Having business income is a “good problem to have”, though many small business owners do not understand exactly just how to pay themselves. Here’s how.
Disclaimer: The info presented on our website is meant for general and informational purposes only. It’s a simple guide for beginners and does not replace the need to seek help form a business tax professional. We strongly recommend that you seek council form a qualified practitioner. The advice given within is very general and may not apply to your specific situation. Relying on this guide could cause many misunderstandings leading to penalties, fees, and even actions taken against you from the IRS or your state taxation department.
Payroll and the Sole Proprietorship
If you have not taken any steps to organize your business, then you are probably a “sole proprietor” for general liabilities and tax purposes. You may also have a single member LLC that can be taxed as a sole proprietorship.
When you are organized and taxed this way, you can simply take any net profit as a draw.
Other than keeping track of your income and expenses, there is no special way that you have to pay yourself and there are no payroll tax returns to complete.
All you have to do is write yourself a check form your business account to your personal account and book it as a “draw”.
How the Sole Proprietor’s Draw is Taxed
In most cases, the draw itself is not actually taxed. It is the “net profit” of your business that is taxed, on a yearly basis.
A simple definition of “net profit” is your remaining income after your expenses it’s actually more complicated than that – but that’s all we need for discussion’s sake).
To understand this concept better, let’s look at a simple example:
Let’s say your business saw $20,000 in gross sales in a year, and also had $15,000 in deductible business expenses. This means that your net profit is $5,000.
Now let us picture your business doing this every year for 10 years.
If you waited 10 years to pay yourself, you would have $50,000 in the bank ready for you to take (draw).
So when you take the $50,000 in year #10 – on how much are you taxed?
The answer is $5,000.
Every year that you make $5,000 in net profit, that is what you pay income taxes on. It does not matter how much of that you draw out of the business’s bank account. You are free to contribute money into your business bank account and take money out as you wish – you are simply taxed on the net profit each year.
Note that later, if you sell your business, you might have a different type of income to be taxed(income from a capital gain).
In summary, go ahead and pay yourself at your own discretion. Obviously you want to leave enough money in your business bank account for your normal operating expenses (plus perhaps some cushion). Other than that, take the money out as it suits you. It will not change the amount of tax that you must pay for the year’s profits.
Estimated Tax Payments
Some things to consider is that you are not having any income taxes withheld from paychecks – as you would with a normal job. Because of this, you will likely be required to make estimated tax payments. The income tax system is “pay as you go” – not “pay at the end of the year”. If you skip this step, you will likely face penalties.
Not only are you not having income tax withheld, but you are not paying social security and medicare taxes either. These will be included in your tax return as “self employment” taxes and added to you income tax liability.
So even though you do not have to do anything special besides recording the transactions and putting the money in your pocket, you should still have to figure and make your estimated payments to the IRS on a regular (quarterly) basis.
Hawaii General Excise Taxes
This applies to our Hawaii readers or for those doing business in Hawaii.
Some other things to consider for a newly profitable sole proprietorship might be obtaining the required business licenses, including a Hawaii GE Tax License. You also must file and pay Hawaii General Excise Tax for all of your gross (before expenses) income.
It is important to note that Hawaii General Excise tax is imposed on your gross sales (like a sales tax) and NOT on your net profit. You can lose money and still have to file and pay Hawaii General Excise Taxes. The “net profit” example above is only applicable to INCOME taxes, not GENERAL EXCISE Taxes.
Payroll and S Corporations
As your small business income continues to grow, it might be wise to organize as a business entity of some sort. This may lead to significant tax and liability advantages.
S-corp taxation allows you to become an employee of your own business. When you do this, you must pay yourself a reasonable salary. Note that you also take the remaining profit from just being a shareholder. The big deal is that the latter type of income is not subject to social security and medicare taxes. This can create a significant tax savings.
If your business makes a reasonable profit, it may be best to get set up this way. In this case you would have to follow the state and federal procedures for hiring employees, pay yourself a reasoable salary, make the appropriate tax deposits, and file timely employment tax returns. You even have to issue yourself a W2.
For these reasons, S Corp Taxation may not be the best way to get started if your net profit might be low at first. There would be no reason to take on the extra complexity and costs of having an S Corp.
S-corp taxation and payroll taxes are quite complicated. We strongly recommend that you find a tax professional to help you with that. Tell your tax pro that you are seeing more and more in profits, and that you want to look into s-corp taxation and running payroll.
- How to Hire Employees in Hawaii – Small Business Employer’s Guide
- Should You Get Your Under the Table Employees On The Books?
- Small Business Payroll – How to Pay Yourself
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