An owner’s draw is when a business owner draws money out of their company to use as they wish. It is available to owners of sole proprietorships, partnerships, LLCs, and S corporations. Owner’s draws are not available to owners of C corporations.
The basics of an owner’s draw
An owner’s draw works similarly to a withdrawal from a checking account. Instead of having an account balance, the owner has a valuation of their stake in the company. They can make a withdrawal (owner’s draw) against the value of this stake to get cash for personal use. Owners can set up regular owner’s draws or just use them whenever the need (or want) arises.
Owner’s draw vs salary
Business owners can choose to pay themselves via an owner’s draw or a salary, or a combination of both. It should, however, be remembered that the IRS requires owners of S corporations to be paid “reasonable compensation” if they also act as officers and/or employees of the company.
From a business perspective, an owner’s draw is not a tax-deductible expense and hence should not be listed on your company’s Schedule C. Salaries, however, are tax-deductible. From an individual’s perspective, owner’s draws are not usually taxed at source in the same way as salaries. They will, however, usually be taxed as income on personal tax returns.
It may also be worth noting that you need to have some form of earned income to be eligible for an IRA (either traditional or Roth). Earned income does include tips, commissions, and bonuses as well as wages and salaries. It does not, however, include owner’s draws or dividends as they are not subject to payroll taxes.
Owner’s draw vs distributions of profits
Both partnerships and S corporations can distribute profits to their owners. In partnerships, this is by means of guaranteed payments. In S corporations this is at the full discretion of the company owner(s).
Guaranteed payments are generally classed as tax-deductible expenses. S corporations distribute profits before taxes. In both cases, the payments are made without payroll deductions. They are, however, treated as income and hence must be declared on personal tax returns.
For completeness, profit distributions made by S corporations are, technically, different from dividends. This is because S corporations make disbursements before corporation tax. C corporations, by contrast, pay dividends out of their post-tax profits. This means that profit disbursements may be treated differently from dividend payments on personal tax filings.
Accounting for owner’s draws
To account for an owner’s draw, deduct the funds from the owner’s equity account and add it to the cash account. At year/period end, subtract the balance of the owner's draw account from the total of the owner's equity account.
Managing owner’s draws
An owner’s draw is intended to be a permanent withdrawal rather than a loan. It’s therefore important that the business can continue to function without the money the owner wishes to draw.
At a minimum, the business should be able to meet all its projected expenses based on its projected income. Ideally, however, the owner will leave the business with a healthy “cash cushion” in case the unexpected happens. This is particularly important if the company is still building up its credit record.
If this is not possible, and potentially even if it is, it may be advisable to look into the options for obtaining business credit. For smaller companies, a business line of credit or a business credit card may be sufficient. It is, however, important to remember that financing always has a cost, and lines of credit/revolving credit tend to be particularly expensive.
Alternatively, the owner might consider borrowing money from the company and repaying it with or without interest. This arrangement is entirely legal. It is, however, crucial that repayments are agreed upon and properly made. If they are not, the IRS is likely to treat the loan as a form of profit distribution and hence tax it as income.
How we can help
If you’re interested in finding out more about owner’s draws, or any other aspect of your business finances, then get in touch with our financial experts at GoCardless. Find out how GoCardless can help you with ad hoc payments or recurring payments.