Whether you’re first starting out as a freelancer or you’re a self-employed freelancer who’s already making money, it’s vital to understand how to go about paying yourself. After all, being self-employed means you’re responsible for your own salary.
How can you take money out of your business so you can pay your personal bills? While you might not know where to start, the truth is that paying yourself as a freelancer is actually pretty simple. Seriously!
Below is our short guide to paying yourself when you’re a freelancer. Just keep in mind that, while we’ve made every effort to ensure that this information is up-to-date and accurate, it doesn’t constitute legal advice or tax advice, and it shouldn’t be considered a substitute for legal or tax advice. If you need personalized guidance, be sure to consult with a lawyer or tax expert.
- Your Classification: Sole Proprietor
- Should You Set Up a Business Checking Account? Yes!
- Take an Owner’s Draw
- An Owner’s Draw Isn’t Taxable
- Okay, But How Much Should You Pay Yourself?
- Don’t Forget to Pay Estimated Taxes
- What About When You’re Running an S Corporation?
- Paying Yourself as a Freelancer Can Be Easy
When you’re running a one-person business as a freelancer, you’re ordinarily classified as a sole proprietor for tax and other legal purposes.
Basically, if you start a business by yourself and you don’t incorporate your business or form a limited liability company (LLC), you’re automatically a sole proprietor. Also, even if you form a one-owner LLC, you’re still considered a sole proprietor for tax purposes unless you elect to have your business taxed like a corporation (but that’s actually rare).
By the way, if you’d like more information on filing your taxes, check out: A Freelancer’s Introduction to Getting Taxes Right. You can also click here to learn about the different business entities and how they’re taxed.
Getting back to sole proprietorships, when you operate as a sole proprietor, you and your business are one and the same for tax purposes. Therefore, sole proprietorships don’t pay taxes or file tax returns. Rather, you are required to report the income that you earn, or the losses that you incur, on your own personal tax return (IRS Form 1040).
Earned a profit from your freelance business? Great! Just add it to any other income that you’ve made. For example, you’d add it to your interest income or to your spouse’s income if you’re married and filing jointly. Then, the total amount, after all of your various income sources are added together, is what will be taxed.
But, wait, there’s another tax form that you need to fill out when you work as a sole proprietor. That’s IRS Schedule C, Profit or Loss from Business. You’ll use this to show whether you have a profit or loss from your sole proprietorship, so you’ll list all of your business income and deductible expenses on this form. Then, you’ll file it with your tax return.
Sure, you can use your personal checking account for your freelance business when you’re operating as a sole proprietor. But it is always a great idea to set up a separate checking account for your business, so definitely consider doing that instead.
Why should you go through the trouble of setting up a separate business bank account when you could just keep doing what you’ve been doing with your personal bank account? Well, it’s a perfect way to keep your business assets separate from your personal assets.
All of the money that your business earns should be deposited into your business bank account. And all of the business-related payments that you make should be made by check or electronic withdrawal from that account.
Pro tip: Don’t use your business account for personal expenses, or your personal account for business expenses. Keeping things separate will make it a lot easier to track all of your business income and expenses. And that will be super helpful when it comes to paying taxes, as well as extremely helpful if you’re ever audited by the IRS. See how having a separate bank account for your freelance business is a smart move?
What if you form a single-member LLC? In that case, open up a separate bank account in your LLC’s name. This is necessary. If you fail to do this, you could end up losing the limited liability from debts and lawsuits that your LLC is supposed to provide. Not good!
Want to learn more about opening up bank accounts for sole proprietorships and LLCs? Check out this article.
To pay yourself when you’re a sole proprietor, all you have to do is write a business check to yourself and then deposit that money into your personal bank account. Easy enough, right?
Alternatively, you can do what’s referred to as an “owner’s draw” or a “personal draw”. Simply set up periodic electronic bank transfers between your business account and personal account. It’s called a “draw” because you’re drawing money out of one account to put it into another account. So simple!
For accounting purposes, an owner’s draw is a distribution from your owner’s equity account. This account represents your investment in your business, and it includes any personal funds that you put into your business, as well as the profits that it earns.
When you’re a sole proprietor, you aren’t an employee of your business; you’re the business owner. Therefore, your owner’s draw isn’t an employee paycheck, and no tax needs to be withheld from your draws because taking an owner’s draw isn’t a taxable event. But, even though you don’t need to report owner’s draws to the IRS, you should keep track of them.
Note: Owner’s draws shouldn’t be listed in your business profit and loss statement.
An owner’s draw isn’t deductible as a business expense, so it shouldn’t be listed on your Schedule C. And you also shouldn’t list it as business income on your Schedule C.
Something else worth noting: the amount of your owner’s draws has no bearing on how much tax you must pay on your business income. When you’re a sole proprietor, you pay income tax and self-employment tax (Social Security and Medicare taxes) on your net self-employment income, as shown on your Schedule C, not on your draws.
What is net self-employment income? That’s your total business income, minus business expenses that don’t include draws. As a result, you pay the same tax if you leave all of your money in your business bank account or you take all of your profit out and put it into your personal account through owner’s draws. Make sense?
Here’s an example to help clarify this topic:
Bill is a freelance app developer and a sole proprietor. This year, he made $100,000 in profit from his business. During the year, he withdrew $70,000 from his business bank account and put that money into his personal checking account. He doesn’t list the $70,000 as income or as an expense on his Schedule C, or otherwise record it on his tax return. He pays income and self-employment taxes on his $100,000 total business profit, as shown on his Schedule C.
As a sole proprietor, you can pay yourself as much as you want, as often as you want. It really is totally up to you. The IRS doesn’t care about how often you take owner’s draws or how much you take out. Not bad, right?
What the IRS does care about is this: that you report your total business income and expenses on your Schedule C, and that you pay tax on your profit.
Some freelancers opt to pay themselves the same amount every month. Of course, you don’t have to do this if this doesn’t work for you. If you wanted to, you could pay yourself a different amount every month. You could even take out every penny of profit from your business account every month, or leave a certain amount in there. As far as your taxes go, it doesn’t make a difference! But here’s the thing: you’ll probably want to leave at least enough money in your business bank account to pay your fixed monthly business expenses, such as rent, utilities, insurance, etc.
So, go ahead, pay yourself whatever you wish!
You don’t have to withhold any tax from your owner’s draws, but you also aren’t allowed to wait until April 15 to pay your taxes in one lump sum if you’re a self-employed sole proprietor.
Sole proprietors can make four quarterly tax payments throughout the year. These payments are referred to as estimated taxes, and each estimated tax payment will include your self-employment taxes and your income taxes.
If you expect to owe at least $1,000 in federal tax for the year, you must pay these estimated taxes.
Remember: the amount of your owner’s draws doesn’t have any bearing on how much estimated tax you have to pay. Your estimated tax is based on the profit your business earns.
You’ll pay estimated taxes in four installments, with the first one due on April 15. The table below gives you the whole schedule to make things as clear as possible:
|Income received for the period:||Estimated tax due:|
|January 1 through March 31||April 15|
|April 1 through May 31||June 15|
|June 1 through August 31||September 15|
|September 1 through December 31||January 15 of following year|
How should you calculate how much estimated tax to pay? You could either:
- Pay the same amount in tax that you paid the previous year
- Estimate what your business profit will be this year, and then base your payments on that amount
What happens if you don’t pay enough in estimated tax during the year? Well, you’ll have to pay an underpayment penalty when you file your annual income tax return.
Pro tip: You don’t want to take out so much money in owner’s draws that you don’t have enough left to pay estimated taxes. A lot of freelancers set up separate bank accounts specifically for saving up for the taxes that they’ll owe. By depositing a portion of every payment they receive, they have some assurance that they’ll have enough funds to cover their taxes. If you take this route, the amount you should deposit will depend on your federal and state income tax brackets, as well as the amount of tax deductions. Depending on your income, you’ll likely need to deposit 25-50% of your pay. The good news is that, if you end up depositing more than you actually need, you could always take that money and put it to use in other areas of your business.
Here’s another example:
Amy is a freelance writer who lives in Massachusetts. She’s in the 22% federal income tax bracket, and she has to pay a 6% state income tax. She also has to pay a 15.3% self-employment tax. This comes out to 43.3% of her pay. But she doesn’t have to set aside that much because her deductions will reduce her actual tax liability. Using the amount of her deductions from last year as a guide, she calculates that she needs to set aside at least 35% of her income for estimated taxes.
If you’ve decided to set up your business as an S corporation, things are a bit different when it comes to paying yourself.
- S corp shareholder-employees must pay themselves a reasonable employee salary, which is taxed. But they can also take distributions that don’t incur payroll taxes.
- After you incorporate your business, you’ll be considered its employee for tax and legal purposes, so you’ll have to pay yourself like an employee, with your business paying half of your payroll taxes.
- Both salary and distributions have to be reported to the IRS.
- Although distributions from an S corp aren’t taxed when they’re given out, you’ll need to pay income tax on your distributions.
We cover all of this in much greater depth here: Freelancer’s Guide to Paying Yourself a Salary From an S Corporation.
Ultimately, even though there might be a bit of a learning curve at first, paying yourself when you’re working as a freelancer isn’t all that challenging after all. And, with services like Hyke, you can rest assured that you’re doing it all the right way. That’s because the experts at Hyke can support you when it comes to business accounting, banking, payroll, taxes, and more, so you’ll always stay on top of your finances and get paid what you deserve.
Now that you know the basics of paying yourself as a freelancer when you’re running a business as a sole proprietor, you can go forth with greater confidence. So, what are you waiting for? There’s never been a better time to be self-employed!
Stephen has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.