The most common type of business in the US is a sole proprietorship. If there is only one owner with no formal and registered structure, it is automatically considered a sole proprietorship. Since the owner is not exactly an employee of the business, the next question is how a sole proprietor gets paid?
What is a Sole Proprietor?
Before we worry about how they get paid, let’s talk about what they are and what the business is. A sole proprietor is the name of a business owner who is by themselves in ownership in an unincorporated business (called a sole proprietorship). There is no distinction between the business and the owner, meaning that the owner enjoys the profits but also personally bears the liabilities of the business. This is the default structure if you do not formally register a business with one owner.
How a Sole Proprietor Gets Paid
As a sole proprietor, you are not considered an employee as the owner and therefore do not technically get a salary. The owner can take money out of the business for personal expenses at any time in what is called a “draw”.
The good news is that since this is not a paycheck, the owner is not required to withhold federal taxes, state taxes, or FICA (Social Security and Medicare taxes) when paid like they would for employees.
The bad news is that owners are required to pay quarterly tax estimates and self-employment taxes. As well because it is a pass-through entity, the owner must pay on their individual tax returns for the profits of the business.
What is a Draw and How Does a Draw Work?
A draw is simply when the owner of a pass-through entity (which sole proprietorships are) takes money out of the business account and moves it to their personal account. While I don’t suggest it, some sole proprietors do not distinguish between business and personal accounts, so this is more of the business paying for the personal expenses of the owner.
There are some accounting terms you need to understand to understand draws. First, the equity the owner owns in the company is reflected in the balance sheets as the difference in business assets and business liabilities. Assets are things that bring money (or could) into the business. Liabilities are things that take money out of the business (draws don’t count).
Ideally, the business is making (assets) more than it is losing (liabilities) to make what is called a profit. This profit represents the equity the owner owns in the company. Profits are considered capital and the owner can draw from the capital of the business to pay for their personal liabilities.
Let’s use an example to better understand. I invented in some of my previous articles Bob Smith who is the sole proprietor of BS Mowers. BS Mowers has contracts to mow lawns that equal $4500 a month (assets) and spends on average for payments on mowers, gas, and other needed items about $3000 a month (liabilities). BS Mowers has an equity/profit/capital of $1500 a month for Bob to make his draws from to pay his personal expenses.
[I am personally a fan of the Profit First Accounting Method. It teaches you to set aside profit and taxes first and then find a way to only spend on the business’s liabilities what is left after.]
Paying Taxes with Sole Proprietors
It is important to remember that since draws are not salaries, the business doesn’t withhold employee taxes like Fed, State, and FICA when sole proprietorship gets paid. The owner as well is not required to pay any taxes at the time of taking the draws.
The sole proprietorship’s tax amount is determined by the net income and reported on a Schedule C which is filed along with the owner’s personal 1040 tax return.
It is also important to note that the sole proprietor pays income taxes on the net income (i.e., profits) reported on Schedule C, not on the draws taken out of the business solely.
Oversimplified Example
- Bob Smith takes a draw of $1000 out of the $1500 equity each month totaling $12,000 for the year.
- BS Mowers has a profit of $18,000.
- Schedule C will reflect $18,000 profit and Bob will have to pay taxes on his personal 1040 on the $18,000, not the $12,000 he took in draws.
- Hopefully, Bob has been using some of the $500 a month left equity to pay his quarter tax estimates by the 15th of April, June, September, and January so he is not devastated come yearly 1040 tax filing time.
Self-Employment Taxes and Sole Proprietor
Since the draws are not considered salary when the sole proprietor gets paid and no FICA (Social Security/Medicare) is withheld and everyone in the US is required to pay into the Social Security and Medicare programs, sole proprietors have to pay self-employment taxes equaling 15% at the time of writing this.
Remember two things with this. 1. This is above and beyond income taxes owed and 2. It is paid on the net income/profits of the business, not the draws.
In my example above, Bob is paying self-employment taxes on the $18,000 that BS Mowers profited, not the $12,000 he took in draws for the year.