How To Run Payroll If You Are Self Employed

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Managing day-to-day business operations is a little different when you’re self-employed. Payroll can be one of the more time-consuming tasks since you must calculate wages and taxes.

Whether you’re a sole proprietor or hire contractors and W-2 employees, you can follow these steps to run payroll yourself. 

What Does it Mean to Be Self-Employed?

self employed lady with business

Being self-employed means that you don’t work for an employer. Instead, you own your own business.

Depending on your business industry, you may work consistently for the same clients or just complete one-time projects for customers.

It can be a full-time income or a part-time side hustle that can eventually replace your day job. You may also hire contractors or employees if you have the budget and need.

As a result, you have more liberty with how you work. However, there are more administrative responsibilities as you handle payroll, payroll taxes, human resources and other tasks that don’t fit into your job description.

While every freelancer makes money differently, you draw a salary, pay self-employment tax and file additional income tax forms. Since you’re self-employed, your taxable income reports on tax forms like a Form 1099 instead of a W-2. 

Self-Employed Business Structure

Business Structure

How you structure your business can determine some of your payroll processes. An accountant can help you choose the best structure for paying yourself a salary, pay self-employment tax and determine how to pay contractors as well as employees.

Your business structure will be one of the following:

The self-employment tax treatment can differ for each filing status, with S-Corp and C-Corp businesses being taxed as corporations. Therefore, the payroll rules can be more formal for these entities. 

Sole Proprietor vs. Independent Contractor

If you’re a one-person business that hasn’t formed an LLC or corporation yet, you will file a Schedule C with your federal Form 1040 to report your business income and expenses. 

As you sign up for freelancer business tools, you may need to distinguish if you’re a sole proprietor or an independent contractor. The self-employment tax treatment is similar, but how you receive payments from clients can differ.

Sole proprietors typically invoice clients and can receive payment from various platforms, including direct deposit, third-party payment apps or checks.

Independent contractors are paid through the client’s desired platform and receive a set salary or hourly rate.

However, independent contractors are not eligible for employee benefits like W-2 workers. Two examples are being an IT programmer or delivery app driver

It’s possible to run payroll for either self-employment status, and it’s not uncommon to fall into both camps simultaneously.

You can have all of your business income deposited via direct deposit into the same banking account and make personal withdrawals as you deem fit. 

With either status, you’re responsible for self-employment tax since your client won’t withhold any money from your payments. This means that you must remember to set some cash aside for the tax collector. 

What is Payroll?

Image of payroll

Payroll is the process of paying independent contractors and W-2 employees their earned income, income taxes and corresponding benefits like vacation time, medical and retirement plan contributions. 

Large companies have a payroll department that solely focuses on issuing paychecks as well as withholding self-employment tax and other voluntary contributions. 

There are three different methods to run payroll and payroll taxes when you’re self-employed.

Manual Payroll

With manual payroll, you send payment by check or through a digital wallet like PayPal and track transactions with a paper ledger or a self-made spreadsheet using Microsoft Excel or Google Sheets. 

A manual payroll system can be sufficient if you’re just starting, and it’s easy to track income as well as expenses. For instance, it’s great if you have a part-time side gig in addition to your day job.

However, you should consider upgrading to a dedicated platform as your business expands or if you need advanced financial help to calculate your payroll taxes and other withholdings.

Payroll Software

Payroll software lets you schedule payments to employees through your accounting software. This tool can also pay merchant invoices and balance the books.

It can be more affordable to use payroll software vs. a full-service payroll company, but it lacks certain in-depth features.

Payroll Service

You can also use a dedicated payroll service for hands-on help with self-employment tax payments and year-end tax documents. This option can even make it easier to pay independent contractors and W-2 employees you employ now or in the future.

How to Pay Yourself When You Are Self-Employed

There are several factors for self-employed individuals to consider when running payroll or payroll taxes. 

1. Open a Business Bank Account

open bank account

The first step is opening a business checking account to receive client payments and pay bills. This account funds your payroll transactions. 

Having a dedicated spending account prevents self-employed individuals from combining their business and personal funds. It also makes tracking tax-deductible expenses easier.

You can connect this account to your preferred payroll provider to pay yourself. It’s also possible to transfer funds to your personal bank through ACH transfers if you don’t use a payroll service initially. 

Most banks require these business details to open an account:

  • Business name and mailing address
  • Proof of business name registration
  • Employer Identification Number (NOT a Social Security number)
  • Personal identification information

Banks and payroll services typically require an EIN to serve the self-employed.

If you currently use your Social Security number to file your taxes, you can apply for an EIN through the IRS for free. Typically, your Social Security number won’t be enough to open an account.

Additionally, business formation services offer this feature when you incorporate.

2. Determine How Often and How Much to Pay Yourself

When to pay yourself

You will need to decide how much you want to pay yourself and how frequently. This exercise can ensure you have a healthy balance to pay your personal bills while having sufficient funds to invest in your business. 

Decide When and How Often to Pay Yourself

Each business owner establishes a different payment schedule for themselves and their employees.

You may decide to draw funds as your clients pay each invoice, allowing you to get paid multiple times each month. That can potentially be several times per week.

Other people prefer more structure with weekly, biweekly or monthly payments. You may also decide to set fixed paydays, such as the 1st and 15th of every month.

Gusto is an online payroll software that can help you schedule automatic payments for yourself and any hired help at your desired frequency.

With Gusto, it’s possible to receive additional one-time payments at no extra cost if you have a productive month or need more personal funds.

The service sends a payment confirmation email once the money is deposited into the personal account.

Learn More: Gusto Payroll Review: Is It Worth It?

Determine How Much To Pay Yourself

how much to pay yourself

You will want to make sure you pay yourself enough to cover your most common monthly expenses plus a little extra to have some wiggle room in your spending plan.

Some of the items to budget for include:

  • Childcare
  • Food
  • Housing
  • Insurance (i.e., auto, health and life)
  • Investing (taxable and retirement)
  • Self-employment tax
  • Utilities 

Make sure you keep enough money in your business banking account to cover essential expenses, such as licensing fees or software purchases. 

Additionally, your business income and expenses can be variable. As a result, you may strive to keep your salary as low as possible to avoid using up your cash reserves. 

For example, you may consistently earn from $5,000 to $6,000 per month. To prevent overdrawing your account, your fixed monthly salary may total $4,000.

Along with helping schedule your payment frequency and amounts, Gusto payroll software has a burn rate calculator.

This estimates how long your cash reserves will last if you need to invest money into your business to create a foundation to earn more revenue.  

Adjusting to a self-employment payroll mindset requires a little extra work at first because you pay out of pocket for several core expenses that employers automatically withhold.

Two prime examples include medical insurance and retirement plan contributions.

3. Pay Yourself

Pay Yourself

After setting up your payment framework, it’s time to pay yourself at your desired intervals. It’s easy to transfer these funds to a free checking account to avoid banking fees that reduce your take-home pay. 

The process can be automated so that you have one less administrative task to complete each month. Automating payroll also ensures there are sufficient funds in your personal account for your recurring bills.

If you hire contractors or employees, the payroll processor will pay them according to your schedule. They will receive their funds within a few business days. 

Owner’s Draws

Your payroll provider may allow you to make owner’s draws along with traditional payroll payments. 

Either payment method transfers funds from your business account to your personal account. The primary difference is that owner’s draws are not taxed at distribution, while payroll deposits are.  

Owner’s draws are a convenient way to tap your business revenue for personal expenses, but they require more year-end paperwork since you must attach a Schedule K-1 to your tax return.

Additionally, not all payroll providers furnish this tax document. As a result, look for ways to run payroll for extra payments to avoid a potential tax headache.

4. Pay Taxes

Taxes

Income taxes are a variable expense that can be challenging for new and experienced entrepreneurs to calculate. This is because the self-employment tax rates differ from traditional employees. 

You’ll generally pay more in taxes because you deal with additional Social Security and Medicare costs.

Additionally, you’re not filling out a W-4 withholding form when you’re self-employed. Instead, you receive a pre-tax gross salary for each paid invoice.

It can be easy to forget that you owe income taxes and spend that portion instead. 

While the self-employment tax treatment is different from payroll taxes that you paid as a W-2 employee, Gusto can help self-employed individuals calculate their tax bill, pay estimated taxes and generate year-end tax documents. 

You can also share access to Gusto’s payroll software with your accountant, which can make preparing your Form 1040 easier.  

Federal Self-Employment Taxes

pay quarterly taxes

Federal self-employment taxes apply to all freelancers and consist of self-employment tax and federal income tax.

The federal self-employment tax is 15.3% versus 7.65% for an employee. This is because you pay for all of your Social Security and Medicare taxes.

Your tax liability consists of the Social Security as well as Medicare payroll taxes, at 12.4% and 2.9%, respectively.

Your earned income is also subject to federal income taxes ranging from 10% to 37%, depending on which brackets your adjusted gross income falls in. 

You’re unable to calculate your final tax liability until you file your taxes and claim tax deductions as well as credits, but you can make an educated projection.

Most business owners pay federal estimated income tax on a quarterly basis to avoid potential tax penalties. Quarterly payments are expected if your annual tax liability exceeds $1,000. 

The quarterly estimated due dates for self-employed individuals are:

  • April 15: January 1 to March 31 (1st quarter) 
  • June 15: April 1 to May 31 (2nd quarter)
  • September 15: June 1 to August 31 (3rd quarter)
  • January 15: September 1 to December 31 (4th quarter)

You may only have to pay estimated taxes once per year if you won’t owe more than $1,000. However, making smaller payments through the year reduces the chance of a huge end-of-year tax bill because your calculations were inaccurate.

When you set up your Gusto payroll software account, one of the interview questions asks if you have a Form 941 (quarterly payments) or Form 944 (annual payment) with your EIN.

The payroll provider will automatically calculate your estimated tax liability and submit payment when necessary.  

State Self-Employment Taxes

State Taxes

If you’re subject to state income taxes, you will need to budget for this tax liability as well. Once again, you can schedule estimated quarterly payments and cover any difference after filing your return.

Gusto’s tax calculator can help self-employed individuals project their state-level income and payroll taxes. You can also check with your state tax agency to determine your quarterly and year-end obligations. 

Local Self-Employment Taxes

local taxes

Certain cities and counties require quarterly or annual self-employment tax payments. For instance, Philadelphia requires individuals, partnerships, LLCs and corporations to file a Business Income and Receipts Tax (BIRT) form.  

Summary

While most large companies have a dedicated payroll department to verify their employees are correctly paid, running payroll by yourself doesn’t have to be complicated.

Switching to a full-time payroll service can be a wise decision as your business grows since it makes bookkeeping easier and more accurate.

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