Today, we are going to talk about how to pay yourself as a sole proprietor.
If you are a sole proprietor, or in other words, you are doing business and have not formally incorporated into an LLC, Corporation, or Partnership, then you are a Sole Proprietor.
And guess what, today’s episode is all about you.
Today, we’re going to walk you through, step-by-step, how to pay yourself as a sole proprietor.
We’re going to explain:
- Who is a sole proprietor?
- How sole proprietors pay taxes?
- How much to pay yourself as a sole proprietor?
And if you stick to the end, we will give you our framework for how sole proprietors should be paid.
So let’s begin!
What is a Sole Proprietor?
A sole proprietor is simply someone who owns an unincorporated business. So if you…
- earn money,
- you are not employed, and
- you haven’t registered as an entity with your state
…you are a sole proprietor.
So let’s say you wake up and decide to cut your neighbor’s yard in exchange for money, then the moment you get paid, you are a sole proprietor.
And if you’re wondering if that money is taxable, well you bet it is!
According to the IRS, all income received is considered taxable.
So let’s talk about how sole proprietors pay taxes.
For tax purposes, sole proprietors are considered disregarded entities.
All this means is that you do not have to file a business tax return when you file your taxes. Instead, you will file a Schedule C when you file your personal tax return.
This is good news because business tax returns are generally more expensive and have to be filed earlier.
Normally the deadline for filing a business return is March 15th, and personal deadlines are April 15th. Check out this post on tax season 2021 new update to learn more about these deadlines.
So as a sole proprietor, you get an extra month to file your taxes.
What Taxes Do You Have to Pay as a Sole Proprietor?
Generally, the main taxes are Federal income taxes, State taxes, and the big-ugly-fat 15.3% self-employment tax on your income.
By the way, you can limit self-employment tax exposure by incorporating it into an S-Corporation.
Now, of course, you pay these taxes on your income, but what exactly is income when you’re operating as a sole proprietor?
A lot of people get this wrong so allow us to explain.
Your income is simply the amount of money your business earns, minus all tax-deductible expenses (or deductions) you can take.
Generally, it is your net profits from the business you’re operating.
Many people get this confused with the money they pay themselves from their business.
You are not taxed on the money you take out of your business.
So if your business earned $100,000 in profits, and you did not take a penny out of that business. Guess what? You’re going to pay taxes on the full $100,000.
Fair enough. Well then, you might think that the money you pay yourself from your business is tax-deductible.
So if you paid yourself $50,000 out of the $100,000, then that would mean that you should only be taxed on the remaining $50,000 right?
Wrong. The money you pay yourself is not tax-deductible. You do not subtract the money you pay yourself from your business from its income.
You are not an employee of the business, therefore in the eyes of the IRS, all the money the business makes is yours.
You are also not a 1099 contractor in your business. Your customers might issue you 1099, but that just means you are a vendor of their business.
They’re just writing you off as an expense to their business.
But you are not an expense in your own business, so when you file your taxes, you can’t deduct yourself.
Therefore, the transfers you make between yourself and the business are completely irrelevant for tax purposes.
So again, business revenue minus tax-deductible expenses equals your taxable income.
And that’s the tax-side in a nutshell.
You earn money. You deduct your expenses. And you’re taxed on the rest.
The only other tax piece is that, technically, you should pay your estimated taxes on a quarterly basis.
So let’s say you owed $10,000 in taxes last year, you’d simply divide this amount by 4, and pay $2500 each quarter.
As long as you pay 100% of what you paid last year in taxes on a quarterly basis, then you don’t have to worry about paying any penalties.
Or, if you pay 90% of what your tax liability will be this year, then you are also safe.
But to us, this is a little more tedious to keep up with as numbers fluctuate, so we prefer just paying 100% of our tax liability last year on a quarterly basis.
However, if you expect to earn much less in this tax year than you did in a prior tax year, then it might make sense to pay 90% of what you think you’ll owe this year.
That way you don’t have to put yourself in a position where you’re giving the IRS way too much money.
So as long as you understand that side of things, then you are pretty much covered on the tax side.
Now let’s discuss how to pay yourself in a sole proprietorship. Here are the steps you should take.
Steps on How to Pay Yourself as a Sole Proprietor
Step 1: Operate out of a business bank account
This is business 101. You do not want to commingle your business funds with your personal funds.
It’s going to make bookkeeping and finding tax deductions a nightmare. Furthermore, it can also complicate things if you get audited by the IRS.
Somehow they are going to have to make sense of the things you claimed for tax purposes, and if this is not clear, you can get into some serious trouble.
Step 2: Transfer money from your business bank account to your personal account
You can write yourself a check. You can wire funds to yourself. Or, you can go to the bank and just take out cash.
Remember, the money you pay yourself is your business. Your taxes are going to based on the business’s overall profits, not how much you pay yourself.
But does this mean you should take all of the business profits to pay yourself?
No, so let’s move on to step 3.
Step 3: Pay yourself, but don’t hurt your business
A lot of sole proprietors make the mistake of paying themselves too much.
They don’t leave enough money in their business, and then they find themselves going into debt to fund their operations, or just going out of business all together.
A lot of times it’s because they’re taking too much money out of your business.
You need to think about cash like fuel. If you run out of cash, you’re on E. The game is over.
You want to keep enough fuel in your business so you can make it to where you’re trying to take it.
So here is our framework to make sure this happens. And it doesn’t involve creating 7 different bank accounts or some of this other stuff we’re seeing out here.
Rule #1: Leave 3-months of operating expenses in your business.
This is your safety net.
If you always leave 3-months of operating expenses in your business, then you will be able to stomach any sudden or unexpected expenses that may come up.
Rule #2: Put aside money to pay your estimated taxes
Your taxes are not optional. Don’t be that person at tax time who does not have the money to pay their tax bill, because you’re driving it or spent it on a vacation.
Put yourself on a schedule to pay your estimated quarterly taxes. And also leave that amount in your business.
Rule #3: Put aside money to reinvest in your business
If your goal is to grow your business, then chances are that it is going to cost you some money to do this. This is especially true if you want to grow your business quickly.
So whether that’s upgrading your equipment, hiring employees to help you, or developing some type of software or process, be sure to leave this dollar amount in your business.
Rule #4: Pay yourself everything that is left
If you have money set aside for the first 3 things, then go ahead and rob the bank of everything that is leftover. It’s your money. You earned it.
And most importantly, you can have peace of mind in not worrying about Uncle Sam or your ability to pay your bills on time.
Now if you need some help with your taxes as a Sole Proprietor, work with our CPA tax services today.
Contact us at 470-240-1437 to schedule a meeting.