It’s a very exciting time. You’ve just gone into business for yourself, made a sale and earned your first profits. Now, you need to get at your money, but you have a few questions. How do you pay yourself as a sole proprietor? How much money should you transfer? What does it all mean for your taxes?
Fear not, we’ve got you covered. Firstly, we’ll break down all of the important information about paying yourself as a sole proprietor. Later on, we’ll share some hints, advice and insight from experts in the field aimed at freelancers and sole proprietors like you.
How to Decide If You’re a Sole Proprietor
Let’s kick things off by figuring out if you’re actually a sole proprietor. The important thing to remember here is that “sole proprietor” is mainly a tax designation. It determines how you’re treated by the IRS and your state’s Department of Revenue when it comes to filing and paying your taxes. Here’s what you need to know:
- If you work for yourself and earn money from that, it typically means that you’re self-employed.
- If you’re self-employed, you’re automatically a sole proprietor unless you meet some other criteria — like forming an LLC or corporation or being in business with others.
So, if you earn money for yourself by being self-employed, you’re a sole proprietor unless:
- You’re in business with others who also own part of your business, in which case you’re a partnership.
- You’ve formed a Limited Liability Company (LLC) by yourself, in which case you’re a single-member LLC.
- You’ve formed an LLC with others, in which case you’re a multi-member LLC.
- You’ve incorporated as an S Corporation or C Corporation, in which case you’re a corporation.
- You’ve formed a nonprofit.
If you don’t meet any of the above criteria, you’re almost certainly a sole proprietor. This applies even if you also have a regular full-time or part-time job where you’re employed by someone else.
You might be wondering: “Is a sole proprietor the same as a sole trader or independent contractor?” The answer is that these terms are not inherently the same, although they might be. Sole traders and independent contractors could be sole proprietors. They may also be LLCs or even set up as corporations.
Personal and Business Bank Accounts for Sole Proprietors
Although we always recommend a separate business bank account, that’s not a legal requirement for a sole proprietor. A business bank account keeps your finances separate and can make your bookkeeping, accounting and tax calculations much easier.
But, many sole proprietors simply take payment into their personal bank accounts, in which case their personal and business finances are mingled together. We’ve covered how to pay yourself whether you’re using a personal or a business account.
How Much to Pay Yourself as a Sole Proprietor
There aren’t any hard and fast rules on exactly how much to pay yourself. Instead, we suggest basing your pay around these considerations:
- Always retain enough money in your accounts to cover your tax liabilities, which will likely be around 30 percent of your profits.
- Make sure you have enough put aside each month to cover your business expenses, like advertising, utility costs, software you use, payment processing fees and other common payments.
- Take out enough money so that you can meet your essential living expenses.
- Get a cash buffer and savings in your business so that you can meet a few months of expenses in case you hit a cash flow issue or rough financial patch.
- If you get money from a regular, employed role, take that into consideration when deciding how much to pay yourself.
- If you have extra money, consider investing it or saving towards retirement. Putting money into a retirement account can reduce your taxes.
Here’s an example:
- You earn $12,000 in a month.
- You have $1,000 a month in business expenses, leaving a profit of $11,000.
- You put aside $3,500 of that for taxes, leaving $7,500.
- You save $1,000 of that as a cash buffer, leaving $6,500.
- You put $500 of that towards retirement, leaving $6,000.
- You pay yourself $6,000.
Tax Considerations for Sole Proprietors
The most vital thing to know about taxes as a sole proprietor is that you will pay taxes on all of the profits your business makes. It doesn’t matter which account your money is in — a business account or a personal one — you will need to pay taxes on those profits, whether you move money between accounts or not.
Types of Taxes for Sole Proprietors
Sole proprietors will typically need to pay three types of taxes:
- Self-employment taxes, charged on all the profits you make at a rate of around 15 percent.
- Federal income taxes, charged on your profits, depending on your federal income tax band, typically between 10 and 22 percent.
- State income taxes, charged at the rate defined by your State’s Department of Revenue. Not all states have a state income tax.
As we mentioned above, a good rule of thumb is to put aside between 30 percent and 35 percent of your profits for taxes, although you may need to put aside more if you’re already in a high tax band.
If you earn money from a regular, employed job, your employee income will be added to your self-employment income to determine your federal and state income tax bands.
Estimated Taxes for Sole Proprietors
Sole proprietors will need to pay estimated taxes four times a year, typically on the following dates:
- For the first quarter, on or around April 15
- For the second quarter on or around June 15
- For the third quarter on or around September 15
- For the last quarter on or around January 15 of the following year
You will need to pay estimated taxes for self-employment, federal and state income taxes.
The Process to Pay Yourself as a Sole Proprietor
Here’s the process to follow when paying yourself as a sole proprietor:
- Decide how much you’re going to pay yourself.
- Ensure that you keep enough money back for taxes and business expenses.
- If you have a separate business bank account, move money from that account into your personal account.
- Show your payment in your bookkeeping software as a distribution.
- Make a note of your revenue, expenses, profits and payments.
- Use these records to calculate and pay your estimated taxes and to file your tax forms at the end of the year.
Advice from the Experts for Sole Proprietors
Now that we’ve covered how to pay yourself as a sole proprietor, let’s get some advice from experts in the business world. We talked to several people about advice they might have for freelancers and sole proprietors. Here’s what they told us.
Treat What You Do Like a Business
If there’s a key lesson to learn as a new sole proprietor, it’s this: your business is a real business. According to Brian Meiggs, Founder of My Millennial Guide, “Something freelancers tend to forget or overlook is the fact that they're running a business.” And that’s the first step in paying yourself as a sole proprietor. Simply recognize that your business is a true, legitimate business and you have to treat it as such.
“The best way to manage your finances as a sole proprietor is to look at yourself as an actual business with employees,” says Chris Misterek, Founder of Self-Made Web Designer. “So, if you’re a solo freelancer, your employee is yourself.”
It can feel odd at first, but thinking of yourself as two separate identities (you, the business owner, and you, the employee of the business) but it can be a helpful first step in legitimizing your business in your mind. As an employee who works at your company, your time and expertise are valuable and you should be compensated accordingly.
And, you're not alone. The SBA estimates that over 20 million small businesses in the U.S. have fewer than 20 employees. Many of those are single-employee businesses, just like yours.
It can take some time to grow your salary and budget, but from day one, start thinking of yourself as an employee who gets a salary, even if it’s only a couple hundred or thousand dollars a month. As your business grows, you can increase your salary and business spending. Andrew Latham, Managing Editor at SuperMoney, says, “I recommend freelancers set themselves up as a real business. That means paying yourself a salary, having a marketing and expenses budget and setting up a company retirement plan.”
Each month, you'll want to cover any outgoing expenses, set aside money for taxes, put a little into savings and the rest can make up your salary.
Create an LLC
As a sole proprietor, one of your biggest assets is your business and brand. To protect your business and continue paying yourself, it’s important that you set up an LLC.
“Having an LLC is particularly important if there is a possibility your work could result in personal legal liability or if you (or your spouse) have substantial assets, such as a home or other businesses,” says Latham. “If you don't, creditors could claim your company is not a separate entity, which would make you personally liable for business debts and lawsuits.”
An LLC is one of the most popular business structures for small businesses because they’re easy to set up and maintain and they provide legal protection. Incfile offers a $0 LLC + state fee, meaning all you'll need to pay is your state fee, which can range from $40 to a couple hundred dollars.
Get Separate Bank Accounts
An important step in making your finances easier is to get a separate bank account for your business. This means you’ll have one bank account for your business and one for your personal use. “It not only saves you from an accounting nightmare, but it also ensures you're able to plan for growth and keep track of your finances,” says Meiggs.
And, according to Latham, “Once you have a business account, make sure all your business's income goes into that account and use it to pay for your business expenses.” You want to keep your business and personal income and expenses completely separate. This makes it easier to pay your taxes at the end of the year and keeps the IRS happy.
Set Up a Transfer for Your Salary
To treat your business like a real business, pay yourself a salary every two weeks or once a month, just like a W-2 employee would at a large corporation.
And, paying yourself as a sole proprietor or LLC is simple. Just initiate a transfer. By transferring money from your business account to your personal account, you’ve paid yourself.
While it can be difficult early on in your career as a sole proprietor, it’s important to pay yourself first. Latham recommends you “give yourself a monthly salary to make sure you get paid first. If your company does not have a regular income, give yourself a percentage of every invoice. Paying yourself first will help simplify your budget and streamline your finances.”
Figure Out Your Salary
If you’re not sure how to figure out your salary, that’s totally ok. There’s some math you can do.
Here’s how Misterek puts it:
“Take an average of the total amount you’ve made for a given period of time and subtract the cost of doing business like any subscriptions you pay for or website hosting. That’s the number you have to play around with when you pay your employee. But be careful here; you shouldn’t pay your employee 100 percent of your net income as a business. You need to be putting aside a percentage of that for taxes, slow seasons or plans to grow your business.”
Why put money into savings? “You might have a slow month in the future and only make $2K,” says Misterek. “But, because you’ve been putting aside whenever you have extra, you can still pay your employee $4K every month. This is a way to keep your income consistent as a freelancer and be able to plan for the future.”
Putting money into a savings account is also a great way to start saving for your quarterly and end-of-year taxes. Before paying your salary, you should remove the percentage you expect to pay in taxes.
Build Up Savings for Slow Months
One of the most important parts of paying yourself as a sole proprietor is building up your savings. “Freelancing comes with plenty of freedom and flexibility, but it has its share of limitations,” says Meiggs. “One of them is going through periods of little to no work. It’s advisable to plan ahead by having savings in place to cushion you during these times. An ideal amount would be three to six months' worth of expenses in savings.”
And, even if you never have to dip into your savings to pay your salary, those savings can come in handy at the end of the year. You can give yourself an owner distribution or pay yourself (as an employee) a bonus. Or, you can put that extra money into long-term savings and retirement accounts.
Latham suggests, “in some cases, it makes sense to become an S Corporation or limited liability corporation and set up a 401(k) plan. In the case of solopreneurs, I recommend setting up a SEP IRA and maxing it out every year you can. You can save up to 25 percent of your income in a SEP IRA. If it's a good year and you still have money to save, max out your Roth IRA.”
Putting money into savings for slow months and saving money for retirement all set you up to be a successful business owner who pays themselves every month.
Create and Track Invoices
As a new sole proprietor, it’s important to put on the trappings of business, such as sending invoices to receive payment for your work.
“Ideally, you must be offering invoices to all of your clients, no matter how big or small the rendered service/amount,” says Tim Clarke, Director of Sales and Marketing at SEOblog.com.
“Invoicing is the best way to request payment and track the services you have done with your client. It also determines how much you earn in a month and can instantly track your income.”
When you track your invoices, you know how much money you made in a month. This will help you to determine just how much you can pay yourself. And, it’s OK to start off small. You can always give yourself a raise later. The most important part is paying yourself.
Track Expenses and Finances
If you want to be able to pay yourself as a sole proprietor, then it’s critical to know what’s going on with your finances. The best way to know what’s going on with your finances is to track your expenses.
“Knowing how much you are earning versus what you are spending will give you a better idea of preparing for the crests and difficulties in your career graph,” says Clarke. “It would help if you composed a spreadsheet to track your income and prepare yourself beforehand for the challenging and slow times of the year. It would help to monitor your income and obligations, compare your income versus your expenses and then design a budget accordingly.”
And, you can even have all of your business’s financial information in one place by using accounting software. Accounting and payroll software can help you track your income and expenses, send invoices and collect money and can even help you to save money for your business. A few to try include:
- Horizon Payroll Solutions
- WebHR
- Payroll Network
- AllWork
- Patriot Software
- OnTheClock
- OnPay
- Rippling
- Oyster
- SutiSoft Inc/SutiHR
When you’re a sole proprietor and business owner, one of the most important things you can do for yourself and your business is to pay yourself. Your time as an employee of your business and your expertise are valuable and you deserve to be paid.
The best part? At the end of the month or year, if you’ve got extra money, you get to choose what to do with. As Misterek says, “You can give yourself a raise or decide to invest it back into the business. It might be time to hire another employee or do some paid marketing to attract new clients.” As long as you pay yourself first when your business has extra cash, the world is your oyster and you get to choose how to spend that money.
So, now you know how to pay yourself as a sole proprietor. For even more reassurance, take advantage of Incfile's Accounting and Bookkeeping service to stay on top of your finances and pay your taxes.
Paul Maplesden
Paul is a freelance writer, small business owner, and British expat exploring the U.S. When he’s not politely apologizing, he enjoys hats, hockey, Earl Grey Tea, mountains, and dogs.
