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 pay yourself. After all, one of the best parts of being self-employed is that you’re responsible for your own salary.
How do 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 easy. 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
When you run a one-person business as a freelancer, you’re usually classified as a sole proprietor for tax and other legal purposes.
Basically, if you start a business by yourself and don’t incorporate your business or form a limited liability company (LLC), you’re automatically a sole proprietor.
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).
To learn more about 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 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? Congrats! Just add it to any other income that you’ve made like interest income or your partner’s income if you’re married and filing jointly. After all of your various income sources are added together, the total amount 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 the Schedule C, Profit or Loss from Business. You use this to show whether you have a profit or loss from your sole proprietorship and list all of your business income and deductible expenses. Then, you’ll file it with your tax return.
Should You Set Up a Business Checking Account? Yes!
Sure, as a sole proprietor, you could use your personal checking account for your freelance business, but we don’t recommend it. Instead, set up a separate checking account for your business.
Blerg- more things to set up! Why should I bother doing this?
Because it’s the perfect way to keep your business assets separate from your personal assets. Which makes tracking your income and expenses, and figuring out how much to pay yourself, way easier.
Here’s how to use your snazzy new business checking account: Deposit all of the money that your business earns here. and pay for all of your business-related payments using this account.
Pro tip: Don’t use your business account for personal expenses, or your personal account for business expenses. Keeping things separate makes it a lot easier to track all of your business income and expenses. And that will be super helpful when you’re paying taxes or if you’re ever audited by the IRS.
But what if I’m a single-member LLC?
As a single-member LLC, the main difference is that you should open up a separate bank account in your LLC’s name. This is 100% necessary. If you don’t do this, you could end up losing your limited liability protection from debts and lawsuits.. Not good!
Want to learn more about opening up bank accounts for sole proprietorships and LLCs? Check out this article.
Take an Owner’s Draw
To pay yourself as a sole proprietor, all you have to do is transfer money from your business account to your personal bank account. It’s super easy.
Better yet, set up ongoing bank transfers between your business account to personal account so you never forget to pay yourself.
This is called an “owner draw” or “personal draw”. It’s called a “draw” because you’re drawing money out of one account to put it into another account.
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.
An Owner’s Draw Isn’t Taxable
When you’re a sole proprietor, you aren’t an employee of your business; you’re the business owner.
This means that your owner’s draw isn’t an employee paycheck and no tax is withheld from your draws.
But, even though you don’t need to report owner’s draws to the IRS, you should keep track of them.
Also, owner’s draws shouldn’t be listed in your business profit and loss statement or Schedule C because an owner’s draw isn’t deductible as a business expense. The same goes for contributing personal funds to your business. Don’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’s net self-employment income? That’s your total business income, minus business expenses (not including draws).
That means 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.
Let’s do an example:
Alisha is a freelance app developer and a sole proprietor. This year, she made $100,000 in profit from her business. During the year, she withdrew $70,000 from her business bank account and put that money into her personal checking account.
Alisha doesn’t list the $70,000 as income or as an expense on her Schedule C or mention it at all on her tax return. Instead, she pays income and self-employment taxes on her $100,000 total business profit, which is what’s reported on her Schedule C.
Okay, But How Much Should You Pay Yourself?
As a sole proprietor, you can pay yourself as much as you want and as often as you want. It’s really up to you. The IRS doesn’t care about how often you take owner’s draws or how much you take out.
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. While others pay themselves 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 enough money in your business bank account to pay your fixed monthly business expenses, like rent, utilities, and insurance.
Don’t Forget to Pay Estimated Taxes
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.
Sole proprietors should make four quarterly tax payments throughout the year. These payments are called your estimated taxes, and each estimated tax payment includes your self-employment and income taxes.
If you expect to owe at least $1,000 in federal tax for the year, you’re required to pay estimated taxes.
Remember: the amount of your owner’s draws doesn’t have any bearing on how much estimated tax you 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. Here are the due dates for estimated taxes:
|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 the following year|
How do you calculate your estimated taxes? 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.
Don’t 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 their taxes. By depositing a portion of every payment they receive, they build up enough funds to cover their taxes.
If you take this route, the amount you deposit will depend on your federal and state income tax brackets and your total 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 can take that money and put it to use in other, more exciting, areas of your business.
What if You’re Running an S Corp?
If you’ve decided to set up your business as an S Corp, 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 which aren’t subject to payroll taxes.
- After you incorporate your business, you’ll be considered its employee for tax and legal purposes. That means you’ll have to pay yourself like an employee, with your business paying half of your payroll taxes.
- Both your 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 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 Corp.
Paying Yourself as a Freelancer Can Be Easy!
Even though there might be a learning curve at first, paying yourself as a freelancer isn’t as hard as you think.
And, with services like Collective, you can relax knowing that you’re doing it all the right way. That’s because the experts at Collective help you with the legal and financial side of running your business like your accounting, banking, payroll, taxes, and more. You’ll always stay on top of your finances, stress-free.
Now that you know the basics of paying yourself as a freelancer, you can go forth with greater confidence and dollars in your wallet. So, what are you waiting for? Go ahead and pay your bad self.
Stephen Fishman 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.