Can I Put Myself on Payroll as a Sole Proprietor?
Understand the unique financial relationship between a sole proprietor and their business. Learn how owners compensate themselves and navigate tax obligations without traditional payroll.
As a sole proprietor, your business and you are legally considered one entity. This inherent legal unity means you generally cannot place yourself on traditional payroll as an employee of your own business. The absence of a legal distinction between you and your business for tax and employment purposes prevents a typical employer-employee relationship. This article explains how sole proprietors compensate themselves and outlines the important financial and tax considerations involved.
Owner’s Draw Explained
An owner’s draw, also known as an owner’s distribution, represents the primary method by which a sole proprietor extracts funds from their business for personal use. This action involves transferring money directly from the business’s bank account to a personal account or simply taking cash from business earnings. Unlike employee salaries, an owner’s draw is not considered a business expense and therefore cannot be deducted from business income for tax purposes.
These draws are distinct from business operating costs because they represent a distribution of accumulated profits, not an expense incurred to generate revenue. Maintaining clear and accurate records of all owner’s draws is important for internal accounting purposes. Separating business and personal bank accounts is highly recommended to simplify financial tracking and avoid commingling funds.
Tax Implications for Sole Proprietors
Sole proprietorships operate under “pass-through taxation,” meaning the business itself does not pay income tax. All business profits and losses are reported directly on the owner’s personal income tax return, specifically on Schedule C. This net profit is then subject to both income tax and self-employment tax.
Self-employment tax covers Social Security and Medicare taxes for self-employed individuals, serving as the sole proprietor’s equivalent to the FICA taxes withheld from an employee’s paycheck. For 2024, the self-employment tax rate is 15.3% on net earnings from self-employment, consisting of 12.4% for Social Security up to an annual earnings limit ($168,600 for 2024) and 2.9% for Medicare with no earnings limit. After accounting for the deductible portion of self-employment taxes, this calculation determines the total self-employment tax liability.
Owner’s draws are not taxed again when taken from the business. The net profit of the business has already been subjected to income tax and self-employment tax on your personal return. To manage these tax obligations, sole proprietors are generally required to pay estimated taxes quarterly using Form 1040-ES. These quarterly payments cover both income tax and self-employment tax, and failing to pay enough tax through these installments can result in underpayment penalties. Business expenses directly reduce the net profit, decreasing the amount subject to both income and self-employment taxes.
Differences from Employee Payroll
The financial and tax treatment of an owner’s draw differs from employee payroll. As a sole proprietor, you do not receive a W-2 form from your business, unlike an employee who receives this statement detailing their wages and tax withholdings. This distinction highlights the lack of an employer-employee relationship within a sole proprietorship.
Employees have income tax, Social Security, and Medicare taxes (FICA) automatically withheld from each paycheck by their employer. In contrast, sole proprietors are personally responsible for calculating and remitting these taxes themselves through quarterly estimated payments. An employee’s salary is a deductible business expense for the employer, reducing the business’s taxable income. An owner’s draw, however, is merely a transfer of funds and is not a deductible expense for the sole proprietorship. Employees may also receive benefits such as health insurance or retirement contributions, whereas sole proprietors cover these costs personally or through specific self-employed deductions.
Business Structure Alternatives for Owner Compensation
For a business owner to receive a W-2 and be on traditional payroll, the business needs to be structured as a distinct legal entity, most commonly an S corporation. By electing S corporation status with the Internal Revenue Service, the owner can become an employee of the corporation. This arrangement allows the owner to receive a “reasonable salary” reported on a W-2 form, which is treated as a deductible business expense for the S corporation.
After receiving a reasonable salary, any remaining profits can be distributed to the owner as distributions, which are not subject to self-employment tax. Operating as an S corporation introduces additional complexities and compliance requirements, such as maintaining a separate legal entity, annual corporate filings, and managing payroll processing. While C corporations also allow owners to be employees, their structure involves double taxation, making them less common for small businesses. Changing a business structure involves significant tax and legal considerations, warranting professional advice.