What Is a Draw Commission and How Does It Work?
Understand the structure and implications of draw commissions, a common compensation model providing advances on future earnings.
A draw commission is a common compensation method, particularly prevalent in sales-focused industries. It serves as an advance payment to employees, providing a steady income stream against future earnings from commissions. This structure helps bridge potential income gaps, especially during initial training periods or slower sales cycles.
What is a Draw Commission?
A draw commission is an advance payment provided to an employee, typically a salesperson, against the commissions they are expected to earn. This financial arrangement ensures a predictable income for individuals whose primary compensation is commission-based, offering a level of stability that pure commission structures lack. The purpose is to provide a financial cushion, allowing employees to cover living expenses even when sales cycles are long or inconsistent.
The “draw” acts like a temporary loan. It helps alleviate financial pressure, enabling sales professionals to focus on relationship building and closing deals without immediate income concerns. Employers often utilize this structure to attract and retain talent in roles where income can fluctuate significantly based on sales performance.
Types of Draw Commissions
Draw commissions primarily come in two forms: recoverable and non-recoverable, each carrying distinct financial implications for the employee.
A recoverable draw functions like an interest-free loan that an employee is obligated to repay from future commissions. If the commissions earned during a period are less than the draw amount, the deficit becomes a debt that carries over to subsequent pay periods. This means the employee must earn enough in future commissions not only to cover new draws but also to pay back any accumulated deficit.
Conversely, a non-recoverable draw is a guaranteed minimum payment that does not need to be repaid by the employee, even if earned commissions fall short of the draw amount. In this scenario, the company absorbs any shortfall, and the employee retains the full draw without owing anything back. This type of draw provides greater financial security, similar to a base salary.
How Draw Commissions are Applied
The application of draw commissions involves a systematic process of payment and reconciliation against earned sales. At the start of a pay period, the employee receives the predetermined draw payment.
At the end of a specified reconciliation period, which could be weekly, bi-weekly, or monthly, the total commissions earned by the employee are compared against the draw amount received. If the commissions earned exceed the draw, the employee receives the difference as additional compensation. For instance, if a $2,000 draw was received and $3,500 in commissions were earned, the employee would be paid an additional $1,500.
When commissions are less than the draw amount, the treatment depends on the type of draw. For a recoverable draw, the deficit (the draw amount minus commissions earned) becomes a negative balance, or debt, owed to the company. This debt is typically carried over and recouped from future commission earnings. For example, if an employee received a $2,000 recoverable draw but only earned $1,200 in commissions, the $800 deficit would be repaid from their next commission earnings. In contrast, with a non-recoverable draw, if commissions are less than the draw, the company absorbs the difference, and the employee keeps the full draw amount without any repayment obligation.
Tax Considerations for Draw Commissions
Both draw payments and any additional commissions earned are generally considered taxable income to the employee. The Internal Revenue Service (IRS) classifies commissions, including draw payments, as “supplemental wages.” This means they are subject to federal income tax withholding, as well as Social Security and Medicare taxes (FICA).
Employers are responsible for withholding these taxes, similar to how they handle regular wages. The total amount of draw payments and commissions earned by an employee during the year will typically be reported in Box 1 (“Wages, tips, other compensation”) of their Form W-2. The specific tax withholding amount depends on the employee’s Form W-4 elections and how the employer combines the draw with other wages.
If a recoverable draw results in an employee owing money back to the company, the repayment reduces the employee’s gross taxable income in the period the repayment occurs.