How to Pay Yourself as a Sole Proprietor: Here's Everything You Need to Know

13

Min Read

David Maina

As a sole proprietor, you have total control over how much you pay yourself and when you pay yourself. You don't have to wait for a board of directors or shareholders to vote on your pay -- nor do you have to go through a lengthy approval process.

This can be a great perk of running your business, and there are a few different ways to pay yourself as a business owner.

In this article, we'll cover the following:

  • What is a sole proprietorship?
  • Benefits and drawbacks of starting a sole proprietorship
  • How to pay yourself as a sole proprietor
  • How much do you pay yourself as a sole proprietor
  • Why do you need a business bank account for your sole proprietorship?
  • How are sole proprietorships taxed?
  • How to keep track of your business expenses

Let's dive in.

Note: If you are a sole proprietor starting out that would like ready-to-edit templates and tools to help you run your freelance business, then try Bonsai. Our templates for proposals, invoices, contracts and our expense tracker make managing your business less stressful. Claim your 14-day free trial here.

What is a sole proprietorship business structure?

A sole proprietorship is the simplest and most common type of business structure in the United States. It’s a one-person unincorporated business, meaning you are the only owner/operator. 

The only owner can be an individual or a married couple. There are no special state or federal filings required to create or maintain this type of business entity—the owner simply needs to get any licenses or permits required by their municipality.

Let's review the positives and negatives of a sole proprietorship.

Sole proprietorship pros

Here are some of the benefits of starting and running a sole proprietorship: 

Simplicity

The sole proprietorship is the simplest type of business structure to form and operate. There are no special filings or registrations required with any government agencies.

Flexibility

The sole proprietor has complete control over all aspects of the business, from day-to-day operations to long-term planning to business performance.

No entity-level taxes

The sole proprietor reports all business income and expenses on their personal tax return ( IRS Form Schedule C ). This can be a benefit come tax time, as the sole proprietor only pay taxes on net business profits—meaning they don’t pay any taxes on money that is reinvested back into the business.

Sole proprietorship cons

While running a sole-proprietorship can offer you several perks, it also comes with its fair share of drawbacks which include: 

Unlimited liability 

The sole proprietor is personally liable for all business debts and obligations of the sole proprietorship, meaning that if the business is sued or can’t pay its debts, the sole proprietor’s personal assets are at risk.

Less credibility

Because a sole proprietorship is just one person, it can be harder to build credibility with customers, vendors, and other business partners. This is often because they perceive sole proprietorships as less stable and less professional than larger businesses.

Sole proprietorship taxes are higher

Sole-proprietors are responsible for paying both the employer and employee portions of Social Security and Medicare taxes. This can add up to a significant amount of money each year.

How do I pay myself as a sole proprietor?

Just like how to pay yourself as an LLC, the most common way for a sole proprietor to take money out of their business is through what’s called an owner's draw. A owner's draw is simply a payment from the business to the owner/operator, and it’s not considered taxable income—meaning the sole proprietor doesn’t have to pay any taxes on the money they take out of the business. The amount of the draw can be based on a set schedule (e.g., once per month) or it can be determined on an as-needed basis.

To determine how much you can take from your business, you need to consider several factors, including your desired salary, the company's profits, and how much money is needed to cover personal expenses.

Here’s an example: Let’s say you’re a sole proprietor who wants to take a $50,000 salary. If your business is profitable, you can simply take $50,000 out of the business each year through a draw. However, if your business isn’t yet profitable, you may need to take a smaller owner's draw—or even no draw at all—until the business is generating enough income to support your desired salary.

There are a few different ways you can take draws from your sole proprietorship:

• Cash. The simplest way to take an owner's draw is to simply withdraw cash from the business’s bank account. This method can be helpful if you need money for immediate expenses, but it’s not the best long-term solution as it can make it difficult to track how much you’ve withdrawn from the business over time.

Check. Another way to take an owner's draw is by writing yourself a check from the business’s bank account. This can be helpful if you want to keep track of how much money you’ve taken out of the business over time.

Credit card. If you need cash for immediate expenses, you can also use your business credit card to withdraw cash from an ATM. This method can be helpful if you have a business credit card with a low-interest rate.

Learn more about the different types of business owners pay themself.

How much should I pay myself as a sole proprietor?

As a sole proprietor, determining how much you should pay yourself can be tricky, as there are no set rules or guidelines—it’s up to you, the business owner, to decide what’s appropriate.

One way to think about it is to consider how much you would need to pay someone else to do the work you do. This can help you determine fair compensation for yourself.

Another way to look at it is to calculate your business’s net profit (total revenue minus total expenses) and then divide that number by 12. This will give you an estimate of how much money you can take out each month without affecting the overall health of your business.

Whatever method you choose, it’s important to be realistic about your expenses and income. It can be tempting to pay yourself a high salary, but if your business isn’t making enough money to cover those costs, you’ll soon find yourself in financial trouble. A reasonable salary would be based on how much revenue you generated from the company earnings.

How are sole proprietorships taxed?

The tax implications of paying yourself are something you need to be aware of. As we've mentioned earlier, when you take money out of your business through an owner's draw, that money isn't considered taxable income. But there are a couple of taxes you need to take care of as a sole proprietor, and we'll discuss them below.

The Internal Revenue Service (IRS) taxes sole proprietorships like a Limited liability company -- as pass-through entities. This means that the sole proprietorship itself is not taxed. -- instead, the IRS taxes the business owner’s income from the business on their personal tax return. The benefit? You'll often deal with less paperwork when you file your annual taxes.

That said, you need to understand which sole proprietor taxes you need to pay. Sole proprietors have the responsibility of paying:

  • Self-employment taxes
  • Filing federal income tax returns
  • Sales tax, if applicable
  • State tax, if your state requires you to pay them
  • Federal and state estimated taxes

Each type of tax has its own requirements for reporting and payment, so let's look into each one of them.

Pay Self-employment Taxes (Social Security and Medicare Taxes)

If you're a sole proprietor, you need to pay self-employment tax or Social Security and Medicare tax. It's similar to the taxes that are withheld from an employee's paycheck.

The current self-employed tax rate is 15.30%, which consists of 12.4% for social security and 2.9% for Medicare taxes. However, this only applies to the first $142,800 of your net earnings.

Self-employment taxes are calculated and paid with your annual federal income tax return. The IRS provides a Tax Worksheet in Publication 505, Tax Withholding and Estimated Tax, to help you figure out how much to pay.

Federal income taxes

As a sole proprietor, you're also responsible for paying federal income taxes on your business earnings. You'll need to report all of your business income and expenses on Schedule C, Profit or Loss from Business. This is where you'll calculate your net business profits or loss.

Your net profit or loss is your total business income minus your total business expenses. If you have a net profit, you'll need to pay income tax on that amount. If you have a net loss, you may be able to deduct it from other sources of income on your personal tax return.

You can use the IRS Tax Calculator to estimate your federal income tax liability. This can help you plan for how much to pay when you file your return.

Sales tax

If you sell physical goods, you may be required to collect and pay sales tax. This is a state-level tax, so the requirements vary by state. You'll need to check with your state's department of revenue to find out if you need to collect and pay sales tax, and how much you'll need to charge.

State income tax

Many states also require sole proprietors to pay state income tax. The rules vary by state, so it's important to check with your state's department of revenue. You'll need to report all of your business income and expenses on your state tax return.

Federal and state estimated taxes

As a sole proprietor, you may also need to pay estimated taxes. This is a tax you pay throughout the year, instead of all at once when you file your annual tax return.

The IRS estimates that most taxpayers will need to pay around 90% of their total tax liability during the year. This helps ensure that you don't have a big tax bill at the end of the year.

You may need to pay estimated taxes if:

  • Your tax liability will be $1000 or more for the year
  • You expect to owe at least 90% of the tax shown on your current year's return
  • Your tax liability for the current year at least 100% of your tax liability for the previous year

As a sole proprietor, you'll need to file the following forms:

  • Schedule C, Profit or Loss from Business
  • Form SE, Self-Employment Tax
  • Form W-12, IRS Voluntary Withholding Agreement
  • Form 8829, Expenses for Business Use of Your Home

These forms are all available on the IRS website.

When you file your taxes, you'll need to include a copy of your Schedule C with your Form SE and Form W-12. You'll also need to include a copy of Form 8829 if you're claiming expenses for business use of your home.

You can find more information on the IRS website, including a list of all the forms you may need to file.

Also, there are several tax deductions sole proprietors can take to reduce their tax liability. Deductions can be claimed for things like business expenses, the cost of equipment and supplies, and the mileage traveled for business purposes.

It's important to keep track of all your deductible expenses throughout the year, so you don't miss out on any tax savings. You can use a simple spreadsheet or accounting software to track your expenses.

It can be a lot to keep track of, but knowing what taxes you need to pay and when is essential for running your business. By understanding the basics of sole proprietorship taxes, you can avoid any surprises come tax time. And if you have any questions, don't hesitate to consult a tax professional.

Read our resource on how to file taxes for income from a sole proprietorship.

5 Reasons why you need a separate bank account for your sole proprietorship

A business checking bank account is one of the most important tools that any sole proprietor should have in their toolbox. For one, it allows you to pay yourself seamlessly. With a business checking or savings account, you can make an "owner's draw" easily as you only need to transfer money from the separate business account to your personal account -- or write yourself a check.

With only a personal account, your business and personal finances are mixed up, and determining exactly how much you need to draw can be difficult.

That said, other reasons why you need to apply for a business account include:

Keep personal and business finances separate

It can be difficult to keep track of your personal and business finances when they’re mixed together. This is especially true if you’re using a personal checking account to pay for business expenses. Not only will this make it more difficult to track your spending, but it could also lead to mistakes and missed tax deductions.

Again, paying yourself from your business can be as easy as transferring money from your business to your personal bank account.

Avoid costly mistakes by keeping business expenses separate

When you’re running a business, it’s important to track your expenses carefully. This is the only way to ensure that you’re making a profit and that you’re not spending more money than you’re bringing in. But if your business and personal expenses are mixed together, it can be difficult to track which expenses are related to your business, and this could lead to costly mistakes down the road.

Establish credibility with clients and vendors

When you’re operating as a sole proprietor, it’s important to establish yourself as a credible business. This can be difficult to do if you’re using a personal checking account for your business transactions. Having a dedicated business bank account shows clients and vendors that you’re serious about your business and that you’re taking the necessary steps to protect your finances.

Access to business-friendly banking products 

As a small business owner, you’ll likely need access to a variety of banking products and services, such as loans, lines of credit, and merchant accounts. And many traditional banks don’t offer these products and services to small businesses. But by having a business bank account, you can gain access to a wide range of business-friendly products and services.

Get a business credit card for emergency funds

When you’re running a small business, it’s important to have access to emergency funds. This could be money that you can use to cover unexpected expenses or to tide your business over until its next payday. And one of the best ways to access emergency funds is with a business credit card.

Business credit cards offer a variety of benefits, including the ability to build your business’s credit history, earn rewards and cash back, and get 0% APR financing on purchases. And if you have a business account, you may be able to get a business credit card with a 0% APR promotional offer.

How to keep track of your business owner expenses

Aside from opening a business bank account, here are other ways to keep track of your sole proprietorship's expenses:

Keep receipts and invoices 

Be sure to keep all of your receipts and invoices in a safe place. This will help you keep track of your expenses and make it easier to file your taxes.

Use a business credit card

A business credit card can be a great way to track your expenses. This is because most business credit cards come with features like expense tracking and account management tools.

Hire an accountant

If you’re not comfortable managing your finances, you can always hire an accountant or use tax software to help you out. An accountant can help you keep track of your expenses, prepare and file your taxes, and more.

Always reach out to a professional for tax advice.

Note: If you need help automatically tracking your business expenses, try Bonsai Tax. Our expense tracker scans your bank/credit card receipts to discover all your potential tax write-offs. In fact, users typically save $5,600 from their tax bill. Claim your 14-day free trial today.

Bottom line

So there you have it: a few different ways to pay yourself as a sole business owner or proprietor. Just remember to be realistic about your expenses and income, and to always keep track of your business’s financial health. With a little business planning and organization, paying yourself as a sole proprietor can be easy and stress-free.

David Maina
David is an experienced B2B financial copywriter, specializing in content related to accounting, financial planning, and small businesses. Over the years, he has helped fintech brands win more traffic and skyrocket conversions with engaging, long-form content. A nerdy interest in numbers, and passion for creative writing drives him to create financial content that's truly unique. You can reach him at financeandinsurancewriter.com

Join 500,000+ freelancers using Bonsai's free contracts & invoices.

Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

Discover the integrated all-in-one software suite Bonsai.

Oops! Something went wrong while submitting the form.