What Is an Owner’s Draw and How Is It Taxed?
Understand how business owners take money from their company. Learn the financial treatment and tax considerations of an owner's draw.
Understand how business owners take money from their company. Learn the financial treatment and tax considerations of an owner's draw.
An owner’s draw is a common method for business owners to take money from their company for personal use. This mechanism allows for flexibility in managing personal finances, particularly for small business owners whose income might fluctuate. Understanding how an owner’s draw functions, its accounting treatment, and its tax implications is important for maintaining sound financial practices and compliance.
An owner’s draw represents funds a business owner withdraws from their business for personal expenses. This differs from a salary, which is a fixed, periodic payment subject to payroll taxes and withholdings, or dividends, which are distributions of corporate profits to shareholders. Instead, they are a direct reduction of the owner’s equity in the business.
The purpose of an owner’s draw is to provide personal income to the owner, serving as a form of compensation for their efforts in managing and operating the business. This method offers flexibility, allowing owners to adjust the amount and frequency of withdrawals based on personal needs and the business’s cash flow. This flexibility can be beneficial for businesses with inconsistent revenue streams. It is crucial for owners to ensure the business retains sufficient funds for operational needs and future investments, even while taking draws.
The accounting treatment of an owner’s draw primarily impacts the balance sheet, specifically the owner’s equity. When an owner takes a draw, it reduces the owner’s equity, reflecting a withdrawal of assets from the business for personal use.
To record an owner’s draw, a journal entry is made. The owner’s draw account, which is a temporary contra-equity account, is debited, and the cash or bank account is credited. For example, if an owner takes a $5,000 draw, the entry would debit “Owner’s Draw” for $5,000 and credit “Cash” for $5,000.
At the end of the fiscal year, the balance in the owner’s draw account is typically closed by transferring it to the owner’s equity or retained earnings account. This closing entry credits the owner’s draw account and debits the owner’s equity account, reducing the total owner’s equity for the year. This step resets the owner’s draw account to zero for the new fiscal year.
Owner’s draws are generally not considered a deductible business expense for tax purposes, meaning they do not reduce the business’s taxable income. Instead, the owner is typically taxed on the business’s net profit, regardless of whether that profit is taken as a draw or retained within the business. For pass-through entities like sole proprietorships, partnerships, and many LLCs, the business income “passes through” to the owner’s personal tax return. The owner reports these profits on their individual tax return, and the draw itself is not separately taxed as income when taken. The income that generated the funds for the draw is subject to the owner’s individual income tax rate.
Owners of these entities are also responsible for self-employment taxes, which include Social Security and Medicare contributions, calculated based on the business’s net earnings. Owner’s draws do not reduce the amount owed in self-employment tax. Since taxes are not withheld from owner’s draws at the time of withdrawal, owners may need to make estimated quarterly tax payments to the Internal Revenue Service (IRS) to cover their federal, state, and self-employment tax liabilities. Failure to make sufficient quarterly payments can result in penalties. A portion of self-employment taxes may be deductible on the owner’s personal tax return.
For sole proprietorships, an owner’s draw is the primary and often only method for the owner to receive funds from the business for personal use. There is no legal separation between the owner and the business, so any funds taken are considered a draw.
In partnerships, owners also typically use draws to receive their share of the business’s profits. The partnership agreement usually outlines the rules for these withdrawals, which can be taken periodically or as needed. Each partner’s share of the profit, whether distributed as a draw or not, is reported on their personal tax return via a Schedule K-1.
For Limited Liability Companies (LLCs), the treatment of owner’s draws depends on how the LLC is taxed. If an LLC is taxed as a sole proprietorship or a partnership, owners can utilize draws in a similar manner to those structures. However, if an LLC elects to be taxed as a corporation (either an S-corporation or a C-corporation), the rules change.
Corporations, including S-corporations and C-corporations, are distinct legal entities from their owners. Owners in these structures generally receive compensation through salaries and/or dividends, not owner’s draws.
S-corporation owners who actively work in the business are typically required by the IRS to pay themselves a “reasonable salary” as a W-2 employee. Any additional profits can then be taken as distributions, which are generally not subject to self-employment taxes. C-corporation owners also receive salaries and may receive dividends, but these dividends are subject to double taxation—once at the corporate level and again at the shareholder level. Owner’s draws are not available for C-corporations.