In many businesses workers are paid wages or a salary, and that compensation is subject to income tax withholding and employer taxes. But sole proprietors, partners in a partnership, and the members of a limited liability company are never paid wages because they are considered to be self-employed. So how do such individuals take money out of the business? It is by means of an “owner’s draw,” or just plain “draw.”
What is an owner’s draw?
Technically, an owner’s draw is a distribution from the owner’s equity account, an account that represents the owner’s investment in the business. Owner’s equity is made up of any funds that have been invested in the business, the individual’s share of any profit, as well as any deductions that have been made out of the account. That means that an owner can take a draw from the business up to the amount of the owner’s investment in the business.
The Balance Sheet: Sole Proprietorship
Every business financial statement has at least five basic parts:
The Profit and Loss Statement shows the business’s Income and Expenses, and the difference is either a Net Profit or a Net Loss. On the Balance Sheet the total Assets should be equal to the sum of the Liabilities and Equity.
For a sole proprietor the Equity section of the Balance Sheet will have at least three accounts:
- Owner’s Initial Equity
- Owner’s Draw
- Net Profit
When a sole proprietor starts their business, they often deposit their own money into a checking account. This is recorded on their Balance Sheet as a debit to checking (an Asset) and a credit to their Owner’s Initial Equity account. When a sole proprietor’s business becomes profitable, their Income will be greater than their Expenses, and the balance in their checkbook will increase. In order to balance their Balance Sheet, they have to add the Net Profit to their Equity.
At this point, when the business becomes profitable, they can draw funds from their equity account by writing a check, thus crediting their checking account and debiting their Owner’s Draw account. The transaction only affects their Balance Sheet, so it is not recorded on their books as an Expense. A sole proprietor pays income taxes based on their Net Profit, not on anything on their Balance Sheet. As long as the Equity account is greater than zero, the sole proprietor can continue to take draws from the business.
The Balance Sheet: Partnership
In a partnership, two or more individuals will share the profits and pay income taxes on those profits. A partner’s share in a partnership is not necessarily based on the amount each partner has invested in the business, so an owner’s share of the business’s equity may not be the same as their share of the profits. A partnership agreement is used to specify each partner’s share of the profits or losses of the business. Taxes are paid on the partner’s share of the profits.
On a partnership’s Balance Sheet, each partner’s equity has to be tracked separately, either on the Balance Sheet itself or in a set of sub-ledgers. For instance, in a two-person partnership one partner may have invested all of the start-up funds, but the partnership agreement specifies that each of them will have an equal share in the profits. However, each partner’s equity has to be tracked separately because the one partner’s equity is the sum of their investment and any profits, and the other partner’s equity consists only of their share of the profits.
Each partner may draw funds from the partnership at any time up to the amount of the partner’s equity. The only other way for a partner to take funds out of a partnership is by means of guaranteed payments. These are payments that are similar to a salary that is paid for services to the partnership. Guaranteed payments are an expense that reduces the partnership’s profits. However, these are not wages subject to income tax withholding, so the partner will have to report these payments as income on their tax return, whereas the draws are not treated as income.
If a partner receives guaranteed payments during the year, their Schedule K-1 will report their guaranteed payments as a separate line item from their share of the profits, and he will report as income the sum total. However, any draws that he has made are not reported on Schedule K-1.
The Balance Sheet: LLC
A limited liability company is a special legal entity that has some of the legal protections of a corporation, but it is taxed as either a single-member sole proprietorship or a multi-member partnership. Therefore, the procedures for owner’s draws are the same as those described above.
So handling owner’s draws doesn’t have to be complicated. Only profits or losses have to be reported on income tax returns. Owner’s draws simply reduce the owner’s equity as he recovers their initial investment or takes the profits out of the business. The key is to keep the business’s finances totally separate from personal finances, so that the flow of money from the business to any personal account is clearly documented.
Use Justworks to take an owner's draw
On the Justworks platform, to take an owner’s draw, simply create an off-cycle payment for the amount needed. Have questions about owner’s draws, or anything else? Contact us at email@example.com.
We originally published this on our blog.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.