The Tax Benefits of Paying Yourself as a Freelance Business Owner
The Draw Method
The draw method is likely how most freelancers are paying themself. Also known as the owner’s draw, freelancers will take from the companies profits as they see fit. It doesn’t really matter how much you withdraw from your account because the draw itself doesn’t have any effect on tax.How Tax is Treated With the Draw Method
As a sole proprietor, you’re entitled to as much of your company’s money as you want. Keep in mind that freelancers won’t be taxed differently if they make an owner's withdrawal, but a sole proprietor will. Anything a sole proprietor withdraws is treated as business income.That means you’ll have to pay income and self-employment taxes for Social Security and Medicare quarterly, on an estimated basis, and when you file your individual tax return.
Single-owner LLCs are treated as sole proprietorships by default for federal tax purposes. It’s essential to keep your business and personal income separate. Depending on your business structure, you can reduce your taxes by reducing the amount you draw from your company.
The Salary Method
Freelancers who pay themselves a salary regularly receive a fixed amount of money. Some owners will use a paystub maker to physically “pay” themselves from their accounts. You’ll automatically deduct state and federal income taxes from your pay by using the draw method.How Tax is Treated With the Salary Method
If you decide to take a salary and/or bonus, you’ll be taxed personally on your income tax return based on your regular tax rate. Keep in mind that only members of a not-for-profit, S Corp, or C Corp can use the salary method. Freelancers can change their LLCs to an S Corp or C Corp.In an S Corp, freelancers are allowed non-taxable distributions. C Corps can also take distributions, but they’re taxable. A not-for-profit will only be taxed at their regular tax rate.
If you pay yourself a salary, know that it isn’t static. You can increase your salary or give yourself a lump-sum bonus at the end of the year if your net profit grows more than 15%. You're also allowed to give yourself a quarterly bonus if you receive a net profit after each quarter.
Paying via a salary can get tricky because you’re limited in the amount you can take out each year. If you take too much out of the business, you may hurt your growth. If you try to put that money back in, you may be doubled tax. You’ll need to plan appropriately with this method.
The Dividend Method
A dividend is the distribution of some of a company’s earnings to its shareholders. If you’re a business entity, you are a business shareholder. LLCs cannot distribute with dividends, but freelancers who own a closely held corporation (S Corps or C Corps) can.How Tax is Treated With the Dividend Method
If the business owner chooses to pay themselves with dividends, the company (freelancer) will pay the income tax on the income earned. This is true for S and C corps who elected to be taxed as a corporate entity. However, you don’t have to be a public corp to take dividends.Dividends are taxed less than self-employment and income tax, making dividends the best way to receive compensation if you have access to it. LLCs can technically pay in dividends, but they’re called “distributions'' instead, so some sole-proprietors may be able to use this method.
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Posted - 02/01/2022
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