Fear of failure and a lack of support or delegation can lead business owners to work more than their employees. Over 80 percent of business owners work more than 40 hours a week. When a traditional salary doesn’t match their ever-changing job responsibilities, many seek a more flexible option. Owner’s draws, also known as “personal draws” or “draws,” allow business owners to withdraw money as needed and as profit allows.
A draw may seem like a superior option over a salary. But is it always the best solution? What are the tax implications? Keep reading to determine if owner’s draws are the best fit for your business.
An owner’s draw is when an owner of a sole proprietorship, partnership or limited liability company (LLC), takes money from their business for personal use. The money is used for personal expenses as opposed to taking a traditional salary.
An owner’s draw can help you pay yourself without committing to a traditional 40-hours-a-week paycheck or yearly salary. Instead, you make a withdrawal from your owner’s equity. Owner’s equity includes all of the money you have invested in the business, plus any profits and losses.
An owner can take up to 100% of the owner’s equity as a draw. However, the more an owner takes, the fewer funds the business has to operate.
Owner’s draws are ideal for business owners who put in more than 40 hours a week or have significantly different profits from month to month. Plus, if you are the sole proprietor, taking a draw is the only way to provide yourself with an income from your business.
If there are any co-owners, you should run any draws by all those involved. Hiding draws can lead to distrust among owners and a reduced cash flow.
Owner’s draws aren’t limited to cash withdrawals such as debiting from an ATM, transferring money between accounts online, or writing a paper check. Business owners can also benefit from material goods perks. For example, if your company has discount opportunities with vendors, your company can purchase the discounted goods and give them to you. The price of the goods would also be considered a draw.
Owners of some LLCs, partnerships and sole proprietorships can take an owner’s draw. S corporations and C corporations cannot take draws. However, corporation owners can use salaries and dividend distributions to pay themselves.
>> Learn More: LLCs vs. S Corporations
There are few rules around owner’s draws, as long as you keep up with your withdrawals with the IRS. You can take out a fixed amount multiple times (similar to a salary) or take out different amounts as needed.
Since draws are not subject to payroll taxes, you will need to file your tax return on a quarterly estimated basis. However, all owner’s withdrawals are subject to federal, state, and local income taxes and self-employment taxes (Social Security and Medicare).
Owner’s draws should not be declared on your business’s Schedule C tax form, as they are not tax deductible. If you are looking to boost your deductions, pay yourself a salary that is considered deductible through the IRS.
Taking various owner withdrawals as a sole proprietor is easy to manage. However, if you own an LLC, managing your business and personal finances together can lead to losing your limited liability status.
If you are unsure which owner’s payment method is best for your business, contact a trusted CPA or attorney who can walk you through the best way to withdraw money from your business to your personal account and save money on your taxes too.
Your books need to be up to date so you know your equity balance and ownership interest value. Your equity balance is the total of your financial contributions to the business along with the accumulation of profits, losses and liabilities.
If you draw more than your business ownership or what your business is worth, you will be borrowing money from your business worth and creating a loan. Once you take out more than the business is worth, you can create tax complications.
Once you have an amount in mind, consider the following factors before you make an owner’s draw.
A spreadsheet is one possible way to track the owner’s withdrawals. However, you will need to have bookkeeping experience and the ability to make a custom spreadsheet, as most online spreadsheet templates do not have this option.
Maintain a balance sheet to track all of the money you are taking in and out of your business. Tracking this money will help you determine if the company is still profitable after the money you transfer from your business account to your personal account.
Most payroll software will set up an equity account as part of the overall accounting structure and payroll process. However, this default equity account often isn’t specific to the money you take out of the business.
It’s best to create a new equity account that you can use just for your owner’s draws. Once this custom equity account is set up through your software, you can run reports periodically to keep track of all the money taken out of your business account and into your personal account.
A balance sheet is essential if you take multiple draws, or draws in different amounts. The software will automatically track each draw, so it is easy to monitor your spending.
Not all businesses will have multiple options for paying owners. Consult a tax professional if you are unsure of the best way to pay yourself.
To be paid a salary, business owners must classify themselves as an employee. A salaried worker receives a fixed payment on intervals decided by the company, regardless of the hours they work.
Salaries are subject to payroll taxes at the time of payment. Both salaries and payroll taxes can be classified as business expenses and deducted from your business’s taxes. Paying yourself a salary is beneficial because it can reduce your business’s net income.
All S corporation owners must take salaries, as they are considered management employees. When a business is profitable, an S corporation owner can earn dividend distributions. Other business types pay owners in different ways.
Guaranteed payments are a fixed amount mirroring a salary, prevalent in partnerships. They can help you securely plan for your future each year, even if the business is in the red.
If you request a guaranteed payment, all terms must be stated in the partnership agreement. Guaranteed payments are not taxed as income, and no payroll taxes are withheld from your company. They can be listed as distributions or partnership income. The payments are tax deductible as a business expense, unlike owner’s draws. Like salaries, guaranteed payments also lower your business’s net income.
Dividends are a shareholder distribution and include a portion or all of the business’s profits since its establishment.
For example, a sole proprietorship that earned $200,000 in profits and has $400,000 in cash has up to $200,000 in available dividend distributions. If more cash funds are needed, the sole proprietor must use an owner’s draw to make up the difference.