An owner's draw is money taken out by a business owner from the company for personal use. It's considered an owner's draw if you transfer money from your business bank account to your personal account and use that money for personal expenses. There are no rules regarding the intervals of an owner's draw. As a business owner, you can draw at regular intervals or only when you need it.
There are several ways you can get paid as an owner of a business. In this article, we'll be comparing the draw method and the salary method. The best method for you depends on your role in the company's day-to-day operations and your business structure. Keep reading to find out if an owner's draw is the best method for you to get paid by your company.
Owner's Draw vs. Salary
As a business owner, you can receive compensation for your work in your company through an owner's draw or a salary. Through the salary method, you'll receive a fixed amount of money regularly as an employee. In contrast, the draw method allows you to withdraw from your owner's equity account as your profits increase and cash becomes available to you.
With the salary method, your personal income taxes and self-employment taxes are automatically deducted. This makes it easier to keep track of your business expenses and manage your cash flow. The downside of the salary method is putting it into practice successfully.
For instance, you need to determine reasonable compensation for your role in the company. And your salary should not diminish your operating capital significantly or result in double taxation. Lastly, your salary should also be deemed reasonable by the Internal Revenue Service (IRS), or else you'll be inviting an audit.
Note that if your business is structured as a sole proprietorship or a partnership, the IRS does not allow you to be considered an employee. Therefore, you can't pay yourself a salary. Draws are permitted for companies structured as sole proprietorships, partnerships, or limited liability companies (LLCs).
How Much Should You Take Out With an Owner's Draw?
Technically, there's not a set amount that you can or can't take out with an owner's draw. Your main consideration would be to limit your draws to the amount of cash available without taking away capital that can be used to grow your business or maintain its operations. And since the owner's draw is deducted from your owner's equity, it should not exceed that amount either.
Owner's equity is an account found on the balance sheet. It represents your stake in the company. Equity includes accumulated capital you've contributed to the business and shares of profits and losses if any.
Business Taxes on Owner's Draw
Your tax responsibilities on an owner's draw depend primarily on your business structure. As a business owner, you'll be expected to pay income taxes, self-employment taxes, and estimated quarterly payments. Find out the tax implications of your draw amounts below.
Owner's Draw as a Sole Proprietor
A sole proprietorship is a business owned and operated by one person. As a sole proprietor, the amount of money you take out from your company as an owner's draw doesn't have any bearing on when or how much you pay in taxes. Instead, you report business profits or losses on your personal tax return. Profits are also taxed at your personal income tax rate.
As a sole proprietor, you're required to pay income taxes and self-employment taxes as you earn income during the year through estimated tax payments. It doesn't matter if the money is in the business account or you've withdrawn it for personal use. If you think you will owe at least $1,000 at the end of the year, you need to remit estimated tax payments quarterly. The amount should cover both income tax and self-employment tax, which pay for Medicare and Social Security.
To calculate your estimated taxes, you will add up your total tax liability for the year - including self-employment tax and income tax - and divide that number by four. You can use your previous year's income and expenses as a guide to estimate how much income you'll earn this year. You can also match what you paid on taxes last year, plus a small adjustment if you think you'll make more this year.
Owner's Draw in a Partnership
Partnerships refer to businesses owned and operated by two or more individuals. The IRS treats partnerships like sole proprietorships for tax purposes. Although a partnership reports an annual information return that shows the company's income, deductions, gains, and losses, the business itself does not pay any income tax.
Business profits or losses are divided according to each partner's share in the company. And each partner reports their share on their personal income tax return. You'll pay income taxes, self-employment taxes, and quarterly estimated taxes based on profits.
Like a sole proprietorship, an owner's draw made by a partner doesn't impact their tax obligations. However, you would have to limit your draws according to the partnership agreement you signed with your co-owners.
Owner's Draw in an LLC
An LLC is a business entity that offers owners the liability protection of a corporation with the tax benefits of a sole proprietorship or partnership. Similarly, the owner or owners of an LLC may elect to be treated as an S corporation or a C corporation. For tax purposes, here's how the IRS treats LLCs.
- A single-member LLC is treated as a sole proprietorship: If you're a single owner of an LLC, the frequency and the amount you take as an owner's draw won't impact your tax liabilities. This means you can draw as much or as little as you want. Your tax obligations are based on profits or losses of the business, which you'll report on your personal income tax return.
- A multiple-owner LLC is treated as a partnership: If you're a member of a multi-member LLC, your owner's draw will be subject to the agreement you have with the other owners of the company. But your tax obligations will depend on your share of the business profits or losses of your company.
- As an S corporation: If your business is structured as an S corp, you should pay yourself a reasonable salary. From the remainder of your profits, you can also take the equivalent of a dividend called distributions. Your salary will be subject to employment taxes, but distributions are non-taxable.
- As a C corporation: Corporations don't allow owner's draws. If your business is structured as a C corp, and you actively participate in its operations, you'll be paid a salary as a W-2 employee. If you don't work for your company, you'll receive non-taxable dividends.
Keep Your Company Finances in Check With Skynova
One of the most complex parts of running your business is understanding your company's finances. As a small business owner, you need to get paid to cover your personal expenses and leave enough money in your company to keep it going. You also have to make sure you're fulfilling your tax responsibilities. It can certainly feel overwhelming at times.
Save yourself time and overwhelm. Use Skynova's accounting software for small businesses to help you manage your bookkeeping. Keep track of your income, expenses, and sales tax. And if you want to take an owner's draw, you can simply generate reports like balance sheets and cash flow statements to help you make better-informed financial decisions for you and your business.
Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure you're in compliance with tax regulations.