Getting paid when you work for yourself isn’t as simple as it may seem. Sole proprietors should follow these guidelines for paying themselves in a way they don’t get in trouble with the IRS or other government agencies.
How do you pay yourself when you are self-employed and haven’t incorporated your business or haven’t chosen to form an LLC? It ought to be simple, right? You sell or do something and get paid. That’s how self-employment works, for freelancers, DBA’s, consultants, independent contractors and other self-employed, right?
If only it were that simple. When you are self-employed, you are running a business and have to pay taxes on your income and abide by certain rules. For tax purposes, if you haven’t incorporated or formed an LLC, the form of business you are operating under is called a sole proprietorship.
As a sole proprietor, you don’t pay yourself a salary and you cannot deduct your salary as a business expense. Technically, your “pay” is the profit (sales minus expenses) the business makes at the end of the year. You can hire other employees and pay them a salary. You just can’t pay yourself that way.
You don’t have to wait until the end of the year to withdraw your profits, though. To pay yourself when you need money during the year, you take what’s called a draw on the profits. Taking a draw, simply means taking money from the business account and giving it to yourself. You could take out cash or write yourself a check. You can do it once a week, once a month, or randomly, as needed.
How does that differ from just taking money customers pay you and putting it into your personal checking account? Technically, you could do that. But you shouldn’t. You’re going to need detailed, accurate records of your business income and expenses when you file your taxes. Here’s the best way to handle things.
Am I a Sole Proprietor?
First, you need to be sure you understand what a sole proprietor is. According to the IRS, “a sole proprietor is someone who owns and operates an unincorporated business by himself or herself.” The business can have a name that’s different from your given name (or not – that’s up to you). But even when the business has a distinct name, if you are the only owner and haven’t incorporated the business, all the profits of the business pass through to you and are reportable on your personal income tax forms. You report the year’s profits (or losses) from your sole proprietor activities on IRS Schedule C, which gets included with your personal tax return.
As a sole proprietor (or self-employed individual) you will need to pay federal, state and possibly local income taxes on all the profits. You will also need to pay a self-employment tax. (The self-employment tax is simply Social Security and Medicare taxes for the self-employed.) Since your “salary” when you are self-employed is actually the profit from the business, the self-employment tax is calculated on the business profits.
Separate Business Accounts from Personal Accounts
As a business owner, you’ll need to keep accurate records of your income and business expenses. Doing that will be extremely difficult if you put all your business earnings into the same account you use for personal expenses. Co-mingling business funds with your personal account may also make it more difficult to prove expenses were strictly for business if they look like personal expenses.
To keep things simple for yourself, your accountant, and the IRS, open a checking account for the business. If you aren’t using a business name, open the account in your own name, but be sure to use it only for the business. If you are using a business name (i.e., Joe’s Clam House), the bank will require a copy of a DBA certificate (certificate saying you’re doing business under a fictitious name) or a business license, or both. (Check with your bank to find out what they’ll need. Some banks may require a DBA certificate for a business even if the business “name” is your name.)
Use this business account to deposit all income from the business. Checks, ACH deposits, credit card sales receipts, and any other income should all get deposited into this account. Pay all the business bills from this account as well. Your bank statements, along with records you keep about income and spending, will give you and your accountant a clear picture of how much the business earned, how much it spent and what its profits are. (If there’s a business name on the account, it will also help your business look more established to customers.)
If your business is homebased, get a separate phone line for your business. You’ll be able to deduct the entire cost of the business phone – plus you can then answer all calls with your business name so you sound more professional.
If you will be charging any business expenses, get a separate charge card for use by the business. Chances are the credit card will be issued in your name, not the business’ name, or if the business name is on the card, yours will be too. Use this credit card only to buy products or services for your business. Do not make any personal purchases with the card. That way, you’ll know that everything charged to that card is for the business.
Use an accounting program to record all the deposits and withdrawals from the business checking account. Use the accounting program to characterize the nature of the expenses as you pay them. (i.e., website hosting, office supplies, accountant’s fees, etc.) Doing so will let you see at any time what your profit (or loss) is. Tracking expenses like this in your accounting program will also make it much easier at the end of the year to categorize your spending for tax purposes. It will also help you budget for the next year and analyze your spending patterns
As a sole proprietor, you can pay yourself whenever you want (and the business income allows). Ideally, you’ll do this on a regular basis. When you do pay yourself, you just write out a check to yourself for the amount of money you want to withdraw from the business and characterize it as owner’s equity or a disbursement. Then deposit the check in your personal checking or savings account.
Remember this is “profit” being withdrawn, not a salary. Therefore, no income taxes, Social Security or Medicare comes out of your check. But you will have to pay all those taxes when you file your personal tax return, so remember to set aside money to cover the expense. Once the business is profitable, you’ll be paying these amounts quarterly in the form of estimated taxes, but in your first year of business operation you may not have to pay anything until you file your annual return.
If you have expenses that will ultimately be shared between personal and business accounts, (ie, the cost of Internet use, if your home-based business uses the same Internet connection the family does) those costs won’t get recorded in your accounting program. You’ll calculate them at the end of the year when you prepare your taxes and take a deduction for them on the Home Office Deduction tax form.