An owner's draw is a way for a business owner to withdraw money from the business for personal use. Typically, owners will use this method for paying themselves instead of taking a regular salary, although an owner's draw can also be taken in addition to receiving a regular salary from the business.
When the owner receives a salary, the amount must be consistent from workweek to workweek, and taxes must be withheld from the salary as they are for any other employee. Depending on the type of business structure you choose, you may instead opt for an owner's draw, which allows you to receive income when the company is doing well without jeopardizing the solvency of the business.
How Does an Owner's Draw Work?
When you own a company through a sole proprietorship or partnership, you don't have to answer to stakeholders, and you can run the business however you (and your partner, if applicable) decide. This includes when to take profits out of the business and how much to take. As an owner, you can take owner distributions — and tap into the business profits for your personal gain — whenever you deem appropriate.
If you are self-employed or a sole proprietor, you can take an owner's draw whenever you need funds and the business has them available. Keep in mind, however, that taking too much from the business can cause cash flow problems in the future. You'll also need to keep track of how much you pull from the business each year, so you can document any cash received on your personal income tax return.
In a partnership, each partner is personally taxed on half of the business profits. If one owner repeatedly takes more than their half of the profits through owner's draws, this is likely to negatively affect the other partner and cause friction in the business. However, as long as both partners agree, owner's draws can be taken at any time and in any amount inside a partnership as well.
For other business types, owner's draws are not as straightforward, and they may not be available at all.
LLC
Depending on how the Limited Liability Company (LLC) is structured, owners may take a draw in some cases. For example, single-member LLCs, also referred to as SMLLCs, generally do not have any shareholders or other owners who would be affected when profits are removed, so owner's draws are allowed in SMLLCs in most states. Rules regarding LLCs are state-specific, so it's best to review your state's laws if you are a member in an LLC.
S Corp
In an S Corporation (S Corp), the business elects to pass any financial gains or losses through the business and to their owners/shareholders for tax purposes. Since an S Corp is structured as a corporation (which is a legal entity in its own right), the profits belong to the corporation and owner's draws are not available to owners of an S Corp. Owners drawing funds can receive non-taxable distributions on a limited basis, but income must generally be structured through a traditional salary as a W-2 employee.
C Corp
For tax purposes, a C Corporation (C Corp) is taxed separately from any owners or shareholders. Since C Corps are also a corporation (and therefore a separate legal entity), owner's draws are also not available. While owners can take a distribution, any money paid out in distributions through C Corps are subject to double taxation — once to the corporation as revenue and again to the owner as dividends received.
What Is the Difference Between an Owner Draw vs. Distribution?
Essentially, an owner's draw and a distribution represent the same concept. In both cases, an owner is given money for personal use that was generated by the business. However, the terminology varies based on the business structure to coincide with IRS tax laws. In short, "owner's draw" is the term used for business structures that have individual or split ownership (as in a sole proprietorship or partnership), while "distribution" is the term used for cash distributions made to owners of a corporation.
Owner’s Draw vs. Salary
While it may sound ideal to have easy access to business funds whenever you choose, taking an owner's draw isn't the only way to get income from your business. Owners can also opt to take a regular salary instead of or in addition to an owners draw, and each method comes with certain tax implications for both the owner and the business.
The Owner's Draw Method
When taking an owner's draw, the business cuts a check to the owner for the full amount of the draw. No taxes are withheld from the check since an owner's draw is considered a removal of profits and not personal income.
- Pros: Using the owner's draw method can help you, as an owner, keep funds in your business during times when your business may not be able to afford paying yourself a salary. You can also reap the rewards and withdraw higher amounts when business performance is strong.
- Cons: Since your draws are not taxed, taking frequent draws can have significant tax implications on your personal income tax return, and you may be subject to quarterly estimates or self-employment taxes.
The Salary Method
With the salary method, the business owner is treated as any other W-2 employee and receives a regular salary. Once this salary level is set, it must be paid consistently with the appropriate amount of taxes withheld on both the employee (in this case, the owner) and the business side.
- Pros: Using the salary method gives you, as an owner, a consistent level of income to meet your personal needs so you can focus on growing your business. Taxes are deducted from your paycheck through the same calculations as if you were an employee with any other organization, so there are unlikely to be surprises at tax time.
- Cons: Salaries aren't as flexible as owner's draws, and you can't opt to skip paychecks if your company falls on hard times. Giving yourself too high of a salary can also raise red flags with the IRS or future stakeholders.
How Is Owner's Draw Calculated?
According to the IRS, compensation to owners (regardless if it's an owner's draw or salary) must be reasonable. This can mean different things to different people, but essentially you should take out what is needed to cover your expenses and what your business can afford.
To calculate the amount of your owner's draw, you should consider a few factors:
- How much do you need to cover your expenses?
- How much available cash does your business currently have?
- Are there any upcoming business expenses that you will need to cover soon?
- What are your business cash flow patterns?
- Will your planned income be able to cover your business expenses after the owner's draw is taken out?
- If applicable, what does your partner think is fair for both of you?
After considering those factors, you can arrive at a reasonable amount to withdraw without jeopardizing the stability of your business.
How Often Can You Take an Owner's Draw?
If you are taking a draw from your business as a sole proprietor, you can draw as many times as desired, as long as funds are available. The IRS does not limit the number or frequency of owner's draws on partnerships either, but you should consult with your partner to be in alignment with any funds extracted from the business.
How Does an Owner's Draw Get Taxed?
The specific tax implications for an owner's draw depend on the amount received, the business structure, and any state tax rules that may apply. In most cases, the taxes on an owner’s draw are not due from the business, but instead the income is reported on the owner's personal tax return. For many individuals, an owner’s draw is classified as income and may be subject to federal, state, local, and self-employment taxes, so it's important to plan ahead before filing taxes.
Payments by Business Entity Type
Depending on the structure of your business, certain payment methods are more ideal when factoring in flexibility, IRS regulations, and tax implications.
- Sole proprietorship: It's best to start out using the draw method, especially when your sole proprietorship is in its first few years of operation. Once your business is more established with consistent revenues, you can consider switching to the salary method or taking a combination of salary and owner's draws as your cash flow allows.
- Partnership: Using the draw method, especially for a younger partnership, can help ensure that each partner is receiving a fair share of the business profits. Using the salary method can be challenging since the partnership would need to support two salaries, not just one.
- LLC: For single member LLCs, the draw method can help maintain control over business profits. Larger LLCs or LLCs in states that have excessive tax regulations may opt for the salary method.
- Not-for-profit: Since NFPs are not designed to generate a profit, owner's draws can raise red flags to the IRS. Salary method is best to track all labor costs incurred by the company.
- S Corp: Owners must take income through a salary. Since the corporation is a separate legal entity, owners can only take distributions, not owner's draws; distributions must be limited in scope and not in lieu of a regular salary.
- C Corp: Owners must take income through a salary. Since the corporation is a separate legal entity, owners can only take distributions. In addition, those distributions are taxable to the owners, which can create a double-taxation scenario.
How Much Should You Pay Yourself as a Business Owner?
When paying yourself as a business owner, generating a reasonable income while still maintaining the health of your business is possible. While there is more than one way to withdraw income, you'll want to consider the pros and cons of the salary vs. draw method before pulling any money from your business. It's also important to track and document any withdrawals correctly so there are no unintended tax consequences or penalties. For additional assistance with payroll tax services, connect with the experts at Paychex.
