How to Pay Yourself as a Sole Proprietor
Empower yourself as a sole proprietor to confidently manage personal earnings and tax obligations from your business.
A sole proprietorship is a business structure where an individual owns and operates an unincorporated business. The owner and the business are considered one and the same for legal and tax purposes, as the entity is not legally separate from its owner. A sole proprietor does not receive a salary or wages as an employee would. Instead, the owner takes money out of the business for personal use through an owner’s draw.
Understanding Owner’s Draws
An owner’s draw is how sole proprietors compensate themselves. This involves withdrawing funds from the business for personal expenses, such as living costs or investments. Unlike employee salaries, owner’s draws are not considered a business expense. They do not appear on the business’s income statement or reduce its taxable income.
An owner’s draw reduces the owner’s equity in the business. From an accounting perspective, it is recorded as a debit to the owner’s equity account and a credit to the cash account. This direct reduction of equity contrasts sharply with how a business would account for employee wages, which are recorded as an operating expense. Businesses do not withhold payroll taxes, such as federal income tax or Social Security and Medicare taxes, from an owner’s draw, nor do they issue a W-2 form to the owner.
The distinction between an owner’s draw and a salary is important for financial reporting and tax obligations. For instance, if a sole proprietor needs money for a down payment on a home, they would take an owner’s draw. This reflects the owner’s access to business cash flow for personal needs, rather than fixed compensation. Owner’s draws allow sole proprietors to manage personal finances directly from business profits, subject to cash availability.
Tax Responsibilities for Sole Proprietors
Sole proprietors have tax responsibilities that differ from employees. They pay self-employment tax, which funds Social Security and Medicare. This tax applies to a sole proprietor’s net business income. The self-employment tax rate is 15.3%.
Sole proprietors must pay self-employment tax if their net earnings from self-employment are $400 or more. This tax is calculated on 92.35% of the net earnings from self-employment. One half of the self-employment tax paid is deductible as an adjustment to income, which can help reduce the overall income tax liability.
Since no employer withholds taxes, sole proprietors must make estimated tax payments quarterly. These payments cover both income tax and self-employment tax. Typical due dates for these quarterly payments are April 15, June 15, September 15, and January 15 of the following year.
Sole proprietors use Form 1040-ES to calculate and pay estimated taxes. Failure to pay sufficient estimated taxes on time can result in penalties. Accurately projecting business income and deductions is important to calculate appropriate quarterly payments.
Practical Financial Management
Financial management is important for sole proprietors to sustain their business and personal finances. Maintaining separate bank accounts for business and personal transactions is a foundational practice. This separation helps track business income and expenses, simplifies record-keeping, and provides a clear distinction for tax purposes. Using a dedicated business credit card also helps.
Diligent record-keeping of all business income and expenses is necessary. Accurate records are fundamental for determining the business’s net income, impacting self-employment and income tax calculations. This practice also provides a clear picture of funds available for owner’s draws, enabling informed personal withdrawal decisions. Detailed records are crucial for preparing Schedule C (Form 1040) to report business profit or loss and Schedule SE (Form 1040) to calculate self-employment tax.
Establishing a consistent schedule for owner’s draws brings stability to a sole proprietor’s personal finances. While not a formal salary, treating draws as a regular personal budget item allows for better financial planning and spending control. This approach helps prevent erratic withdrawals that could strain the business’s cash flow or jeopardize its operational stability.
Setting aside funds for estimated tax payments is a prudent financial strategy. Since sole proprietors pay their own self-employment and income taxes quarterly, allocating a portion of business income to a separate savings account helps ensure tax obligations are met without financial stress. This proactive approach supports tax compliance and avoids penalties for underpayment.