One of the most frequently asked questions I get from business owners is “how do I pay myself?”
What should be a pretty simple concept throws people for a loop because they aren’t sure what’s allowed, what’s taxable, what types of taxes to pay, etc.
This post covers sole proprietors and single-member LLCs, which are by far the most widely-used business types for entrepreneurs and small business owners. Quick recap – you’re a sole proprietor if you don’t have a separate legal entity under which you do business. You’re a single-member LLC if you’re the only owner of an LLC. These two business types are basically identical in the way that they’re treated from a tax perspective.
How to pay yourself in a single-member LLC or sole proprietorship
Just transfer money from your business bank account into your personal account whenever you want to pay yourself.
I know, it almost seems too easy.
You can write yourself a check, Zelle yourself, send a bill payment check, transfer funds over if your accounts are at the same bank, or even withdraw cash (although I’m not a huge fan of this approach because you can’t track cash).
You do not have to set up payroll for yourself! You do need to consider making estimated tax payments, but you don’t need to go through the trouble of setting up a payroll system and filing all those extra forms.
How your income is taxed
One of the most common misconceptions I see with business owners who have a single-member LLC or sole proprietorship is around whether they have to pay taxes on the money they transfer to pay themselves.
Remember, you will be taxed on the net income of the business, whether you pay yourself any money or not. Paying yourself is NOT a business expense and is therefore not deductible on your tax return. Put another way, the money you pay yourself is disregarded when you’re doing your tax return.
Let’s look at a basic example:
Revenue = $10,000
Business Expenses = $4,000
Owner Pay = $2,000
Owner Income Tax Rate = 25%
The net income of the business is $6,000 ($10,000 – $4,000)
Quiz: How much is owed in taxes?
A) $6,000 * 25% = $1,500
B) $2,000 * 25% = $500
The correct answer is A! Remember, you are taxed on the net income of the business, whether you pay yourself that much money or not.
One more thing to remember
If your business is making money, you probably need to make estimated tax payments every quarter to avoid owing penalties and interest when you file your annual tax return.
Uncle Sam likes to get paid early and often. If you end up owing too much money when you file your tax return, you’ll get charged penalties and interest.
If/when you were an employee, your employer withheld taxes on your behalf as you got paid and sent the money to the IRS and your state’s department of revenue. Now that you’re a business owner, you’ll have to send that money on your own. So, if your business is making money, you should at least pay yourself enough to cover your estimated tax payments.