A sole proprietor is not an employee of the business, so how does he or she get paid?
Sole Proprietor Income
As a sole proprietor, you are a business owner, not an employee of your company. You don't receive a paycheck. If you need money for personal living expenses, you take what's called a "draw" from the business. The draw is usually in the form of a check, written to you personally on a business check. But this check is NOT a paycheck.
Owner's Capital Account/Owner's Equity
A draw is an amount of money you take (or, draw) out of your ownership in the company. This ownership (or equity) is shown in your capital account. The capital account is shown on your business balance sheet and it's the difference between your business assets and your business liabilities.
How Draw Works: An Example
If you put your own money into the business, you can draw it out to pay yourself back. You can also increase your capital account by making a profit. The profit goes into your capital account. So, if your revenues exceed your expenses this month by $3,000, you can draw out all or some of that $3,000 for your personal expenses.
If you don't have any money in your capital account, you can't draw any money out for personal expenses. For example, if you start a new business and you have little income and lots of money that must be paid out - for rent, equipment, interest on your business loan - there is nothing left to pay you for personal expenses.
Taxes on Draw
You (personally and business) don't get taxed on the money you draw out for personal use. Your business tax amount is determined by the net income on the Schedule C you complete each year. That Schedule C income is put into your personal 1040 tax return and is taxed along with other sources of income.
A Detailed Example (Oversimplified)
- Monthly profits average $3,000, and annual net income of the business is $36,000.
- Owner takes a draw each month, and all draws total $30,000 for the year.
- Net income of $36,000 is calculated on Schedule C.
- Schedule C net income of $36,000 is included in owner's personal tax return.
What about Social Security/Medicare Taxes?
Everyone pays Social Security/Medicare taxes on their income. You must pay self-employment taxes, which are Social Security/Medicare taxes on the net income (profit) from your sole proprietorship business. In the example above, you would pay self-employment tax on the $36,000 of net income from the business.