NOTE: I wrote this post in 2014, so be aware of its age.
When I talk about the topic of salaries in sole proprietorships, I typically get confused looks from people. They run a sole proprietorship, they take money out of the business to live on or to reward themselves … that’s a salary, right?
Variations of this include: “I get to deduct my salary, right?” or “I only have to pay taxes on my salary, right?”
The answer to all of these questions is … NO.
In a sole proprietorship, the proprietor is free to take money out of the business at any time, of course. People often refer to this informally as “taking a salary.” But it’s not really a salary. In tax terminology, it’s called taking a “draw.”
For tax purposes, draws are a “nothing,” meaning they are not accounted for on the tax return at all.
When a sole proprietorship accounts for its net income, it does so by taking gross income minus expenses. Those expenses DO NOT include draws. So, the proprietor is taxed on the net income of the business and gets no deduction for the draws.
John owns a sole proprietorship. His gross income is $100,000. His expenses are $40,000. He takes out another $40,000 in draws. John’s net income for tax purposes is $60,000 (gross income minus expenses). His draws don’t count as expenses. He’ll report $60,000 as income on his personal tax return.
Same scenario as Example 1 except John takes $0 in draws because he spent the year living on savings and he wanted to keep all of the proprietorship’s income within the business to fund future growth. In this case, John still reports $60,000 as income on his tax return, even though he took no money out of the business at all.
This is hard for people to wrap their heads around, especially if they’re new to self-employment.
One other note: if you have a one-person LLC and you haven’t made any elections with the IRS to be taxed as a corporation, then you’re taxed as a sole proprietorship and the things discussed in this blog post apply to you, too.