Although there are tons of great reasons to start your own business, one of the primary motivating factors for most entrepreneurs is the possibility of earning more money in their profession and securing a better financial situation for themselves and their families.
While there is no guarantee that starting a business will result in large profits, being an entrepreneur does open up this possibility. No matter how much money your business generates, the business structure you choose may impact how much money you, as the owner, take home as income in a given year.
Many business owners start out as sole proprietors, and they can even maintain their structure as a sole proprietorship after they hire an employee. As a sole proprietor, it’s essential to know how your business income is related to your personal income.
What is a sole proprietor?
Before getting into how your business’s profit will be allocated as the owner of a sole proprietorship, it’s important to understand the distinction between this business structure and a corporation. When you incorporate, your company becomes a separate legal entity distinct from you, with many of the same rights and responsibilities as a person.
This means the company can make a profit, be responsible for debts, file taxes, and have legal liability, all separate from you. It also means that you are distinct from the organization even if you are the sole shareholder.
Sole proprietorships, on the other hand, are not distinct from their owners. When you register your sole proprietorship, your business does not become a separate legal entity. You do not file separate taxes for yourself and your business, and you take on any business liabilities as your own.
Who gets the profit from a sole proprietorship?
In short, sole proprietors automatically get the profit from a sole proprietorship. Since you and your business are not actually distinct legal entities, you don’t need to formally draw an income from your small business revenue. Instead, your finances and those of the small business are one and the same. If your self-employment income from your sole proprietorship increases in a given year, such that it pushes you into a higher income tax bracket, you must declare that income as your own on your tax return.
You can certainly take advantage of things like small business tax deductions that reduce your taxable net income. However, when it comes to determining your taxable income as a sole proprietor, it’s important to understand that you do not specify a taxable salary for yourself that you draw from the company. Instead, the business’s profit automatically counts as individual income since you and your business are a single legal entity.
Who is responsible for the debts in a sole proprietorship?
Just as the sole proprietor receives all of the company’s revenue, they also take on liability for any debts incurred by the business. For example, while a corporation can declare bankruptcy without its owners or shareholders having to do so as well, a sole proprietor does not have this option. The owner must pay off any business debts or risk declaring bankruptcy themselves.
This liability can make you more exposed to risk in some ways as a sole proprietor, which is why it’s important to determine how much you can draw and spend as personal income while keeping your company in a healthy financial situation.
As a business owner, your business revenue appears on your income tax return. However, this doesn’t mean you should behave as though you can spend all of that as personal income. This is one reason why some people choose to incorporate their businesses, even as a single-person corporation. It allows them to separate corporate profits from personal income, which opens up the chance to take advantage of opportunities to lower the amount of personal income tax they pay while keeping more profits in the company.
How do I pay myself as a sole proprietor?
As a sole proprietor, you won’t formally draw a salary from your company. Instead, you can set up a business bank account that is distinct from your personal account. A business checking account is a great way to keep the money your business generates separate from your individual bank account. This is good practice for bookkeeping and accounting purposes and if you ever seek funding for your businesses. Anyone investing in your business will want to see a financial statement, and this will be much simpler to create if you keep your business finances distinct, even if you’re a sole proprietor.
You can draw a “salary” from this account monthly that covers your personal expenses and is sustainable for the business as well. There is a range of approaches you can take to determine how much you should be paying yourself. One is to determine how much you need to get by, covering all your essential expenses and eliminating unnecessary or frivolous expenses. You can increase this amount down the line as your business grows.
Another approach is to calculate your payment using the basic worth formula. While there is a level of subjectivity to arriving at this number, a formula you can use as a rule of thumb is to take your current salary (or the last salary you had before starting your business) and add a small percentage to this amount. The percentage is four times the rate of inflation. So, if you were earning $4000 monthly before, and the rate of inflation is two per cent, you might use the formula 4000 + 4000(0.02*4) = $4320.
The rationale for the basic worth formula is that it considers that your value as the owner of the business is greater than if you were an employee. You also have increased responsibility as a business owner, which should be reflected in your personal net income.
Is there an upper limit to the pay I can draw from my sole proprietorship?
When determining how much money you will allocate from your business accounts to your monthly paycheck, it’s important to keep in mind that a salary increase also represents an increase in overhead costs. For example, if you are a year into starting your new business and have just reached your break-even point, you will need even greater revenue to break even again if you suddenly increase your salary.
A sustainable approach to financial planning as a business owner is to tie your own pay to your business’s profits. If you break even if you make profits representing 15 per cent growth over the next quarter, you may increase your income by 15 per cent. If you don’t do this and instead pay yourself all of the additional business profits, you may run into issues when seeking financing.
For example, a bank might wonder if you can repay a loan if the small business seems to just be covering its overhead costs, including your salary. A potential investor may hesitate to buy equity in your company if it doesn’t look like it’s profitable. Even if you don’t plan to seek financing of any kind, your firm may run into unexpected expenses for which you’ll want to have some savings in your business account.
Sole proprietors enjoy the benefit of only having to file a single tax return and aren’t required to separate their business and personal finances. Nevertheless, keeping your business finances organized and distinct from your personal finances is a great practice to get into, even if you are new to self employment. By drawing a limited salary from your total self-employment revenue every month, you’ll be building habits that will help you grow a successful and financially healthy enterprise.
This article offers general information only, is current as of the date of publication, and is not intended as legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. While the information presented is believed to be factual and current, its accuracy is not guaranteed and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by RBC Ventures Inc. or its affiliates.