How do you pay your employees? In most cases, workers are paid wages or a salary via cash, checks, direct deposits, or even with a mobile wallet. For startup founders, who are on a tight budget, they may pay early team members with equity. Regardless of the exact method, this compensation is subject to employer taxes and tax withholdings.
But what about you, the business owner?
Just like your team members, you can also be compensated via salary and wages. For the most part, this is straightforward, and you will have to income tax — however, the company can claim this as a deduction.
You could also be paid in dividends. These aren’t common in startups, and it’s where payments are made to the stockholders of the company. And, there’s also equity. Here you’re not concerned about getting paid, but instead looking to acquire pieces of stock.
But, did you know that these aren’t the only options? Another type of payment is something called an owner’s draw.
What is an owner’s draw?
An owner’s draw, or just simply a draw, is how many small business owners pay themselves. While you aren’t receiving a regular wage, you are pulling funds out of the business for personal expenses. That may sound a bit sketchy. But, it is legitimate.
As Harold Averkamp (CPA, MBA), aka The Accounting Coach, further explains, “The account in which the draws are recorded is a contra owner’s capital account or contra owner’s equity account since its debit balance is contrary to the normal credit balance of the owner’s equity or capital account.”
In other words, you as the business owner are able to withdraw profits that the business has produced. But, they should be withdrawn from the owner’s equity account. Additionally, this can also include the financial contributions you’ve made to operate the company in the past. And, it can be a combination of profits and capital contributed.
Here’s an example coursey of Averkamp. “Let’s assume that R. Smith, the owner of a sole proprietorship, withdraws $2,000 each month for the owner’s household expenses. The company’s entry to record each month’s draws could be” a credit to Cash. Or, “a debit to R. Smith, Drawing (an owner’s equity account with a debit balance).”
An owner’s draw can occur at regular intervals, like every week or month. Or, it can be dictionary payments that are made whenever you chose. That’s some serious upside if you ever run into an emergency.
Who can use an owner’s draw?
Before you start withdrawing funds, you need to make sure that you’re eligible to take an owner’s draw. After all, you don’t want to get yourself in trouble with the IRS, business partners, or investors.
So, how do you meet the criteria? That depends on how you structured your business. If you fall into one of the following types of businesses, then you’re golden:
- Do you have a sole proprietorship? If so, you are permitted to pay yourself through an owner’s draw. In fact, it’s your only option since you cannot legally pay yourself a W-2 salary.
- Are you a partner in a partnership? Good news! You can also take an owner’s draw from your business. And, just like a sole proprietorship, you’re not allowed to pay yourself wages since the IRS doesn’t consider partners employees of a partnership.
- What about an LLC? Here’s where things can get tricky. If you’re the only member of the LLC, the IRS will treat your business like a sole proprietorship. If there are multiple members, then the company will be considered a partnership.
- What if your business is an S corp or a C corp? Typically, active owners of corporations are not eligible for withdraws and must take a salary. However, with an S corp structure, you can pay yourself a salary as a W-2 employee and take an owner’s draw. Just note that it’s called a distribution or a dividend instead.
The pros and cons of taking an owner’s draw.
If you have the right business structure and are interested in taking an owner’s draw, there are some other considerations before going any further. Namely weighing the advantages and disadvantages.
The pros of an owner’s draw.
Arguably the main perk of an owner’s draw is flexibility. As opposed to living paycheck-to-paycheck or having to put something off until you get paid, you can pay yourself whenever you want. What’s more, you can adjust the amount depending on factors like cash flow, the performance of your company, or personal needs.
The owner’s draw ais also perfect for businesses that have inconsistent cash flow. Mainly, these would be businesses that have cyclical or seasonal profits since you draw when you have the cash on hand. For example, if you run a surfboard rental company, you could pay yourself more during the summer since there’s more cash flowing in.
And, since because you don’t have to worry about taxes later, you’ll save money. I’d suggest that you figure out your taxes quarterly just to be safe.
The cons of an owner’s draw.
To be fair, there are some concerns with an owner’s draw. Most notably, it’s not steady like a salary. That can make it more challenging to create and stick to a budget.
And, if you don’t have self-discipline, you may be tempted to withdraw more when you have a higher cash flow. As a consequence, that could leave you with not enough cash for end-of-year liabilities or emergencies. Even worse, you might not have enough to cover your expenses during non-peak months.
What’s more, because taxes aren’t automatically deducted, you are going to self-report.
That includes planning for quarterly tax estimates and self-employment taxes. Also, if you’re a C corp owner you may get double taxed. The first is when your profits are taxed. And, the second when dividends are taxed.
Other snags with owner’s draw are that it can change your equity by losing shares or voting privileges, and potentially jeopardizing your relationships with your partners. And, if you are working towards contributing towards a 401 (k), the IRS only permits you to do so from your salary.
What else should you know about an owner’s draw?
Hopefully, you have a better understanding of what an owner’s draw is and if it applies to you. However, there are a couple more loose ends we should tie-up.
How much can you draw?
You can draw however much you want, whenever you want. You could take a draw of all earnings and contributions. Just keep in mind that if too large, you may not have enough left over to pay your expenses and grow your business.
How does the owner’s draw affect taxes?
An owner’s draw is not subject to payroll taxes when paid. But, this is considered personal income and taxed accordingly. That means you’ll be responsible for self-employment taxes like Medicare, Social Security, and unemployment.
If you’re in a partnership, the IRS takes a similar view to that of a sole proprietorship. As such, each partner claims their share of the income on their individual returns. The same is true for an LLC. But, that caries among each state.
Does an owner’s draw count as salary for PPP?
If you are a sole proprietor who takes an owner’s draw, you can still qualify for the Paycheck Protection Program. You’ll need to use the information from your income tax Schedule C form from the previous year. Specifically, you want to use the net profit from Line 31 and divide that 12 to get an average monthly net profit. Then, you’ll multiply that by 2.5.
It can get more complicated if you run any other business structure. But it’s still possible. I recommend you review this excellent article from Gerri Detweiler over at Nav if you need guidance on this topic.
Do I have to record draws?
Absolutely. All draws must be recorded in an Owner’s Draw Account under your Owner’s Equity account. When the year or period concludes, you’ll need to subtract your Owner’s Draw Account balance from the Owner’s Equity Account total — these are (these are both reflected on your balance sheet.
Also, when recording your journal entry, you’ll “debit” your Owner’s Equity account, and “credit” your Cash account.
The bottom line.
If you run a sole proprietorship, partnership, or LLC, you should consider taking an owner’s draw. Overall, it’s straightforward and grants you flexibility. The key is to keep your financial records organized so that you can make enough money to pay your bills, taxes, and move your business forward.
