Small business owners should learn about the circumstances under which they could pay themselves with an owner’s draw and the tax and legal consequences, if any, of doing so.
What Is an Owner’s Draw?
A sole owner or co-owner can take money out of their business through an owner’s draw. Owner’s draws can be taken out at regular intervals or as needed. The draw comes from owner’s equity—the accumulated funds the owner has put into the business plus their shares of profits and losses. An owner can take all of their owner’s equity out of the company as a draw. But they should first carefully evaluate whether doing so would prevent the business from having enough capital to continue operating. Alternate names: Draw or personal draw
How Does an Owner’s Draw Work?
Business owners generally take draws by writing a check to themselves from their business bank accounts. After they have deposited the funds in their own personal account, they can pay for personal expenses with it. Draws are pretty straightforward when 1) your company is a sole proprietorship, a partnership, or an LLC that is structured for tax purposes as either of the previous kinds of business entities and 2) the money is coming out of your owner’s equity. The money you take out reduces your owner’s equity balance—and so do business losses. Your owner’s equity balance can be increased by additional capital you invest and by business profits.
Alternatives to an Owner’s Draw
Instead of an owner’s draw, partners in a partnership may receive guaranteed payments that are not subject to income tax withholding. They are treated as distributions of ordinary partnership income and are typically deductible by the business as a business expense. If your business is structured as an S corporation, you receive a salary and may take an owner’s draw and get paid dividends. Like a sole proprietorship, partnership, or LLC that is treated for tax purposes like either of those two other kinds of business structures, under an S corporation, profits and losses generally flow through to the owner or owners and are reported on individual (not business) tax returns. Relatively few small business owners choose to structure their company as a C corporation. This type of business is subject to both corporate taxes and taxes on dividends—a phenomenon referred to as double taxation—and it is also more complicated to run in terms of legal and financial issues. Owners/shareholders of S and C corporations who also act as officers or employees of the company are required by the Internal Revenue Service to pay themselves reasonable compensation. Owners/shareholders of C corporations do not take draws from the business. They may be paid dividends on their shares as well as a bonus in addition to their required salary.
How Does a Draw Affect Taxes?
Owner’s draws (as well as dividends and other types of distributions) are generally not subject to payroll taxes when they’re paid, but you will need to pay income and self-employment taxes—for Social Security and Medicare—on them quarterly, on an estimated basis, and when you file your individual federal tax return.
Other Considerations
You cannot contribute money from a draw toward a retirement savings plan. The IRS enables you to do that only from earned income: salary or wages. Taking a draw and lowering your amount of capital in the business could decrease your ownership stake in the business and the value of the company as a whole. Be sure you completely understand the terms of your business agreement with any other owners before taking a draw. The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.
