If you are in business by yourself and you have no formal registered business structure, you are considered to be a sole proprietor, the most common business type in the U.S. Many sole proprietors talk about "getting paid," but that term isn't exactly correct since the business owner isn't an employee of the business.
What is a Sole Proprietor
A sole proprietorship (sometimes called a "sole prop") is a business that is owned and run by one person. The business (called a "sole proprietorship") is not a corporation, and there's no distinction between the business and the owner. This means that the business owner is personally liable for all the debts and other liabilities of the business.
How a Sole Proprietor Gets Paid
As usual with this type of tax situation, there is good news and bad news.
The Good News: As a sole proprietor, you can take money out of the business at any time, and you don't have to pay tax on what you take out. What you take out of your business is called a "draw," not a salary or wages (explained below).
The Bad News: (1) You can't take the money out if there isn't extra money to take out. Well, you can, but your business won't be able to pay its bills if you take out too much money. (2) Your business must pay tax on the net income of the business. (3) You still must pay Social Security/Medicare taxes, called self-employment tax, on the profits (net income) of the business.
As a sole proprietor, you are a business owner, not an employee of your company. If you need money for personal living expenses, you take what's called a "draw" from the business. The draw is usually in the form of a check, written to you personally from your business bank account.
A draw is an amount of money you take (or, draw) out of your ownership in the company. This ownership (or equity) is shown in your capital account, shown under the owner's equity category on your business balance sheet. The owner's equity is the difference between your business assets and your business liabilities.
How a Draw Works
If you put your own money into the business, you can draw it out to pay yourself back. You can also increase your capital account by making a profit. The profit goes into your capital account. So, if your revenues are greater than your expenses this month by $3,000, you can draw out all or some of that $3,000 for your expenses.
If you don't have any money in your capital account, you can't draw any money out for personal expenses. For example, if you start a new business and you have little income and lots of money that must be paid out, for rent, equipment, and interest on your business loan, there is nothing left to pay you for personal expenses.
Paying Taxes on a Draw
You (personally and business) don't get taxed on the money you draw out for personal use. It's not the same as taking a dividend from your shares as a shareholder of a corporation.
Your business tax amount is determined by the net income on the Schedule C you complete each year. That Schedule C income is included in your personal 1040 tax return and is taxed along with other sources of income.
A sole proprietor pays income tax on the net income (profits) of the business, NOT on the money the sole proprietor takes out of the business as a draw.
Paying Taxes – An Example (Oversimplified)
- The owner takes a draw each month, and all draws for the year total $30,000. This total is not shown on the owner's income tax return. But...
- The business had a net income of $36,000 as calculated on Schedule C.
- This net income of $36,000 is included in the owner's personal tax return.
Paying Self-Employment Taxes
Everyone pays Social Security/Medicare taxes on their income. In this case, the income is the income of the business, not your draw. You must pay self-employment taxes, which are Social Security/Medicare taxes on the net income (profit) from your sole proprietorship business. In the example above, you would pay self-employment tax on the $36,000 of net income from the business.
Because no income tax or self-employment tax has been withheld from your business income during the year, you will probably have to pay quarterly estimated taxes to avoid having an underpayment penalty at tax time.