Table of Contents
- What is an owner’s draw?
- How exactly does the owner’s draw work?
- How does an owner’s draw affect taxes?
- Summary of owner’s draw
What is an Owner’s Draw?
No, it is not some “take ten paces, turn, and draw your weapon” way of settling disputes of the owners. An owner’s draw is actually when an owner of a sole proprietorship, partnership, or limited liability company not under corporate tax structure takes money out of the company for their own personal use.
Since they are not employees in the eyes of the IRS, they do not receive salaries and therefore use draws to pay themselves. Each owner has a capital account that contains each owner’s equity. Owner’s equity is the amount of money that an owner had put into the business plus their share of the profits. Profits are the difference in income for the business and expense over a set period, usually per month.
Each owner may “draw” out of their equity account at any time from a portion to all that it contains for their own personal use. It is important to carefully review the company finances before pulling a draw as it is best to leave money in the capital account to prepare for unseen and unusual expenses that may come down the line or losses in given time periods.
How Exactly Does Owner’s Draw Work?
The most common and simplest way to take a draw is for an owner to write a check to themselves on the business account and deposit it into a personal account. Sometimes with partnerships or LLC’s one partner will be in charge of writing checks or possibly the company hires a payroll clerk that pays salaries can pay draws as well.
While draws can be periodic as needed, many companies treat draws like a salary (even though the IRS doesn’t) and pay the owner set amounts at set times. This is much more common in partnership structures. Each partner is paid an amount at the set times based on their percentage of ownership. The amounts are deducted from the equity account of that owner but may allow the partner to take draws from the other money in their equity account at needed times.
When doing so, make sure that the set draws are an amount the company can always handle even in down pay periods or the owner may have to pay some expenses personally, especially sole proprietorships or general partnerships where there is no separation in liability from business and owner personally.
While I don’t suggest this, many sole proprietorships do not set up a business account and do all business and personal items out of one personal account. Part of the reason that I don’t suggest this is that bookkeeping of what are business expenses to reduce taxes is so much easier when you have a business account paying them, but it is important to point out draws are not salary and therefore not a tax-deductible expense of the company.
How Does an Owner’s Draw Affect Taxes?
The short answer is it doesn’t. Sole proprietorships, partnerships, and LLCs (taxed as either of these) are pass-through entities so the owners pay their portion of profits, not draws made, on their personal taxes.
I have in another article invented Bob Smith whose business is mowing lawns. Here is the oversimplified example using Bob I gave in my article “How Does a Sole Proprietor Get Paid” where his sole proprietorship BS Mowers is making $1500 profit average each month:
- Bob Smith takes a draw of $1000 out of the $1500 equity each month, totaling $12,000.
- BS Mowers had a profit of $18,000 for the year.
- The Schedule C will reflect $18,000 profit and Bob will have to pay taxes on his personal 1040 on the $18,000, not the $12,000 he took in draws.
- Hopefully, Bob has been using some of the $500 a month left equity to pay his quarter tax estimates by the 15th of April, June, September, and January so he is not devastated come yearly 1040 tax filing time.
The reason I gave the short answer no is that Bob pays taxes on BS Mowers profits, not his draws. He took $1000 each month in draws and left $500 in his equity account as a safety net for bad months, but he is responsible for taxes on the whole equity account/profits.
If he took out $1600 in a month, even though he only made $1500 profit, the extra $100 would come out of the built-up equity prior to overdrawing or Bob will be having to come up with the extra $100 personally each month when the bills come due, but that would have no effect on taxes.
Summary of Owner’s Draw
- Draws are the way a sole proprietor, partner, or LLC member gets paid by the business. They are easily performed by writing a check to the owner/partner/member.
- Draws come from the owner’s equity in the business, so each draw lowers the equity they have in the business.
- Draws are not salary and therefore are not subject to employee tax withdrawals, but profits of the business that the draws are paid from are subject to quarterly estimated taxes and self-employment taxes.