Small Business Tax Questions: How Does A Sole Proprietor Get Paid?
If you’re a sole proprietor, are you wondering how to compensate yourself? This article will answer that question.
By sole proprietor, we are 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 haven’t 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?
Please make sure to evaluate this content properly, the situation and the solutions have a variety of variations. Don’t pay yourself as an employee. The sole proprietor is never considered an employee of the business. So you shouldn’t give yourself paychecks, nor should you withhold income taxes, social security taxes and Medicare taxes. This also means that you’ll not issue a Form W-2 for yourself at the end of the year.
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Don’t pay yourself as an independent contractor. In other words, don’t 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 will 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’re withdrawing the profit out of the business, and there are no special tax reporting requirements that accompany these “draw” payments.
Perhaps you’re now wondering, “If I do not give myself a W-2 or a 1099, how does the IRS know how much profit I made?” Answer: your profit’s 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’s calculated on the Schedule C, and this “bottom line” profit amount is included in your total personal income on Form 1040, page 1.
You’ll 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’re 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.
Looking for more small business tax deductions? For a free copy of the Special Report “How to Instantly Double Your Small Business Tax Deductions” visit http://www.YouSaveOnTaxes.com. Wayne Davies is author of three ebooks on tax reduction strategies for small business owners and the self-employed.
4 Responses to “Small Business Tax Questions: How Does A Sole Proprietor Get Paid?”
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Tax questions related to covered call options? 1) I was assigned on covered call options. I understand that I should add the premium received for the option to the proceeds from the associated stock sale and report that on Schedule D as part of the sale price of the stock. Is that all that goes on Schedule D? Do I report the option itself anywhere? 2) Separately, I wrote covered call options that had less than thirty days until expiration and identified them as a straddle with the related stock. I later bought back the calls at a loss. Does this count as an “identified straddle” where I just increase the basis in the stock by the amount of the loss or does that fact that the expiration date was less than thirty days away mean that it’s subject to the traditional loss deferral rules? Also, what effect is there on my holding period for the stock – was it terminated when I sold the options or just suspended?
Alimony and taxes questions? If the agreed court alimony payment is 2,000 a month and I pay over that amount to my ex, can I deduct more money from mt GI or only 20,000 because of the courts?
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You can only deduct the amount of alimony you paid which was ordered by the courts. Anything in excess of the court order is not alimony but a gift. Gifts to individuals aren’t tax deductible. Edit to add: For your requested source, IRS Pub. 17, page 132, defines alimony as “a payment to or for a spouse or former spouse under a divorce or separation instrument. It doesn’t include voluntary payments that aren’t made under a divorce or separation instrument.”