Determining Your Salary as a Sole Proprietor

When you are a sole proprietorship, you are not an employee, so you don’t actually earn a salary. The Internal Revenue Service sees you, the individual, as the business—and the business as you! To the government, you are a single entity! If you operate several sole proprietorships, the IRS still sees them all as you the individual. When you file taxes, you do so using an individual 1040 with a Schedule C for each business. What you take from your business is your “draw” and does not appear on your tax forms. If your business is a secondary income and you receive a W-2 from an employer, the income from your business, less business expenses, is added to the amount of income from all other sources for tax purposes.

What that means in practical terms is that even if you determine a “salary” amount for yourself, it doesn’t make any difference to your income tax obligations. With that said, there are several ways to decide how much of your business’s income should stay in your business and how much you should use for personal expenses.

A business that does not have very much overhead, like a consulting business, lets the owner draw more income from the business without jeopardizing the business than one with lots of expenses. In that case, at the end of each month, you can take for yourself most or all the income left in the account after paying expenses like membership dues, Internet and telephone bills, etc.

However, for example, if you made $2,000 this month, but your expenses were also $2,000, your business actually made $0 and you could not draw from the business. If you put the expenses on credit intending to pay them over time, you would subtract the payment from the total income and the remainder would be available to draw.

Businesses that have more overhead expenses, or fluctuating expenses like supplies and materials, might require you to set aside a cushion of savings in your business account or business savings account. When this is the case, drawing a lower percentage and keeping a stricter budget protects your ability to get what you need to operate your business.

So that you know how much money is flowing through your business, open a second checking account. If you use a credit card for business, get one that is just for business so that you can easily keep the expenditures separate. If both of your accounts are in the same bank, just transfer money from one account to the other. Make sure you account for it as an “owner draw” so that you know where your money goes. If your accounts are in different banks, just write a check to yourself.

Just a note regarding income tax: Sole proprietors pay both income tax and self-employment tax. The two together run about 15 percent of your adjusted income at the moment. So that you aren’t shocked at tax time, set aside at least that much each month into a savings account. If your obligation after expenses is less at tax time, you’ll have extra to draw! You can check out more information about self-employment taxes at the IRS web site.