How to Pay Myself as a Sole Proprietor
Sole proprietors pay themselves by withdrawing cash from the business. The cash withdrawals are counted as income and are taxed at the end of the year.
By Brad Nakase, Attorney
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How Do Sole Proprietors Pay Themselves?
In theory, a sole proprietor is able to take money out of their business bank account and use it to pay themselves at any time they please. If the business is making a profit, then the money in the bank account is considered the entrepreneur’s ownership equity. This is the difference between one’s business assets and liabilities. To take money out of the account in this wat is not considered taking a salary. Instead, this is called a “draw.” To conduct a draw, a business owner should write a business check to him or herself. This check is not eligible for federal income tax, state income tax, or FICA taxes.
Why is this? The IRS treats the business’ profits and the owner’s personal income as the same thing. Basically, after business expenses have been deducted via a Form 1040 Schedule C or Form 1065 (for partners), the leftover profit is considered personal income.
That said, a business owner only files his or her personal income tax return once every year. Therefore, he or she may wish to pay themselves more regularly. To do this, he or she will need to examine financial projections (if the business is new) or past financial performance (if the business has been running for a while) and estimate the business’ profits. Based on that estimated number, an owner can decide on a regular, consistent salary for him or herself. If the business performs better than expected, then the owner can grant him or herself a quarterly or annual bonus.
When starting a business, entrepreneurs have plenty of important things to think about. Above all, they are focused on the idea and how to get it off the ground. At this early stage, they do not usually think about the subject of payroll. After all, when the business is just an idea, who is there to pay, and what is there to pay? However, once the business gets off the ground and starts bringing in revenue, a business owners must decide what he or she will pay employees. Also, he or she must decide what to pay themselves. In ways, opening a sole proprietorship is a relatively simple endeavor: get the permits you need, open a bank account, and you’re in business. However, it is not so easy for a sole proprietor to decide how to pay him or herself. Please contact our small business attorney in Los Angeles for your new business.
The answer to this question is not as simple as “pay yourself what you want.” When a business sells a product and makes a profit, the Internal Revenue Service (IRS) will want a cut, as will federal, state, and local agencies. A sole proprietor’s income is determined by the amount of equity he or she has in the business, as well as what is required for living expenses.
Sometimes, sole proprietors that are just starting out think that they can pay themselves nothing and simply live on savings until the business is successful. However, it is good practice to pay oneself some amount. This helps prove to the IRS that the business is legitimate and real, not just a hobby. When it comes to finances, giving oneself a salary also helps create accurate financial projections.
In fact, if an owner’s business achieves break-even or profitability based on the owner bot taking a salary, then the owner does not have an accurate measure of his or her success. If a business owner is looking to get any kind of financing, such as a business loan or private investment capital, this could present a problem. Investors want to see that a business can pay all its overhead costs, including the owner’s salary, and still earn a profit.
What Is a Sole Proprietorship?
As defined by the Internal Revenue Service (IRS), a sole proprietorship is an unincorporated business entity that has one owner. It is also possible for spouses to own and operate a sole proprietorship together.
With a sole proprietorship, it is not necessary to file business formation paperwork with the state. This means that if an entrepreneur is already running a business on his or her own but hasn’t registered the business, it already qualifies as a sole proprietorship. Indeed, at the very moment a businessperson offers goods or services for sale, he or she is running a sole proprietorship.
With sole proprietorships, all the business’ profits pass through to the owner and are reportable on their personal income tax forms. The owner will need to pay state and federal income taxes on the profits as well as pay a self-employment tax. Examples of sole proprietors include freelance writers, consultants, and bookkeepers.
There are benefits and disadvantages to running a sole proprietorship.
What Are the Benefits of Having a Sole Proprietorship?
A Sole Proprietorship Is Easy to Start
When beginning a sole proprietorship, it is not necessary to register the business with the state, nor incorporate it. All that is required is to get any business licenses or permits that the state or local government mandates for the type of business.
There Are Few Legal Requirements
Maintaining the business’ legal status does not require keeping a lot of documentation. Legal paperwork is therefore kept to a minimum.
It Is Easy to Manage a Sole Proprietorship
A sole proprietor has no partners to worry about, other than potentially his or her spouse. This means that he or she has complete control over all business decisions and the direction the business will take. Also, because the profits pass through the owner, the owner’s financial and legal situation, both personal and business, is the same.
Sole Proprietorship Taxes Are Simple
With a sole proprietorship, the owner reports the business’ profit and losses on his or her personal tax return. All that is required is to attach a Schedule C to the 1040 tax return.
What Are the Disadvantages of Having a Sole Proprietorship?
Sole Proprietors Have Unlimited Personal Liability
A sole proprietor is responsible, or personally liable, for all the business’ debts and obligations. This means that if the business owes money, creditors can confiscate the owner’s personal assets. This might include his or her home, car, or personal savings. Also, if the business faces a lawsuit, the owner is liable to pay any judgment made, again putting personal assets at risk.
Taxes Are Higher for Sole Proprietorships
A sole proprietorship must pay income taxes and self-employment taxes on the business’ total income. This means that if a business is making a large profit, the taxes can add up to a significant amount.
Sole Proprietorships Take More Work
A sole proprietor is in charge of marketing, finances, leadership, strategy, and many other responsibilities that come with running a business. It is therefore likely that a sole proprietor will deal with burnout or exhaustion at some point.
How Much Should a Sole Proprietor Pay Themselves?
To figure out how much to pay him or herself as a sole proprietor, a business owner needs to look at projected business profits and how often they would draw from them. To calculate projected business profits, it is important for a sole proprietor to keep records of business assets and liabilities. Essentially, one should not mix personal finances with business finances. Mixing these could make it harder to prove which expenses were for personal reasons and which were for the business.
Because a sole proprietor does not need to register or incorporate the business to get it started, the business name is by default the owner’s full legal name. From the IRS’ point of view, the owner and the business are the same entity. To separate the two, an owner can file a DBA, or “doing business as,” which will allow him or her to do business under a different name than their own. After a DBA has been created and registered, a business owner can open a business bank account under that new name. This account will be used for all business income and expenses, keeping personal expenditures separate. The business’ bank statements will then provide a clearer view of how much the business is earning and spending.
If a sole proprietor wants to charge any business expenses, then it may also be wise to get a separate business credit card. It is also advisable to use a business accounting software such as QuickBooks to keep track of business deposits and withdrawals, as well as the type of transaction performed.
These practices will make it easier to predict future profits. In addition to this, a business owner will need to know how often they wish to draw from the sol proprietorship’s profits for their income. This is a matter of personal preference. Some owners draw money biweekly or once-a-month. Others draw money more or less frequently. In the end, it depends on the owner’s living expenses and what makes them comfortable.
When a business is just getting started, there are two methods used to calculate the owner’s sole proprietorship salary. The owner can choose to pay him or herself the bare minimum needed to pay basic living expenses for the first months. Alternatively, the owner can start out by paying him or herself a fair salary based on market worth.
In the long run, the second method is preferable. This is because by starting out at a fair salary, an owner can keep paying him or herself the same amount when the business becomes profitable. That said, if the sole proprietorship simply cannot afford to pay the owner market worth, then it is a better idea to survive on the bare minimum until the business breaks even or makes a profit.
Once the business is profitable, the owner can give him or herself quarterly bonuses based on the company’s profit. When the business has showed steady profits, then the owner may increase their salary.
How Are Corporations Different from Sole Proprietors in Terms of Salary?
If a business has been incorporated, then the issue of paying oneself is a little different. The owner of a corporation is an officer of the company as well as an employee on the payroll. This means the owner has to pay him or herself a salary or wages which, according to the IRS, must be “reasonable compensation.” This means the pay cannot be too much or too little.
Sometimes, business owners use the business’ money to pay for personal expenses and do not take a salary. They believe that this tactic will save them money on taxes. However, this method can lead to major penalties if the IRS thinks the money should have been used as a salary.
If a business owner owns a corporation, then he or she should figure out the average rate for CEOs in that industry, region, or for companies of a similar size. This information may be received from the industry trade association or from sites like Glassdoor.com and Salary.com.
Determining salary and compensation can be further complicated if the business has investors, as well as how many shares of stock the owner possesses. It is advisable to check the IRS’ guidelines about small business owners’ salaries. It would also be a good idea to talk with a business accountant before deciding on one’s salary.
Summary
Before paying themselves, a sole proprietor needs to have a clear view of the business’ estimated profits, the money needed to live, and what is needed to pay taxes. To make this easier, it is a good idea to invest in bookkeeping and keep trac of the business’ finances. At some point, it may make sense to change the business entity type to either a limited liability company (LLC) or a corporation. Changing the business structure will also change how an owner pays him or herself.
To make sure one is doing everything correctly and legally, it is a good idea to consult a business accountant and lawyer for advice and guidance.
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