Is An Owner’s Draw Relevant To Me?

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Take a moment to reflect on how you account for your employees’ salaries. How are they getting paid? Is it cash or cashless? Is it by checks or payment deposits? Or is it with a pay stub maker anyone can use? Depending on the nature of your business, you might even pay early team members through equity if you’re short on money upon initial startup. On top of all this, you’ll still have to account for employer taxes and retention tax. 

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For business owners, you can also receive compensation through salary and wages. This process would involve income tax upon which the company would simply deduct this from your salary. Additionally, you may also be paid in dividends. This mode of payment involves payments being directed towards the stockholders of the company. However, instead of being concerned with earning income, you’re more invested in acquiring a share of the stocks.

For those experienced in business, these various payment modes shouldn’t be unfamiliar to you. However, there’s one other method that’s less common — it’s called an owner’s draw.

A Quick Rundown: Owner’s Draw
An owner’s draw is a method for small business owners to pay themselves. You might wonder, but don’t you own the business already? How do you still theoretically, pay yourself? Well, according to the Balance Small Business, an owner’s draw is defined as “an amount of money taken out from a sole proprietorship, partnership, limited liability company (LLC) or S corporation by the owner for personal use” instead of a literal wage. An owner’s draw essentially consists of profit and capital involved with your company; you directly withdraw your “income” from the profits generated by your business or whatever additional financial contributions previously. However, it should be noted that it’s accessed from the owner’s equity account.

An example of an owner’s draw record could be:

  • Withdrawing $2000 from your company’s profit and recording the debiting in your Owner’s Draw Account under the Owner’s Equity Account
  • Credit the $2000 into your cash account

Additionally, the frequency of the owner’s draw would be largely dictated by two factors:

  • Business cash flow and profitability (along with additional operating costs)
  • Time of the year

If your business is flourishing, you might find yourself drawing more money and vice versa during an off-peak season. This could be as regular as weekly or slightly longer, monthly.

Who Has Access?
Now, let’s discuss who’s entitled to using an owner’s draw? To determine one’s eligibility, it’s pertinent to consider the type of business ownership occurring. As stated above, typically only business with a sole proprietorship, LLC, or in partnership can qualify for the owner’s draw.

Sole proprietorship and partnership are fairly self-explanatory. The former refers to a single owner overlooking the entire business, permitting the individual to pay for themselves through the owner’s draw. The latter refers to co-owning a business. However, both are similar in that it’s illegal to pay yourself a W-2 salary under these business types by order of the Internal Revenue Service (IRS). They don’t acknowledge (at least for partnership) partners as employees under a business.

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LLCs take it one step further. If you’re the sole member of the LLC, the IRS will count your business as a sole proprietorship, however, if there are multiple members, your business is counted as a partnership.

Regarding S or C corps, active owners are not eligible for the owner’s draw and must take a salary. Instead, the S corp structure permits the owner to consider themselves as a W-2 employee and thus, qualify for receiving a wage. This is known as a distribution or a dividend.

Benefits and Costs of Owner’s Draw
In order to have a comprehensive understanding of the owner’s draw, let’s now address their pros and cons.

Benefits:

  1. Flexibility
    Perhaps one of the best attributes of the owner’s draw of having personal freedom in dictating your expenses according to your immediate monetary situation is something that’s useful as compared to relying and waiting on a monthly paycheck. Additionally, it relinquishes owners with free rein and control over the amount withdrawn depending on business cash flows, company performance, and/or personal circumstances. For businesses with risky cash flows, the owner’s draw is also extremely beneficial in helping to balance out the new profits and losses for each fiscal period. This mostly pertains to smaller businesses that are susceptible to cyclical or seasonal profits either due to their product/service type or their demographic. For example, ski and snowboard rentals would only be active during the winter season, therefore rendering its business unprofitable during the other seasons.
  2. Temporary Tax Relief
    An owner’s draw is not taxable on business income, resulting in the capacity to accumulate savings. The draw is subsequently taxable as income under the owner’s personal tax returns. However, if you’ve been budgeting wisely, paying for this tax shouldn’t be a huge concern.

Costs:

  1. Unpredictability
    Although we mentioned flexibility as an advantage of the owner’s draw, it can also become a disadvantage — simply because it’s unpredictable, unlike an income. This requires the owner to be more strict and deliberate in their financial planning to account for unforeseen business hiccups and tide over those rainy days. This requires significant self-discipline on the owner’s part.
  2. Self-initiative
    Since taxes aren’t automatically deducted from your owner’s draw, you’ll also need to self-declare it. As a result, you’ll be fully accountable for taxes like self-employment taxes including Medicare, Social Security, and unemployment along with quarterly tax estimates. Do note that if you’re a C corp owner, you also run the risk of getting taxes doubly — firstly from your profits, and secondly from your dividends.

Other potential run-ins with the owner’s draw might be the possibility of a change in equity through losing shares or voting privileges. This might be problematic if you’re engaging in a partnership. Additionally, if you’re striving towards a 401 (k) contribution, you’re only permitted to do so from your salary as dictated by the IRS guidelines.

Conclusion
Although the owner’s draw might seem complicated and overwhelming at first, as long as you take the time to properly decompartmentalize each section to understand them, financial concepts and terms are easily digestible as well. We hope that through this article, you’ve been able to gain better understanding and insight on this topic, whether or not it’s directly applicable to your situation. Being aware of the types of businesses and relevant income withdrawals out there is useful as general knowledge.

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Is An Owner’s Draw Relevant To Me?
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Take a moment to reflect on how you account for your employees’ salaries. How are they getting paid? Is it cash or cashless?
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