Robert W Ditmer Financial Support

Understanding Owner's Draws

 

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.”

 

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.

 

Every business financial statement has at least five basic parts:

 

• Income

• Expenses

• Assets

• Liabilities

• Equity

 

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.

 

Sole Proprietorships

 

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 his business, he often deposits his own money into a checking account. This is recorded on his Balance Sheet as a debit to checking (an Asset) and a credit to his Owner's Initial Equity account. When a sole proprietor's business becomes profitable, his Income will be greater than his Expenses, and the balance in his checkbook will increase. In order to balance his Balance Sheet, he has to add the Net Profit to his Equity.

 

At this point, when the business becomes profitable, he can draw funds from his equity account by writing a check, thus crediting his checking account and debiting his Owner's Draw account. The transaction only affects his Balance Sheet, so it is not recorded on his books as an Expense. A sole proprietor pays income taxes based on his Net Profit, not on anything on his Balance Sheet. As long as the Equity account is greater than zero, the sole proprietor can continue to take draws from the business.

 

Partnerships

 

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 his 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 subledgers. 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 his investment and any profits, and the other partner's equity consists only of his 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 his tax return, whereas the draws are not treated as income.

 

If a partner receives guaranteed payments during the year, his Schedule K-1 will report his guaranteed payments as a separate line item from his 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.

 

Limited Liability Companies (LLCs)

 

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 his 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.