Business owners often can’t get paid the same as their employees. Why? It’s a great question, but that’s not why we’re here today. I’m here to tell you about one way business owners can pay themselves.
Overview: What is an owner’s draw?
As a business owner, at least a part of your business bank account belongs to you. You’re allowed to withdraw from your share of the business’s value through an owner’s draw.
Say you open a company with your friend as equal partners, each putting up $250,000 in cash. You can draw up to $250,000, which is your portion of the business’s value. As your business grows, you can also draw your 50% of the profits.
Many business types don’t allow owners to take a salary, making an owner’s draw one of the only ways to get cash out of the business. Companies should limit draws so there’s enough cash to continue operations.
While your employees get paid every time you do payroll, you don’t have to take an owner’s draw at regular intervals. You can generally take a draw when there’s cash available to you.
The most common way to take an owner’s draw is by writing a check that transfers cash from your business account to your personal account. An owner’s draw can also be a non-cash asset, such as a car or computer.
You don’t withhold payroll taxes from an owner’s draw because it’s not immediately taxable. Instead, you pay income tax and self-employment tax on your portion of business earnings, regardless of the amount you draw from the business.
What types of businesses can take an owner’s draw?
Most pass-through entity owners can draw from their businesses. Owners of sole proprietorships, partnerships, and some limited liability companies (LLCs) take draws.
By contrast, corporations don’t take draws. S corporation and C corporation owners take salaries and dividend distributions.
Not all payment methods were created equal. A CPA or attorney can help you decide on the most tax-advantaged way to get money out of your business and into your wallet.
3 alternative payments to an owner’s draw
Not every business type can pay owners through the same methods, so consult a tax professional when deciding on your company’s owner compensation structure.
Employees are the only worker classification where you can pay a salary, which is a fixed payment made at defined intervals regardless of hours worked.
Salaries are part of the payroll process because they’re subject to payroll taxes. Salary and payroll tax expenses are an allowable business expense, reducing your company’s net income.
S corporation owners, called shareholders, who participate in management are considered employees, and they must take salaries. All other business types pay their owners in another way. When there’s extra money in the company, an S corp owner may also earn dividend distributions.
Payroll software can help you distribute salaries to S corp owners and employees.
2. Guaranteed payments
Guaranteed payments also pay a fixed amount to business owners. They are as close as most business owners can get to earning a salary.
Most popular in partnerships, guaranteed payments promise that a business owner will be paid a given amount for the year, even when the business is operating at a loss. Often people who work at their company full-time ask for guaranteed payments in order to be sure that they’ll take home enough cash.
Guaranteed payments need to be written into your partnership agreement.
Like salaries, guaranteed payments are allowable business expenses that lower net income. The difference between salaries and guaranteed payments: Your company doesn’t withhold payroll taxes from the payment. Instead, you pay self-employment taxes on guaranteed payments.
The owner’s draw is accounted for differently than guaranteed payments. Guaranteed payments are a business expense, while an owner’s draw is not.
Dividends are a shareholder distribution of all or a portion of business profits from current and previous years.
Say a sole proprietorship that opened last year earned $100,000 and had $300,000 in cash. The sole proprietor can receive a dividend distribution of up to $100,000. To access more cash, the sole proprietor would take an owner’s draw.
How to pay yourself from an owner’s draw
Taking an owner’s draw is a relatively simple process since it should not trigger a “taxable event.” When done correctly, taking an owner’s draw does not result in you owing more or less income tax.
1. Determine the owner’s draw amount
Some big questions may swirl around in your head before taking a draw. How much cash do I need to live? Can my business afford to do without this cash? The best starting point is taking a look at the value of your ownership stake in the company.
Every owner in your company should have a dedicated equity account on your balance sheet. If your books are up to date, you should be able to look at your equity account balance to know the value of your ownership interest.
Your equity account reflects your portion of the business. It’s an accumulation of your financial contributions and share of profits, losses, and liabilities. Talk to an accountant to get your books updated before taking an owner’s draw.
Generally, the maximum draw is your ownership interest. When you draw more than your business ownership, you’re technically taking out a loan from your business and potentially creating some tax issues.
Once you know your starting point, decide on an amount to draw. Consider the following:
- The next time you’d like to take a draw: You can take multiple draws each year, so you don’t have to take out an entire year’s worth of personal expenses at one time.
- Your business’s cash flow: If you can, keep a healthy amount of cash in the business so your draw doesn’t interrupt business operations. There are no draws to be had when your business can’t run.
- Your ownership agreement: Businesses with multiple owners draft contracts that might restrict the amount of an owner’s draw or require approval before an owner takes a draw.
Even if your ownership agreement doesn’t require your business partners’ approval to take an owner’s draw, you should inform them of your draws. Courtesy is key.
2. Write a business check to your personal account
The easiest and most fun part: Write a check from your business account to be deposited in your personal account. Some accounts require dual signatures for large disbursements, so you might need your business partner’s help.
That’s the whole step.
3. Reduce your equity account by the owner’s draw
Now for some bookkeeping. To record an owner’s draw, reduce your equity account and cash balances.
If I’m a partner of Coffee Connoisseurs — a coffee-tasting bar I just created in my head — and I take a $50,000 owner withdrawal, my journal entry would be as follows.
View more information: https://www.fool.com/the-blueprint/payroll/owners-draw/