If you are a sole proprietor, are you wondering how to compensate yourself? This article will answer that question.
By sole proprietor, we’re talking about the self-employed person who reports his or her small business on Schedule C. This also includes people who are the sole owner of a limited liability company (LLC), but who have not chosen to be taxed as a corporation. By default, an individual who owns and operates a single-member LLC is treated as a sole proprietor for tax purposes and should also report his/her business on Schedule C.
Assuming you have a profit, how are you supposed to pay yourself?
Do not pay yourself as an employee. The sole proprietor is never considered an employee of the business. So you should not give yourself paychecks, nor should you withhold income taxes, social security taxes and Medicare taxes. This also means that you will not issue a Form W-2 for yourself at the end of the year.
Do not pay yourself as an independent contractor. In other words, do not give yourself a Form 1099-MISC at the end of the year. If you do, you’ve just unnecessarily complicated your tax situation, because you’ll end up reporting these 1099 payments as an expense on one Schedule C, but you also have to report those payments as income on another Schedule C. That would be redundant and only confuse the situation.
What you should do is simply write yourself a check as often as you like out of the profits of the business. This is sometimes called an “owner’s draw” or simply a “draw”. You are withdrawing the profit out of the business, and there are no special tax reporting requirements that accompany these “draw” payments.
Perhaps you are now wondering, “If I don’t give myself a W-2 or a 1099, how does the IRS know how much profit I made?” Answer: your profit is reported on Schedule C, which is filed as part of your personal income tax return. Schedule C requires you to show your income (sales or revenue) and your expenses. Income minus expenses equals net profit. And that net profit is calculated on the Schedule C, and this “bottom line” profit amount is included in your total personal income on Form 1040, page 1.
You will then pay both federal income tax and self-employment tax on your Schedule C profit. Regardless of how much profit you actually distribute to yourself via “draws”, you end up paying taxes on the total net profit.
One final comment: since you are not withholding income taxes or self-employment taxes from your draws, you may be required to make quarterly estimated tax payments to the IRS throughout the year via Form 1040-ES. Be sure to consult with a tax professional to get help in determining the amount of these estimated tax payments, because failure to make them can result in penalties and interest.