Want to Do an Owner’s Draw? Here’s the Overview You Need
At first, an owner’s draw might make you think of art class. Paying yourself as a small business owner is definitely an art, but it also has strict rules you need to follow in order to make sure it happens without a hitch.
While taking a salary for yourself is a simple way to go, you also have the option of taking something called an owner’s draw. Drawing a blank on this important payroll term? Scroll on while we explain what this owner’s draw business is all about.
What’s an owner’s draw?
In its most simple terms, an owner’s draw is a way for owners to withdraw (get it?) money from their business for their own personal use. Technically, it’s a distribution from your equity account, leading to a reduction of your total share in the company. That means a draw impacts your balance sheet by making your company worth, effectively, a little less.
Because it’s different from a salary, you can’t deduct an owner’s draw as a business expense. The upside? It’s money whenever you need it (or whenever your company has enough cash flow to part with it). For sole props, the transaction can be as easy as writing yourself a fresh check from your business account.
Who can use it?
The way you structure your business has a big impact on how you can pay yourself:
- If you have a sole proprietorship, you can pay yourself through an owner’s draw.
- If you’re a partner in a partnership, you can also take an owner’s draw from your business, or your partnership may have additional methods for you to pay yourself, such as a guaranteed payment, but you would not pay yourself wages as a W-2 employee.
- For an LLC, it depends on how the business is set up and whether you elected to have it taxed as a corporation or a partnership.
- If your business is an S corp or a C corp… well, that’s where things get a little interesting. Officers in corporations must receive salaries with the appropriate taxes taken out. However, an S corp structure gives you the ability to pay yourself a salary as a W-2 employee AND take an owner’s draw (here called a distribution) or a dividend.
Convinced a draw is for you? Let’s see if we can draw you in a little further…
How does an owner’s draw work?
An owner’s draw may sound tempting to use, but it’s vital to know exactly when you can. Once again, the answer depends on how your business is set up.
If you’re a sole proprietor
In this scenario, you’re the only owner, so you have total control over when you take a draw. Any money you pay yourself is actually an owner’s draw. If you do your own books, you can record it on your balance sheet using an account called a “drawing account.” (Sorry, it’s not your fund for art supplies.) You will debit your business’ drawing account, creating a negative balance, and credit the same amount to your personal account. Super easy.
When you’d like the draw to be reflected in your balance, you reduce the drawing account with a credit, and the debit balance is transferred to your owner’s equity account. This is typically done at the end of the accounting year.
Too much accounting-speak for you? Be sure to dial up your favorite CPA so they can give you a hand while you hash it out.
Own another type of business? Read on.
Partnerships and S corps also have nearly complete discretion over when they can use an owner’s draw/distribution if it follows the rules laid out in the partnership or shareholder agreement. For C corps, the decision is generally up to the board of directors.
Here’s where it gets a tad tricky: Closely held corporations frequently have shareholders, directors, and employees who are all the same people. If that person is you, make sure you’re following all the laws surrounding conflicts of interest when you can take a distribution. Again, your accountant or attorney is your BFF if you’re in this kind of situation.
Sweet, now I know what a draw is. But is it right for me?
In the chart below, you’ll see the high-level pros and cons. There’s some serious complexity involved, so be sure to dive into the details below the chart to get a better grip:
|Sole prop or Partnership||S corp||C corp|
|Pros||You’re essentially already paying yourself from an owner’s draw.||No payroll taxes||No payroll taxes|
|Cons||Self-employment tax may be due on your personal tax return. Deductions for employee benefits are also not available.||Double taxation. Or in other words, the distribution may not be tax deductible for the corporation|
Pros of an owner’s draw
Owner’s draws are flexible
An owner’s draw gives you more flexibility than a salary because you can pay yourself practically whenever you’d like. You can adjust it based on your cash flow, personal needs, or how your company is performing.
Owner’s draws can give S corps and C corps extra tax savings
The IRS tax implications are huge if you’re an S corp or a C corp.
The biggest reason is that draws, dividends, and distributions are typically not subject to payroll taxes. For an S corp, only your wages are subject to IRS payroll taxes — assuming you’re also an employee. So if you have an S corp, taking out less money as a salary and more as an owner’s draw can provide your business with extra federal payroll tax savings.
However, before taking an owner’s draw, you may be required to take a reasonable compensation as an employee. IRS rules regarding a “reasonable compensation” can be found here.
Owner’s draws are great if your cash flow is inconsistent
Owner’s draws can also be a good approach for businesses that have cyclical or seasonal profits (or inconsistent cash flow overall). For example, if you own a pumpkin patch, and you earn most of your revenue during Halloween (which falls in Q4), you can keep more money in the business Q1 through Q3 and take out a larger owner’s draw at the end of the fourth quarter.
By contrast, if you’re locked into paying yourself a larger fixed salary year-round, you may struggle to have enough working capital in the business during your leaner quarters.
Cons of an owner’s draw
Owner’s draws are not steady
Paying yourself a decent salary will provide you with a steady income (and buffer you personally if your business has a down-year). It will also reflect the true cost of operating your company, which comes in handy as you grow.
With multiple owners or shareholders, there’s a twist. Even if you pre-define who can take an owner’s draw or distribution and when, you could wind up with conflicts between owners or get to a point where there aren’t sufficient funds for running the company. Don’t let that happen to you.
Owner’s draws can hurt your retirement savings
If you have an S corp and you’re trying to build up a 401(k), the IRS only allows you to make contributions from your salary, not from your owner’s distributions. Therefore, if you want to add to your 401(k), you need to have a salary. At the same time, you can also use other options to save for retirement, like an IRA.
Owner’s draws can cause double taxation
Owners can deduct their salaries as a business expense. This approach is especially useful in a C corp because a draw or distribution would come as a dividend, which is subject to double taxation. The first tax hit comes when the profits are taxed. The second is when your dividend gets reported as income. Double trouble? No thanks!
Owner’s draws can change your equity
Taking a distribution or dividend in a partnership or corporation could mean losing your share of ownership relative to other owners, which could also include a change in voting rights. If you have this kind of business, you may want to consider whether giving up a big equity investment for a short-term gain is the right approach. Not to mention, taking distributions and dividends may cause changes in the valuation of your company, which can make it hard to raise money.
Owner’s draws can feel a bit onerous and salaries can feel a bit silly — until you know what each one means. While the two types can have big tax advantages, you’ll want to talk to your accountant before taking the plunge.