The Skinny on Owner’s Draw for Small Business

November 8, 2018
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Category: Payroll, Compliance

owner's draw in a small flower shop

What’s an “owner’s draw” and how does it work to benefit the business and the owner? Owner’s draw, or simply draw, is money taken out of the business to pay or repay the owner – either for work performed or for funds provided to get the business started or keep it going. Most small businesses begin with a capital investment from their owners: a sum of money to buy equipment, advertising and more. This capital is a loan to the business from which the owner can “draw” funds, as needed for repayment. 

What’s the difference between draw and salary?

Draw, when taken by the owner, is a deduction from the business’ capital. Owners and partners can take out any amount of money they choose to reimburse themselves from the business account when they take a draw. There is no payroll tax on the amount they take as they are essentially repaying a loan to themselves.

Salaries are structured differently: owners are required to pay the necessary payroll and FICA taxes if they structure their business to pay them a salary. The tax implications can be significant: in addition to payroll taxes incurred by the business, employee-owners will be subject to income tax on the wages they receive.

Owners and partners can take out any amount of money they choose to reimburse themselves from the business account when they take a draw.

The structure of the business may dictate whether or not owners take their wages as a draw or as a salary with deductions for payroll taxes. How a business is set up can make the designation.

Sole Proprietors

Some small businesses are one-person operations, like a dog grooming business or computer repair person. These can be structured as a sole proprietorship. These businesses are not corporations and are not separated from the assets of the owner: the business and its owner are a single entity. Any income made through the business is reported on the owner’s individual tax return.

These types of businesses are categorized by the IRS as “pass-through” entities because profits (and losses) pass through the business to the owner and are taxed on personal income tax returns.

What is an LLC?

A limited liability company, or LLC, is a business designation that shields the owner of the business from the liabilities of the company. They can run in much the same way as a sole proprietorship, but the additional level of incorporation protects the owner’s assets from any liability the company incurs. The LLC makes the business a separate entity – if it’s ever sued, for example, the company would incur any losses, but the owner and their assets would not be at risk. A sole proprietorship can become an LLC to protect its assets and still retain the tax benefits a sole proprietor holds.

The rules for forming an LLC vary by state, and generally require filing articles of organization. Business owners looking to separate their personal assets from the assets of their business should consider forming an LLC designation.

Disregarded Entities

Sole proprietorships and partnerships are considered “disregarded entities” by the Internal Revenue Service. This means the owner(s) are not considered separate from the business in any way, including for tax purposes. Losses and profits are reported on the individual tax returns, rather than as a business profit or loss. Unless a business files additional paperwork with the IRS, sole proprietorships and partnerships are generally automatically considered disregarded entities, with their associated tax benefits and implications.

By default, single owner LLC’s are considered the same as a sole proprietorship; this means that the owner’s draw is not subject to payroll taxes and deductions.

How do LLC owners get paid?

By default, single owner LLC’s (SMLLC) are considered the same as a sole proprietorship: an owner’s draw is used rather than a paycheck. This means that the owner’s draw is not subject to payroll taxes and deductions. Some partnerships may also be LLC’s depending on how the business is structured, allowing multiple owners to be paid a draw, as well.

Are draws from an LLC taxable?

Whether a single or multiple-owner LLC, owner(s) may take as many funds (or draws) out of the business as they choose, without limit. The business and its owners are considered the same entity. Profits and losses are reported through personal tax returns, so any funds of the business belong to the owner(s) who can access them as they choose.

Can an owner of an LLC take a salary?

Some business owners prefer to be compensated in the form of a salary to assure they’ve made their tax and benefits contributions, like FICA, with every paycheck. Owners who want to assure they’re contributing to their Social Security earnings, for example, may elect to take a salary with its associated deductions.

Another benefit of taking a salary from your business is a steady, reportable source of income. If you’re hoping to apply for a mortgage in the near future, for example, a reliable, reported income stream can be beneficial for any credit applications.

If owners do take a salary, some rules do apply. The Internal Revenue Service requires that the amount earned is “reasonable compensation” for the work performed. There are some tests business owners can use to determine whether wages are reasonable, but generally, any salary earned should be what a similar business would pay an employee for similar work.

Can you be an owner and an employee of an LLC?

As the owner of an LLC you can be considered an employee if your structure your wages in the form of payroll, rather than draw. In that way, you would be an employee in addition to being the owner of the company.

Ask a Professional

There are so many tax and income implications that small business owners need to consider when structuring their company.  Whether or not to incorporate, whether to take a salary or a draw, and how each decision will impact the business and the owner are just a few issues to study. Small business owners should work with a financial and tax advisor to assure they’re making the best possible choices with regard to incorporating and wages for the optimal tax and employee benefit.

This article is for informational purposes and is not meant to provide legal, regulatory, accounting, or tax advice.

About

Riia O’Donnell is a Human Resource professional with over 15 years of hands-on experience in every discipline of the field. A subject matter expert, she has written for the online HR market for over 8 years. Her first job, at age 15, was working the early morning shift at a local bakery on weekends.

Category: Payroll, Compliance


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