How Does an Owner’s Draw Get Taxed?

An owner’s draw represents a direct withdrawal of funds by a business owner from their business for personal use. Unlike wages paid to an employee, an owner’s draw is not considered a business expense. Its tax treatment varies significantly depending on the legal structure of the business. This article explains how these withdrawals are treated for tax purposes across different business entities.

What an Owner’s Draw Represents

An owner’s draw represents a direct withdrawal of funds by a business owner for personal use. It reduces the owner’s equity and decreases the owner’s capital account, unlike an operational expense. Owners of pass-through entities, such as sole proprietorships, partnerships, and LLCs, commonly use this method to access business funds. An owner’s draw differs from a salary, a deductible business expense subject to payroll taxes, and from dividends, which are corporate profit distributions. While the draw itself is not directly taxed, the underlying business profit remains subject to taxation.

Tax Implications for Sole Proprietorships and Single-Member LLCs

Sole proprietorships and single-member LLCs, unless electing corporate taxation, are “disregarded entities” by the IRS. This means business income and expenses are reported directly on the owner’s personal tax return, on Schedule C (Form 1040). The owner is taxed on the business’s net profit, whether withdrawn as a draw or retained. Taking a draw does not create an additional taxable event.

The net profit from the business is subject to both regular income tax and self-employment tax. Self-employment tax covers Social Security and Medicare taxes for self-employed individuals. For 2024, the self-employment tax rate is 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare. This 15.3% rate applies to 92.35% of net earnings from self-employment.

The Social Security portion of the self-employment tax applies to net earnings up to an annual limit, which is $168,600 for 2024. The Medicare portion, however, applies to all net earnings without any wage base limit. For instance, if net earnings exceed the Social Security limit, only the 2.9% Medicare tax continues to apply to the excess. Since taxes are not withheld from draws, owners typically need to make estimated tax payments throughout the year using Form 1040-ES. These quarterly payments help cover both income tax and self-employment tax liabilities, preventing underpayment penalties.

Tax Implications for Partnerships and Multi-Member LLCs

Partnerships and multi-member LLCs, unless they elect corporate tax treatment, function as “pass-through entities.” The business itself does not pay income tax; instead, its profits and losses are passed through to the individual partners or members. Partners or members are taxed on their “distributive share” of the partnership’s profits, irrespective of whether they take a draw. The draw serves as a withdrawal of their share of profits or capital, and it is not an additional taxable event.

Active partners or members are generally subject to self-employment tax on their share of the partnership’s ordinary business income, similar to sole proprietors. Draws reduce a partner’s “basis,” which represents their investment in the partnership. Draws are typically not taxable unless they exceed the partner’s adjusted basis in the partnership.

It is important to distinguish owner’s draws from “guaranteed payments.” Guaranteed payments are amounts paid to a partner for services or capital use, determined without regard to the partnership’s income. They are treated as ordinary income to the partner and are deductible business expenses for the partnership.

Tax Implications for S Corporation Owners

S corporations operate differently from sole proprietorships and partnerships regarding owner compensation. S corporation owners generally do not take “owner’s draws” in the same manner as other pass-through entities. Instead, they receive a combination of a “reasonable salary” and distributions. The salary paid to an S-Corp owner is subject to federal income tax withholding and payroll taxes, including Social Security and Medicare taxes.

Distributions, on the other hand, are not subject to self-employment tax, offering a potential tax advantage. These distributions are tax-free to the extent of the owner’s stock basis, which includes their investment and accumulated profits. Distributions exceeding the owner’s basis are taxable as capital gains. The IRS requires S-Corp owners to pay themselves a “reasonable salary” for services provided. This rule prevents owners from recharacterizing wages as tax-free distributions to avoid payroll taxes.

How Owner Draws are Reported

For sole proprietorships and single-member LLCs, owner’s draws are not reported directly on a tax form. Instead, the net profit or loss of the business is calculated on Schedule C (Form 1040) and then flows directly to Form 1040, the owner’s personal income tax return. Self-employment tax on this net profit is calculated and reported on Schedule SE (Form 1040). Owner’s draws are internal accounting entries that reduce the owner’s equity.

Partnerships and multi-member LLCs file Form 1065. Each partner or member receives a Schedule K-1 (Form 1065) from the partnership. This Schedule K-1 reports their share of the partnership’s income, deductions, credits, and distributions. Distributions reduce the partner’s capital account reported on the K-1, but the income reported on the K-1 is ultimately taxed on the partner’s individual Form 1040.

S corporations file Form 1120-S. Owners receive a Schedule K-1 (Form 1120-S), which reports their share of the corporation’s income, losses, and distributions. Distributions are shown on the K-1 and reduce the owner’s stock basis. Any salary paid to the S-Corp owner is reported on Form W-2.