As a small business owner, paying your own salary may come at the end of a very long list of expenses.
Understandably, you might take less money out when you first start your business and get it profitable, but after a while, you’ll need to determine the best way to pay yourself and how much. There are two primary options: treat yourself like an employee and pay yourself a salary, or take an owner’s draw. Each has slightly different tax implications, so you’ll want to weigh your options carefully, based on the business structure you’re operating as.
What is an Owner’s Draw?
If you operate as a sole proprietorship or a partnership, you can take out what’s called an owner’s draw, which is essentially the money a business owner takes out of the business for personal use. The cash drawn out of the business bank account should be taken out of the profits after all business expenses are paid. It’s not a salary in the technical sense, but more of the owner’s equity in the business.
How Does an Owner’s Draw Work?
Unlike how you’d pay an employee a salary through a payroll service that automatically deducts employment taxes, taking a draw in a sole proprietorship, partnership, or LLC simply requires you to take money out of your business checking account whenever you need it. You don’t need to get on a schedule of paying yourself, many business owners prefer to have a guaranteed payment to themselves each month on a regular schedule, such as once a month or every two weeks.
From an accounting perspective, taking a draw reduces your capital accounts, since you are taking out owner’s equity. When looking at your balance sheet, the formula is:
Assets = Liabilities + Owner’s Equity
Owner’s equity refers to what you’ve invested in the company, whether that’s your own personal money or your time. There’s a value to owner’s equity, and it’s an asset. When you take a draw, you essentially are lowering the amount of owner’s equity. Of course, it fluctuates as your net profits ebb and flow each month.
Let’s use the formula above in an example to determine owner’s equity: your dog grooming company has $150,000 in assets, whether that’s money in the bank or the equipment you use. You also have $80,000 in liabilities (payroll for your employees and a business loan). So that means the remaining profit—$70,000—is your owner’s equity. You might choose to leave some of that in your business bank account to cover monthly expenses and unforeseen emergencies, but you could take your owner’s draw from that amount.
Owner’s Draw LLC
Besides sole proprietors and partners, one other type of business structure that can take an owner’s draw is the single-member LLC, if you opt to be taxed like a sole proprietorship or partnership. There is another option to be taxed like a corporation, and if that’s the case, you won’t be able to take an owner’s draw.
If you run a limited liability company, you’d take your draw like a sole proprietorship or partnership: simply take money out of your owner’s equity after you pay all your expenses. If you have other partners, be sure to agree on how much each of you can take in draw out of earnings each month.
Owner’s Draw S Corp
If you run your business as an S corp, you won’t be able to take an owner’s draw like you can with the other business structures we’ve discussed.
Owner’s equity is treated a bit differently, with losses and profits passed through to the owner at the end of the tax year. You can take a distribution from your owner’s equity, based on your percent ownership in the company. These distributions are a deductible expense to the corporation, and you as the business owner will pay taxes on these earnings on your personal income tax return.
While a distribution is one option with an S corp, many business owners opt to take an owner’s salary, which is taxed like any other payroll. Some opt to take both a distribution and reasonable compensation in the form of salary to balance the amount of taxes they owe at the end of the year.
Owner’s Draw vs. Salary
So, to break it down again:
Owner’s draw: money taken out of the business’ profits
Salary: payroll income with taxes taken out
When should you use one over the other? If you’re a sole proprietor business owner or a partner (or an LLC being taxed like one of these), taking an owner’s draw is the easiest. Just keep in mind that you are responsible for paying your own taxes on this draw, which is considered taxable income.
When you file your personal income tax return, you’ll pay state and federal taxes on the earnings you took in your owner’s draw. More on that shortly.
If you run an S corp business, a salary and/or distribution is the right fit. Yes, you will have payroll costs, even if you’re the only employee in the business, but because you are essentially an employee of your company, you’ll pay your taxes through your paycheck.
Whichever option you choose, keep in mind both your business’ short- and long-term expenses. Taking too big a draw might leave you unable to pay a business expense. You might have a base draw you can take out every month, and then, if business is booming during a particular month or season, you can take additional money out of your business account.
Does an Owner’s Draw Count as Payroll for the Paycheck Protection Program?
When it comes to owner’s draw and PPP: you might think you don’t qualify for a Paycheck Protection loan if you’re a sole proprietor who takes an owner’s draw rather than a paycheck. However, you can qualify, if you otherwise meet PPP payroll requirements.
You can use information from your income tax Schedule C form from your 2019 taxes when applying (use net profit from Line 31). Using this number, divide it by 12 to get average monthly net profit, then multiply that number by 2.5.
If you run an S corporation and take distributions and/or a salary, you can include both in your calculations when applying for the PPP loan. Get more information on Paycheck Protection Program loans.
The Economic Injury Disaster Loan (EIDL) takes into account your payroll to calculate the grant amount. Take a look at this if you’re looking for more information on EIDL.
How are Owner’s Draws Taxed?
We’ve touched on how owner’s draws are taxed, but let’s dive deeper. The actual draw—the physical act of taking money out of your business account and transferring it to your personal checking—doesn’t impact either your personal or business taxes. This draw isn’t a business expense; it’s a distribution of owner’s equity.
Where taxes come into play is at the end of the year when you’re filing your personal income tax. Any income you have earned in the year, whether that’s through your business, salary from another job, or a freelance gig, is considered taxable income. So if your business earned $200,000 and you took out $100,000 as your business owner’s equity, you’d pay income tax on that $100,000.
Because you aren’t receiving a paycheck for your salary, you’ll also pay self-employment taxes when you file your personal taxes. These include Social Security and Medicare taxes, which are normally taken out of a paycheck.
You should consider paying quarterly taxes on what you estimate will be your taxable income to keep from having to pay a large chunk when tax time comes around.
Nav’s Final Word: Owner’s Draw
As the business owner of a sole proprietorship, partnership, or LLC, enjoying your equity in the business is fairly straightforward when you take it as an owner’s draw from net profits. Keep good financial records, recording each equity distribution in your accounting software so that, at the end of the year, it’s easy to file your personal income taxes.