March 10, 2015 | 5 minutes read( 1003words)
This guest post by Robert W. Ditmer was originally published on Justworks.
In many businesses, workers are paid wages or a salary, compensation that is subject to income tax withholding and employer taxes. But sole proprietors, partners in a partnership, and members of a limited liability company are not paid wages because they are considered to be self-employed. So how do such individuals take money out of the business? They do so via an “owner’s draw,” sometimes known as just a “draw.”
What Are Owner's Draws?
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 taken from the account. That means an owner can take a draw from the business up to the amount of his or her investment in the business.
The Balance Sheet: Sole Proprietorship
Every business financial statement has at least five basic parts:
- 1. Income
- 2. Expenses
- 3. Assets
- 4. Liabilities
- 5. Equity
The profit and loss statement shows the business’ income and expenses, with the difference being either a net profit or a net loss. On the balance sheet total assets should be equal to the sum of the liabilities and equity.
In a sole proprietorship the equity section of the balance sheet has at least three accounts:
- Owner’s Initial Equity
- Owner’s Draw
- Net Profit
When a sole proprietor starts a business, he/she often deposits his/her own funds into a checking account. This is recorded on the balance sheet as a debit to checking (an asset) and a credit to the owner’s initial equity account. When a sole proprietor’s business becomes profitable, income exceeds expenses, and the checking account balance increases. In order to get the balance sheet, to balance, the owner needs to add the net profit figure to equity.
Once the business becomes profitable, he/she can draw funds from the equity account by writing a check, thus crediting her checking account and debiting her owner’s draw account. Since the transaction affects only the balance sheet, it does not get recorded on the books as an expense. A sole proprietor pays income taxes based on the business' net profit, not on balance sheet figures. As long as the amount in 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 share the profits and pay the related income taxes. Since the partners' shares are not necessarily based on the amount each has invested in the business, owners' shares of the business’s equity may not be the same as their respective profit shares. A partnership agreement is used to specify each partner’s share of the business' profits or losses. Partners pay taxes on their share of the profits.
On a partnership’s balance sheet, each partner’s equity must be tracked separately, either directly on the balance Sheet or in the subledgers. For instance, in a two-person partnership one partner may have invested all of the startup funds, but the partnership agreement specifies that each receive an equal share in the profits. Each partner’s equity has to be tracked separately because one partner’s equity is the sum of his investment and any profits while the other partner’s equity consists only of her share of the profits.
Each partner may draw funds from the partnership at any time up to the amount of his/her equity. The only other way a partner can withdraw funds from the partnership is by means of guaranteed payments. These are payments that are analogous to salary paid for services to the partnership. Guaranteed payments are an expense that reduces the partnership’s profits. However, since they are not wages subject to income tax withholding, the partner would need to report the payments as income on her tax return, versus draws which are not treated as income for tax purposes.
If a partner receives guaranteed payments during the year, he'll need to report them as a separate line item on his Schedule K-1
Total income is reflected as the total of guaranteed payments and the partner's share of the profits. Draws 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 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.
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 an owner's equity as he/she recovers an initial investment or takes profits from the business. The key is to keep the business’s finances completely separate from personal finances, so that the flow of money from business to personal accounts is clearly documented.
What are your top tax concerns? Tell us about them in the comments section below or contact Early Growth Financial Services for a free 30-minute financial consultation.
Robert W. Ditmer has over 35 years of experience as a payroll specialist and a professional bookkeeper. In addition to running his own consulting and tax preparation business, he worked as a Controller or Financial Manager for several different companies, and has been active in educating other payroll professionals through his writing and speaking engagements.
Justworks is a technology platform that helps entrepreneurs grow and manage their businesses by offering a comprehensive one-stop-shop approach for self-service payroll, compliance, and benefits (including health insurance, commuter benefits, and 401k).