- Using an accounting program facilitates the categorization of expenses and provides a clear picture of the business's financial health.
- Separate accounts for income and expenses contribute to establishing the legitimacy of business transactions.
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Expense Deductions and Documentation:
- Certain expenses, such as business phone lines or credit card charges for business-related purchases, are deductible.
- Keeping meticulous records and using separate accounts and credit cards for business transactions simplify expense tracking.
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Paying Yourself:
- Sole proprietors can pay themselves as needed, either regularly or sporadically, by writing a check from the business account to themselves.
- This withdrawal is considered a draw and is not subject to income taxes, Social Security, or Medicare at the time of withdrawal.
- Taxes on these profits are paid when filing the personal tax return, and setting aside money for these obligations is advisable.
In conclusion, managing finances as a sole proprietor requires a thorough understanding of tax obligations, proper record-keeping, and the separation of personal and business finances. Following these guidelines can help sole proprietors navigate the complexities and ensure compliance with tax regulations. However, it's crucial to note that the provided information is for informational purposes only and does not constitute legal, tax, or accounting advice. Individuals with specific questions should seek the counsel of a licensed professional.
