Is an Owner’s Draw a Business Expense?

An owner’s draw is a withdrawal of funds or assets by a business owner for personal use. It is important to understand that an owner’s draw is not considered a business expense from either an accounting or tax perspective. This distinction is important for small business owners to accurately manage their finances and comply with tax regulations.

Understanding Owner’s Draw

An owner’s draw is how business owners take money directly from their business accounts for personal needs. This differs significantly from operational costs, which are expenses incurred by the business to generate revenue, such as rent, utility bills, or employee salaries. An owner’s draw functions as a distribution of the business’s profits or a return of the owner’s investment in the company.

When an owner takes a draw, it directly reduces the owner’s equity in the business. Owner’s equity reflects the owner’s stake in the company, representing the residual value of assets after liabilities are settled. A draw is a reduction in the owner’s capital account, rather than an expense that impacts the business’s profitability. This concept primarily applies to business structures where the owner’s personal finances are closely integrated with the business, such as sole proprietorships, partnerships, and Limited Liability Companies (LLCs) taxed as pass-through entities.

Recording Owner’s Draw in Your Books

Recording an owner’s draw accurately in the business’s accounting records is important for maintaining clear financial statements. The specific accounts involved include an “Owner’s Draw” account, which is a contra-equity account, and the “Cash” or “Bank” account.

When an owner takes a draw, the “Owner’s Draw” account is debited, and the “Cash” or “Bank” account is credited. For example, if an owner withdraws $1,000, the journal entry would involve a debit of $1,000 to the Owner’s Draw account and a credit of $1,000 to the Cash account. This recording reduces the cash balance and owner’s equity. Owner’s draws do not appear on the income statement, as they are not business expenses that affect net income.

Owner’s Draw and Your Taxes

Owner’s draws are not tax-deductible for the business and do not reduce the business’s taxable income. For pass-through entities, such as sole proprietorships, partnerships, and LLCs, the owner is taxed on the business’s net profit, regardless of how much money they personally withdraw. This means the business’s income “passes through” to the owner’s personal tax return.

For example, a sole proprietor reports business income and expenses on Schedule C (Form 1040) of their personal tax return. Similarly, partners and members of multi-member LLCs receive a Schedule K-1 from their business, reporting their share of the business’s profits or losses. The owner is responsible for paying self-employment taxes, which include contributions to Social Security and Medicare, on their share of the business’s net earnings, not on the amount of the draw itself.

Owner’s draws are not considered taxable income to the owner at the time of withdrawal. This is because the draw is seen as a return of capital or a distribution of profit that has already been earned by the business and will be taxed at the owner’s personal income tax rate. This differs from a salary paid to an owner in an S-Corporation or C-Corporation, which is treated as a deductible business expense and is subject to payroll taxes. While S-Corporation owners must pay themselves a reasonable salary as a W-2 employee, they can also take non-taxable distributions, which are not subject to self-employment taxes, in addition to their salary.