Dear Danielle: How Do I Pay Myself?

Dear Danielle:

I am always curious and have asked lots of people.  I am wondering just how you pay yourself.  Do you pay yourself sick/annual leave?  Aside from overhead costs, do you deduct taxes?  What kind of taxes do you face (i.e., self-employment, FICA, etc.)?  Your help is greatly appreciated. –SH

Seems like such a simple question, doesn’t it?

You don’t mention what your business formation is and that’s going to be very relevant to how you pay yourself and what your tax and reporting legal obligations are.

The very, very first and most important advice I can give you is that you need to get yourself—quick—to an accountant or bookkeeper.

And I don’t want to hear any whining about how that would cost you money.

Yeah. Business costs money and you are simply going to have to spend money on important professionals and advice if you want to be successful. Not doing so now could end up costing you far more later.

And given how you’ve asked the question, I can tell there are some significant gaps in your business knowledge that will do you great harm if you don’t get the right professional guidance and advice.

In the meantime, here is some general information when it comes to paying yourself in business (and, understand, this is for U.S. based business; you’ll have to bone up on your own country’s laws and taxing requirements if you reside and operate elsewhere)…

The first thing people need to understand is that they are either an employee or they are a business.

I see so many people who decide to “work from home” or “freelance on the side” or become an “independent contractor” who don’t realize this.

There is no third classification. If you are working for yourself, no matter what you call it, you are a business.

Even if you might have an actual job as an actual employee somewhere, whenever you are wearing the hat of “freelancer” or “independent contractor” or whatever you want to call it, you are operating a business during those times. You MUST understand this because there are legal implications and obligations.

So that’s the first thing to understand, and the reason I mention it is because the way you ask the question, I’m not sure you entirely understand that.

If someone doesn’t have this understanding, it’s pretty safe to bet that they haven’t done any official or intentional business formation.When that’s the case, they are by default running a sole proprietorship.

In a sole proprietorship, which is the simplest and most common business formation to operate, you simply take money when you want and how much you want. For bookkeeping purposes, these are recorded as “owner’s draws.”

The question about sick leave and vacation pay is moot in this circumstance. You simply pay yourself when you want and how much you want (well, that is, if the money is there, lol).

I would always advise you to keep separate accounts for your business. (In fact, there are some circumstances where you are required by law not to co-mingle your business and personal funds).

Either way, at some point, you will want to “pay” yourself from the monies you have earned in your business. All that is entailed is simply withdrawing funds like you would any other account.

So, for example, if you went to the ATM and took out $X dollars for your personal use, you would simply record that as an owner’s draw. Same thing if you transferred funds from your business bank account to your personal bank account or if you wrote a check for something for personal use. Anything that goes out of the biz accounts that is not related to the business is recorded as an owner’s draw.

That said, being in a sole proprietorship doesn’t mean you are exempt from paying employment taxes. It’s just that you pay and report them differently than you would if you were an employee, where actual paycheck processing is required by law.

In a sole proprietorship, you will pay what are called “self-employment taxes” and they are to be estimated and paid/reported at certain, specific intervals.

You’re going to want to set aside a percentage of funds every time you receive client monies so that you have enough when it becomes time to pay these taxes. A good rule of thumb to be safe is one third or half of every dollar coming in.

Here again is where an accountant or other kind of financial advisor can give you the best guidance based on your specific business.  (For more info on U.S. based self-employment tax reporting, start here)

While a sole proprietorship is the simplest/easiest business formation to operate, it also is the one that puts you at the greatest legal liability should a client sue you for any reason. All your personal income and assets are at risk in a sole proprietorship. This is why many folks opt to go into some kind of corporate business formation where personal assets are not at risk (or are, at least, at less risk).

There are many kinds of corporations which also involve varying levels of complexity: corporation, LLC, PLLC, S-Corp, and partnerships to name just a few. Consult with a business attorney to get the right guidance in selecting the formation that is best for you and your business circumstances.

This is where paying yourself becomes more complicated and where you will definitely want to seek the advice and guidance of some kind of accountant or financial advisor.

For example, in some corporate formations, you are required to pay yourself as an employee or as an owner/operator. When that’s the case, formal employment payment processing is required which entails a whole host of accounting, processing, reporting and taxing obligations you must abide by and be knowledgeable of.

There may be some minimal salary requirements you must pay yourself as an owner/operator. You may be required to pay out profits to partners and shareholders in dividends. Or you may need to know how to record reinvested profits back into the business. In other formations, while you report otherwise as a corporation, you may be allowed to elect to pay yourself in owner’s draw instead of with an actual employment check.

See how much knowledge is involved?

And if you do things incorrectly according to your particular business formation, it could cost you big time later.

This is why it’s always, always best to seek the services of the right qualified professional (not your colleagues) when it comes to these kind of matters. And if you do go with one of the corporate business formations and don’t have a thorough understanding of bookkeeping yourself, hire a bookkeper (one that also has paycheck processing knowledge for your state/locale) to handle that work for you. It’s just too important.

I do hope this helps you get going down the right paths though. :)

One Response

  1. miko says:

    Thanks for your informative information I greatly appreciate it because finding a mentor and resources can be difficult in regards to admin business and getting started.

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