The Effective Way to Pay Yourself as a Contractor

As a contractor, the way you pay yourself is a crucial aspect of running a profitable and compliant business. Choosing the right method can save you significant time and hassle down the road. This guide will explore the most effective ways to manage your finances as a contractor, including the best practices for payroll and taxation.

Understanding Your Payment Options

When deciding how to pay yourself in a contracting scenario, you have several options to consider. The easiest but least efficient method is to take draws from your business account when there is cash available. However, this approach bypasses essential record-keeping and makes it harder to track the profitability of each job or project. By systematically paying yourself, you can gain valuable insights into your business and improve your financial planning and bidding strategies.

Pros and Cons of Taking Draws

Pros: Flexible and immediately available. No formal payroll process required. Relatively easy to implement. Cons: No consistent record-keeping. Difficulty in tracking income and expenses for tax purposes. Potential for misallocation of funds or overspending.

Advocating for Hourly Wages

For transparency and efficiency, I recommend paying yourself as an hourly employee. This method ensures that you maintain accurate records of your time spent on each project, which is essential for assessing the profitability of your work. By tracking your time, you can determine your cost per hour for different types of projects. This information is vital for more accurate bidding on future jobs and can help you optimize your pricing strategies.

Implementing an Hourly Wage System

Set a reasonable hourly rate based on your market value and experience. Create detailed timesheets to log the time spent on each project. Regularly review and adjust your rates to stay competitive and profitable. Ensure compliance with local labor laws and regulations.

Managing Owner's Draws

While paying yourself as an hourly employee is ideal, there are still situations where you may need to tap into your business account. A common practice is to top up a personal spending account by transferring funds from your business account. This method is straightforward and can help you manage your personal finances while keeping your business funds separate. However, it is crucial to stay within the guidelines set by your business entity structure to avoid tax complications.

Tax Considerations for Contracting

The entity structure of your business significantly impacts how you pay yourself and how you handle taxes. Here are the key considerations:

Sole Proprietorship or Single Member LLC

As a sole proprietor or single member LLC, all income is subject to income and self-employment taxes on Schedule C and Schedule SE, respectively. Income is taxable regardless of whether you take draws or not. Owner's draws do not affect your income and self-employment tax.

LLC with S-election

As an S corporation, you must pay yourself a reasonable wage and file a W-2. Loading payments and distributions are treated differently and may have different tax implications. Distributions are not taxed as dividends but as ordinary income.

Corporation

If the business is structured as a corporation, you can pay yourself a W-2 wage and/or take distributions. Distributions are not called dividends but are taxed under dividend rates. Income is subject to corporate taxes and your wages are subject to payroll taxes.

Conclusion

As a contractor, choosing the right method for paying yourself is essential for maintaining accurate records and staying compliant with tax laws. Whether you opt for an hourly wage or use owner's draws, ensure that you follow the guidelines for your specific business entity structure. Staying informed about the latest tax regulations can help you make the best financial decisions for your business.