How Do You Pay Yourself as a Sole Proprietor?

Many small business owners start their companies as Sole Proprietorships. The Sole Proprietorship business structure offers setup simplicity, cost-effectiveness, and minimal business compliance requirements. As with any form of business, entrepreneurs must consider the pros, cons, and additional nuances such as paying themselves. Before deciding to operate as a Sole Proprietorship or any other business entity, it’s critical to understand how your choice will impact you.

What Is a Sole Proprietorship?

The IRS defines a Sole Proprietor as “someone who owns an unincorporated business by himself or herself.” The owner of a Sole Proprietorship can be one person or a married couple. Sole Proprietors have total control over the administration, operations, and finances of their businesses. In a Sole Proprietorship, the business and its owner are considered the same legal and tax-paying entity. That means the owner is personally responsible for all the company’s lawsuits, debts, and taxes. If someone sues a business operated as a Sole Proprietorship, the business owner’s personal assets (home, retirement savings, checking accounts, vehicles, etc.) could be taken and used as compensation for damages and debts. Also, the owner’s credit score will take a hit if the business fails to pay its bills or loans.

Many types of businesses and professionals choose to begin their entrepreneurial journeys as self-employed Sole Proprietors. Common examples include babysitters, virtual assistants, web developers, marketing consultants, freelance graphic designers, freelance writers, bookkeepers, IT consultants, roofers, handypersons, house cleaners, and caterers.

How a Sole Proprietor is Paid

In a Sole Proprietorship, paying yourself is different than paying hired employees. A Sole Proprietor is considered self-employed but is not an employee of the company. While the business owners can have other employees on payroll who receive wages and salaries from the company, a Sole Proprietor cannot pay themself wages or salaries from which income tax, Social Security tax, or Medicare tax are withheld. Also, Sole Proprietors do not receive a Form W-2 from the Sole Proprietorship.

Sole Proprietors pay themselves by taking draws from the company’s profits. Typically, this is done by writing a business check in the name of the business owner. Or they may take the draw by transferring funds from their business checking account to their personal checking account or withdrawing cash from the company.

This brings up a very important point; even though a Sole Proprietorship is the same legal and tax entity as its owner, it’s critical to keep careful track of business expenses and income. One of the first steps in separating business and personal finances is to set up a business bank account. If the Sole Proprietorship uses the owner’s name, the account can be set up in that name. If the Sole Proprietorship has established a DBA, the business checking account can be set up in that name. Also, if the Sole Proprietor will use a credit card for purchases, it’s helpful to apply for a business credit card for company expenses. Again, that will help prevent the commingling of personal and business funds, which could make tax filing confusing and draw scrutiny from the IRS and other tax authorities.

When and How Much to Pay Yourself

There are no rules for when a Sole Proprietor may take draws from their business. Likewise, they can take draws in whatever amount they wish. However, stating the obvious, it’s wise for business owners to track their income and expenses to ensure they have enough money to pay their bills, loans, etc. before taking money for personal use. It can be helpful to use an online accounting software platform such as QuickBooks, Xero,  Zoho, Wave, or FreshBooks for recording income and expenses, monitoring cash flow, and tracking profit and loss.

How Sole Proprietors are Taxed

Self-employed individuals must pay income tax and self-employment taxes (Medicare and Social Security) when their Sole Proprietorship’s net earnings are $400 or more in the year. Sole Proprietors use IRS Form 1040 and Schedule C to report income and loss from their business. The IRS also requires they file Schedule SE to determine the tax due on net earnings from self-employment.

Also, because draws are not paychecks, no income or self-employment taxes are withheld from them. Therefore, Sole Proprietors are responsible for paying all income, Medicare, and Social Security taxes on the business profits. Usually, this is done on a quarterly basis by estimating the amount of profit for the quarter. When estimating tax obligations, realize that unlike employees’ wages and salaries (which are tax-deductible expenses for a business), owner’s draws are not tax-deductible. When the Sole Proprietor files their personal annual income tax return at the end of the tax year, any discrepancy between what they paid and what is actually owed can be settled. If they overpaid, they would get a tax refund. If they underpaid, they would need to send a check or transfer funds to the IRS (and possibly to the state and local tax authorities).

How to Form a Sole Proprietorship

If you’ve not yet officially started your business, you might be wondering how a Sole Proprietorship is formed. There are no formal requirements for forming a Sole Proprietorship. States do not require that a Sole Proprietor file formation papers to establish the business. As soon as someone offers goods or services for sale for profit rather than as a hobby, they are considered doing business as a Sole Proprietor.

Know that just because a Sole Proprietorship doesn’t have to register as a formal entity doesn’t mean no rules exist for operating the business legally.

Depending on its industry, products, services, and location, a Sole Proprietor may need certain kinds of business licenses and permits. And if the business will have employees, it will need an EIN (Federal Tax ID Number) and must registering for payroll taxes.

Additionally, if a sole proprietor wants to market the business using a name that does not include the owner’s first and last name, they must file a fictitious name registration which is also known as Doing Business As (DBA). For example, if Elana Zorilla opens a cafe and wants to call it Corner of 1st and Broad Cafe, she would need to file a DBA with either the state or county (whichever jurisdiction oversees fictitious name registrations).

Read More About Payroll: What is Payroll?

Should You Register Your Business as an LLC?

Business owners who start as Sole Proprietors may reach a point where it makes sense to change from a Sole Proprietorship to a registered business entity type.

While the Sole Proprietorship structure offers simplicity, several disadvantages may make it a less than ideal choice:

• Owner liability for all business legal issues and debts
• No tax flexibility
• Possible difficulty obtaining financing or funding (Banks and investors often prefer to back companies formed as LLCs or corporations.)

Business owners who want simplicity and the legal protections of a registered business entity may want to consider forming a Limited Liability Company (LLC).

Here are some reasons why an LLC is a great alternative:

• A single-member LLC offers the same tax reporting and compliance simplicity as a Sole Proprietorship.
• Even better, an LLC offers some tax flexibility.
• An eligible LLC may elect to be taxed as an S Corporation, which may reduce the business owner’s Social Security and Medicare tax burden.
• On the legal front, there’s a notable advantage to forming an LLC. A Limited Liability Company is viewed as a separate legal entity from its members. Therefore, a single-member LLC helps safeguard its owner from personal liability for the legal claims and financial debts of the business.
• Also, an LLC may have an easier time securing funding from financial institutions and investors. That can better position it for growth and expansion.

I encourage business owners to consult an attorney and accountant when deciding on a business structure. Those licensed professionals can offer valuable insight into the legal, tax, and financial effects of business entities — and they can provide advice based on your specific situation and goals.

Recommended Reading: Sole Proprietorship vs. LLC