How to Pay Yourself as a Sole Proprietor

A sole proprietorship is a business structure owned and run by one individual, making it the simplest form of business to establish. The owner and the business are considered a single legal entity for tax purposes. This means the business itself does not pay income tax; instead, profits and losses are reported on the owner’s personal tax return.

Unlike employees who receive a fixed salary and a W-2 form, a sole proprietor does not receive a salary from their business. The owner’s compensation is directly tied to the business’s profitability. This intertwined nature of personal and business finances requires a distinct approach to managing and taking money from the business.

Understanding Sole Proprietor Income

Sole proprietor income is viewed by the Internal Revenue Service (IRS) as personal income of the owner, not separate business income. This classification means that the business’s profits are directly attributed to the individual for tax purposes. This differs significantly from employee wages, where an employer withholds taxes from each paycheck.

The primary method for a sole proprietor to take money out of their business for personal use is through an “owner’s draw.” An owner’s draw is a withdrawal of funds from the business for the owner’s personal expenses or investments. It is important to note that an owner’s draw is not considered a business expense and therefore does not reduce the business’s taxable income.

For tax purposes, the entire profit of the sole proprietorship is considered the owner’s personal income, regardless of whether that money is physically transferred out of the business bank account through an owner’s draw. This “pass-through” taxation means that even if profits remain in the business, they are still subject to personal income tax.

Taking Owner’s Draws

Taking an owner’s draw involves moving funds from your business account to your personal account. Common methods for this transfer include electronic bank transfers, which are typically quick and can be set up as recurring transactions. Another straightforward method is writing a check from the business account directly to your personal account.

The flexibility in the frequency and amount of owner’s draws is a notable feature of sole proprietorships. You can take draws weekly, bi-weekly, monthly, or as needed, depending on your personal financial requirements and the business’s cash flow. It is important to ensure the business retains enough funds to cover its operating expenses, upcoming tax obligations, and any emergency reserves.

Maintaining precise records of all owner’s draws is important for personal financial tracking. While these draws are not business expenses for tax purposes, clear documentation helps you understand how much personal income you are deriving from the business.

Sole Proprietor Tax Obligations

Sole proprietors face specific tax obligations, encompassing both income tax and self-employment tax. Unlike employees whose taxes are withheld by an employer, sole proprietors are responsible for directly paying these taxes to the IRS. This requires careful planning and regular payments throughout the year.

Self-employment tax covers Social Security and Medicare taxes, which are typically split between an employer and an employee in traditional employment. For self-employed individuals, the combined rate is 15.3% on net earnings, consisting of 12.4% for Social Security and 2.9% for Medicare. For 2024, the 12.4% Social Security portion applies to net earnings up to $168,600, while for 2025, this threshold increases to $176,100; the 2.9% Medicare portion applies to all net earnings without a cap. An additional 0.9% Medicare tax may apply if net earnings exceed $200,000 for single filers or $250,000 for joint filers. You can also deduct one-half of your self-employment tax when calculating your adjusted gross income.

Due to the absence of employer withholding, sole proprietors generally need to pay estimated taxes quarterly using Form 1040-ES. These payments cover both income tax and self-employment tax based on your projected annual income. For calendar year taxpayers, estimated tax payments for 2025 are typically due on April 15, June 16, September 15, and January 15, 2026. If a due date falls on a weekend or holiday, the deadline shifts to the next business day. Generally, estimated taxes are required if you expect to owe at least $1,000 in tax for the current year, or if your withholding and credits are less than 90% of the current year’s tax or 100% of the prior year’s tax.

Business income and expenses for a sole proprietorship are reported on Schedule C (Form 1040), Profit or Loss From Business. This form is used to calculate the net profit or loss from your business activity, which then flows to your individual income tax return, Form 1040. The self-employment tax is then calculated on Schedule SE (Form 1040) based on the net earnings from Schedule C. This calculated self-employment tax amount is then reported on Schedule 2 (Form 1040).

Essential Financial Management

Meticulous record-keeping for all business income and expenses is fundamental for a sole proprietor. This practice is not just about compliance; it offers a clear picture of your business’s financial health and profitability. Accurate records simplify tax preparation, ensuring you can properly report all revenue and claim eligible deductions on Schedule C.

Various methods can be employed for effective record-keeping, ranging from simple spreadsheets to dedicated accounting software. Programs like QuickBooks Self-Employed or FreshBooks are designed to help sole proprietors track income, categorize expenses, and even estimate quarterly taxes. For those who prefer a more traditional approach, maintaining a manual ledger can also be effective, provided it is consistently updated and organized.

Maintaining distinct business and personal bank accounts and credit cards remains a cornerstone of sound financial management for sole proprietors. This separation prevents the commingling of funds, which can lead to confusion and complications during tax season or financial review.

It also helps immensely with tracking income and expenses for clarity and accurate financial reporting. This simplifies the process of identifying business transactions versus personal withdrawals, making owner’s draws clear and traceable.

Creating a budget for both business and personal expenses is another important practice. A business budget helps ensure there are sufficient funds for operations and growth, while a personal budget guides how much you can reasonably take as an owner’s draw. This dual budgeting approach promotes financial sustainability for both your business and personal life. Setting aside funds for estimated taxes in a separate savings account ensures that money is available when quarterly payments are due, preventing potential penalties and financial strain.