An owner’s draw, usually just called a “draw”, is an amount taken out of money taken out from a sole proprietorship or partnership by the owner for his personal use. It’s called a draw because money is drawn out of the business.
What Business Owners Take Draws?
Owners of small businesses typically don’t take a salary because they aren’t employees. The types of business owners who take draws instead are sole proprietors.
Partners in partnerships and members of a limited liability company (LLC) take a distributive share of income, rather than a draw. But they work essentially the same way.
A self-employed business owner makes an initial investment called a capital contribution to the business from her personal funds. Then, during the course of the business, she takes money out as draws and invests more money from profits or from personal savings.
Business owners generally take draws by writing a check to themselves from their business bank accounts. For accounting purposes, the draw is taken as a negative from their business ownership account, called owner’s equity.
In some cases, self-employed business owners might have an option to take either a draw or a salary depending on the tax circumstances. Check with your tax professional before taking a salary from your business if you’re self-employed.
Why Don’t Corporate Owners Take Draws?
Owners of corporations are shareholders and they take money out of the corporation as dividends. If an owner of a corporation works for the company, she is considered an employee and is additionally paid a salary for her work.
How Does a Draw Affect a Business Owner?
Owners’ draws decrease their capital accounts. This is the account on the business balance sheet that shows how much the owner has invested in the business fewer amounts taken out in draws at any point in time.
Be sure to keep business and personal spending separate if you have a small business. The owner’s draw should be the only place where personal and business funds intersect.
How Does a Draw Affect an Owner’s Taxes?
This is probably the most common misunderstanding about draws. A draw doesn’t affect your taxes, either your personal taxes or your business taxes.
Think of it this way: if you paid taxes on your business income and also on the draw you take out, you would be paying double taxes.
A draw doesn’t affect your business taxes because a business is taxed on the business net income – the income of the business minus expenses. A draw isn’t an expense of the business. From an accounting and tax purpose, the draw is a distribution of income.
Whether or not the income of the business is kept in the business or paid to the owner(s), the owner pays tax on the income, not the distribution.
Here’s a quick example; Let’s say a Sandra is a sole proprietor. Her business net income on Schedule C for the year is $123,000. She takes $50,000 out as a draw. The net income from Schedule C goes into her personal tax return and is included with her other income to determine her income taxes for the year. The $50,000 she took as a draw isn’t recorded anywhere.
One disadvantage to taking a draw is that you don’t have a personal income to show for personal loans or home mortgage purposes because it isn’t reflected on your business tax return.
A draw doesn’t affect the owner’s self-employment tax liability (Social Security and Medicare).
Must Taxes Be Withheld From a Draw?
A draw isn’t taxable, and it isn’t a paycheck, so income taxes don’t need to be withheld from these amounts.
How Many Draws Can a Business Owner Take?
An owner can take as many draws as he likes at any time. Of course, there must be money in the business checking account that’s available to be withdrawn. Some business owners take monthly draws like a salary but remember it isn’t a paycheck.
During the startup of a business, it’s common for the owner not to take a draw until the business has a positive cash flow. Just because your business is profitable on paper, this doesn’t mean you have enough cash in the bank. You might not be able to take a draw at all because all your available cash is needed to pay off bills until your business income exceeds your expenses.
Consider both short-term and long-term needs for the money coming into your business before you take a draw. If you take a draw in one month and you don’t have enough cash to pay a tax bill or make your lease payment the next month, you can get into financial trouble quickly.
How Do Draws Affect Business Profits?
How much a business owner takes out of the business has no effect on the profit of the business. Owner draws are not an expense of the business and amounts drawn are not tax deductible to the business. Owner draws are not taxable as personal income to the business owner.
Article Courtesy of Jean Murray, MBA, Ph.D.
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Please contact your tax professional for advice.
