Most sole proprietors are aware that their business activities are reported to the Internal Revenue Service (IRS) on Schedule C, Profit and Loss from Business, of Form 1040, U.S. Individual Income Tax Return, on an annual basis. And while Schedule C businesses get most of the same tax deductions as incorporated businesses, Schedule C business owners (sole proprietors) do not get the benefit of getting a tax deduction on “salaries” paid to themselves. Read on for some common questions sole proprietors have when it comes time to “pay” themselves from their business.
This may seem downright wrong, especially because many sole proprietors put their heart and soul in running the business, acting as the general manager, the accounting department, the marketing department, and the list goes on. While we know that sole proprietors put their blood, sweat, and tears into their business, the IRS does not see the legal distinction between business and personal activities, which is why sole proprietors report their business activities directly on their individual tax return, instead of a separate tax return required for other types of business entities. Due to the lack of separation between business and personal activities, sole proprietors are not considered employees and cannot take a tax deduction for any money they take out of the business to “pay” themselves. Instead payments to sole proprietors are considered draws from the business or advance payments from net income, not salaries and wages.
What are the tax implications of the money I take out of my business?
Unlike the salaries and wages that wage earners receive from a W-2, Wage and Tax Statement, the money sole proprietors take out of their business does not include Social Security and Medicare taxes. Instead the sole proprietor is responsible for paying 100% of these taxes at the time they file their tax return in the form of Self-Employment Tax which is calculated and reported on Form SE of the Form 1040. Although sole proprietors are responsible for paying 100% of the Social Security and Medicare Tax as Self-Employment Tax, they also receive a tax deduction for the employer-equivalent portion of the self-employment tax in figuring their adjusted gross income. This deduction only affects your income tax and does not affect either your net earnings from self-employment or your actual self-employment tax.
So how do I track payments to myself?
Before we answer this question, we stress the importance of sole proprietors maintaining separate business accounts (bank accounts, credit cards, etc.) to ensure that business activities are not comingled with personal activities so that only business activities are reported to the IRS. This not only simplifies the bookkeeping for the business but also keeps personal and business activities separate in the case of an IRS audit.
So now for the answer. Payments that sole proprietors make to themselves should be tracked within the equity section of the balance sheet as an Owner’s Draw as they are withdrawn from the business cash account. Owner’s draws represents a reduction of owner’s equity in the business and not a business expense which is why it’s recorded on the balance sheet and not on the income statement. The drawing account is closed out at the end of each year, with the balance transferred to the owner’s equity account.
Things to Consider
Keep in mind that the sole proprietor bears the responsibility of reporting and paying the taxes on any income from their business so detailed records should be maintained to support the income and deductions on their tax return. Also, consideration should be made whether quarterly estimated tax payments should be made as a self-employed individual, on annual basis at minimum but more often if business activity fluctuates significantly.
There are always special situations that can occur so if you have any questions regarding payments for sole proprietors, speak with your trusted tax advisors. As always, our CPAs at Mason + Rich are ready to answer any additional questions. Feel free to call us at 603-224-2000.