As the sole proprietor of your business, are you trying to gauge how to pay yourself? Let us help answer some of every entrepreneur’s most pressing questions.
When you decided to start your own business, you took a giant leap of faith. Of all the issues you weighed in your decision, figuring out your payroll was perhaps not high on the list. However, your company is now established, and the time has come for you to learn how to pay yourself as a sole proprietor.
To get this far, you had to figure out how to begin your solo venture, so you gathered the proper licenses and permits, opened up bank accounts, and completed all of the other necessary tasks. However, even successful entrepreneurs struggle with the question of how to pay themselves as they are just starting out. It is a complicated question with no easy answers.
Although many people assume that entrepreneurs have creative control over all aspects of their sole proprietorships, including payment, that is unfortunately not the case. When any entity or individual sells a product and makes a profit, the IRS and agencies from local to federal all tune in, seeking compensation. A business attorney from Nakase Wade can help you deal with these critical issues and provide advice and counsel regarding paying yourself.
Douglas Wade, Attorney
Can Sole Proprietor Take Salary
Usually, the level of equity in the business, coupled with what is needed for daily expenses, becomes the amount that sole proprietors pay themselves. However, there are some variations. When they are just getting off the ground, many business owners think they can live off of their savings and pay themselves nothing until the company is established. However, paying yourself accomplishes two things right off the bat. First, it proves to the Internal Revenu Service that your company is legitimate as opposed to being a hobby. Second, it helps you to calculate precise financial projections for the future of your new venture.
Likewise, many sole proprietors break even in their first year or even make a profit and consider their business a success, all while not paying themselves a cent. Unfortunately, this is in many ways a false sign of success, and it also can hurt your chances of getting business financing. Funding sources such as venture capitalists or banks handing out small business loans want proof that your company can pay the entirety of its debts, such as salaries to employees and owners as well as overhead costs, and still profit.
Before we can determine what your salary should be as a sole proprietor, let’s take a quick look at how sole proprietorships are defined. This might help us to understand why in the United States, 23 million companies operate in this manner. It will also get us closer to figuring out how much you should pay yourself as the sole proprietor of your business.
How Are Sole Proprietorships Formally Defined?
The IRS tells us that sole proprietorships can be summarized as unincorporated business entities that have one owner only. It is also worth pointing out that spouses are able to own and conduct these businesses together in what is a bit of a loophole.
Being a sole proprietor does not mean you must submit business formation documents to your state. What this means is that if you are running a company by yourself and have yet to register the business, guess what? You are already running your own sole proprietorship. You were a sole proprietor from the second you started offering services and products to the public.
When running a business in this format, all profits flow through to the individual and are therefore reported as personal income taxes. You must pay state as well as federal taxes on your business profits, plus the self-employment taxes that are required of all sole proprietorships.
Sole proprietorships come in many forms, and common examples range from freelance writers to local artists. Also, consultants, bookkeepers, local grocery stores and shops, graphic designers, artists, IT consultants, and many more. At some point, all of these different businesses struggled with the question: how do I pay myself as a sole proprietor?
Just like any business arrangement, sole proprietorships come with pros and cons. If you are wondering how to pay yourself within a sole proprietorship, it is a great idea to first look at the drawbacks as well as benefits of running a sole proprietorship.
Benefits of Structuring Your Business as a Sole Proprietorship
Sole Proprietorships are easy and quick to start up. Unlike other business formations, it isn’t necessary to incorporate the business or even register with your state. You simply need to get the proper business licenses as well as the permits required by the state. This time saved can be used for running your business and working on your first profits.
This type of business arrangement comes with very few legal requirements. Unlike other structures, sole proprietors do not need to maintain specific documentation in order to preserve their company’s legal status.
For sole proprietorships, management is relatively easy. Why? Think about it: there are no partners or shareholders, or co-owners to weigh in on your decisions. You have total authority regarding company decisions. Since all profits flow down to you, there is no real difference between your personal financial situation and your business’s financial situation, legally or otherwise. The only exception to this rule would occur if you went into business with your spouse, and that decision is completely up to you.
For this type of solo entrepreneurial arrangement, taxes are simplified. The owner of the business must report their business income as well as any losses, and this is done in their personal return. The key thing to remember is to add the Schedule-C form to your personal tax return, and you will be all set with the IRS for taxes this year.
Drawbacks of Arranging Your Business As a Sole Proprietorship
A sole proprietorship does face limitless personal liability. This means that people can become individually liable for their business obligations plus debts, and if there is a problem with your business, creditors can pursue personal assets in order to recoup their money.
When you are the only one running your company, taxes are raised. A sole proprietorship has to pay income tax plus self-employment tax, both on the entirety of the company’s income. This combination of taxes can amount to a surprisingly large sum.
Essentially, there are a lot of tasks to accomplish on a daily basis. Consider the fact that sole proprietors must cover all of the business responsibilities and tasks, from finances to strategy to marketing and more. Burnout becomes a real risk for these business owners. If you are feeling overwhelmed with all of these decisions, get in touch with a licensed business attorney.
Paying Yourself as a Sole Proprietor
Once your business begins making a profit, and even before that, you will want to have a concrete strategy for paying yourself. This includes not only how to pay oneself but when and how much. This important task is often overlooked, but it is essential for your business, so let’s break it down.
In a basic sense, sole proprietors are allowed to withdraw funds from their business accounts whenever they need to, and that money can be used to pay their own salaries. Therefore, if your business is making a profit, the funds in your bank account are considered ownership equity; this is the margin between your liabilities and business assets.
-
The Draw and Tax Payments
This transaction is not called a salary; instead, it is known as a “draw.” A draw is performed when a business owner writes a company check to themselves. Importantly, a check like this can not be taxed federally, by the state, or by FICA. Why? The Internal Revenue Service considers the profits of your business and your personal income in the exact same way. Therefore, after a sole proprietor, after deducting the expenses outlined in Form 1040/Form 1065, their remaining profits make up their personal income.
Your Salary
Since business owners file personal tax returns annually, sole proprietors usually desire to pay themselves more consistently. The key is to establish a salary for oneself that is consistent. This can be accomplished through examining future financial projections when your business is new and past performance if your business has existed for a while. Using your business records, figure out how to pay yourself an appropriate amount. Your salary should not drain your business of money, but it also should be high enough that you can live comfortably and put enough time and effort back into the business.
-
Payment Amounts
Determining the correct amount to pay yourself can be a little tricky, but it is possible to come up with a suitable figure. First, you will want to estimate your projected profits and how often you are able to draw money from them.
It is essential to maintain precise records of your company’s liabilities and assets. This will help you estimate your estimated business profits. If you do not differentiate between business finances and personal finances, it will become hard to prove to the IRS and others which expenses you used strictly for your company.
-
A DBA Can Help
Since the name of your business as a sole proprietor is the same as your legal name, this differentiation can be difficult to pull off. To the IRS, your business and you are identical. One way to deal with this issue is to file for a DBA. This lets business owners run their companies under names that are not their own. After you have a DBA, you are able to open a bank account using your DBA name, and your company will be considered legitimate. A DBA can create a sense of separation between a sole proprietorship and their individual identity, and then the business owner can rely on their bank statements for a clear picture of their financial progress.
-
Business Credit Cards, Software, and Scheduling
We would also suggest getting a credit card specifically tailored to your business, as well as software intended for business accounting. Why are these important? One of the most important abilities of a sole proprietorship is being able to determine what your estimated profits will be. You may also want to determine how frequently to draw from the profits of your business, as some people decide on a biweekly draw, and others decide on a schedule that suits them. This is really a matter of personal preference, dependent on how much money you want and need in order to pay living expenses.
Salary Determination
In order to figure out how much to pay yourself as a sole proprietor, you can think in two different ways. Once your business is on solid footing, you can simply pay yourself the minimum amount needed for your living expenses. These should be considered basic expenses only.
You can also opt to compensate yourself more in effort to maintain the same salary as your business progresses. This should be what is considered a fair and equitable salary. Now, if your company cannot afford to pay the market price, it is fine to lower your salary until your company is able to break even. Then, you can increase your pay rate to a more acceptable level.
At this point, one can choose to raise your pay. This can be done through quarterly bonuses. These bonuses are predicated on the profitability of your company. As your profits increase, so can your salary. The ultimate amount is up to you.
Salaries: Corporations vs. Sole Proprietorships
For companies that are incorporated yet are not considered sole proprietorships, the conditions change slightly. You are considered an officer and an employee, so therefore you need to pay your own salary. The IRS dictates that your wages must be defined as “reasonable.”
It is true that some sole proprietors use their company profits to pay for personal expenses. They do this in place of a salary, believing this will help them to save on taxes. We do not recommend this idea because the IRS can enforce penalties if they decide that the money in question should be paid as your salary instead.
Conduct Research
For corporations, the optimal plan is to do some research. For example, if you are the CEO of your business, find out what the average pay rate is, be sure to include your company size, industry type, and geographical region. There are websites that can help with this, or you could contact the trade association in your industry. This relatively small amount of research will provide a baseline for your proposed salary.
It is important to remember that your compensation is subject to additional factors, for example, the number of investors that your company may have or the number of the company’s stock shares that you own. It is wise to check the Internal Revenue Service’s guidelines (try their website). It also is wise to contact an accountant as well as a business lawyer.
Pay Yourself What is Fair for You, and Right for Your Company
If you are running a sole proprietorship, it is crucial that you learn when and how how to pay yourself. To figure out what to pay yourself, you’ll need to work backward and take a look at your tax structure, the money required to live, plus your company’s estimated profits.
One of the best ways to do this is to get a clear picture of your company’s finances. This step will make things much easier. Also, remember that all businesses grow and change, so at some point, you might elect to make your business a corporation or an LLC. A change like this, while often a smart move, brings a whole new set of guidelines to light.
As you begin figuring out how, when, and what to pay yourself, our business lawyers and corporate attorneys at Nakase Wade can help. We provide experienced counsel to sole proprietorships at all stages, and we can help you easily navigate all of these challenging issues.