How a Sole Proprietor Gets Paid
If you are in business by yourself and you have no formal registered business structure, you are considered to be a sole proprietor. Sole proprietors are the most common business type in the U.S. As of 2014, according to the Tax Foundation, there were 23 million sole proprietorships in the U.S.
But how does a sole proprietor business really work? And how does a sole proprietor get paid? 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.
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. I'll explain more about how a draw works, 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 still has to pay tax on the net income of the business. (3) You still must pay self-employment tax (Social Security and Medicare tax) on the profits (net income) of the business.
What a Sole Proprietor Is for Tax Purposes
For tax purposes, a sole proprietor is a business owner whose business taxes are not separated from his or her personal taxes. A sole proprietor files a business tax return on Schedule C and adds business profit/loss from that return to the owner's other personal income on Form 1040.
Sole Proprietors Receive a Draw, Not a Paycheck
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 on a business check. But this check is NOT a paycheck. No federal income tax, state income tax, or FICA taxes (Social Security/Medicare) are withheld from this check.
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 owner capital account. The capital account is shown under Owner's Equity on your business balance sheet and it's 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 exceed your expenses this month by $3,000, you can draw out all or some of that $3,000 for your personal 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, 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. The money you take out is totally separate from the calculation of the profits (net income) of the business.
Your business tax amount is determined by the net income on the Schedule C you complete each year. That Schedule C income is put into your personal 1040 tax return and is taxed along with other sources of income.
A Detailed Example (Oversimplified)
- The owner takes a draw each month, and in all draws a total $30,000 for the year. This total is not shown on the owner's income tax return. But...
- Net income of $36,000 is calculated on Schedule C.
- Schedule C net income of $36,000 is included in owner's personal tax return.
Paying Social Security and Medicare Taxes on a Draw
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.