One of the start-up principles of business, an owner needs to understand how and why the transaction is conducted in a certain way. This article will cover the physical transaction and its corresponding legal framework for both ownership and tax purposes. In addition, I’ll explain how the transaction is recorded to the books of record.
As a preliminary step there are certain terms and concepts you should understand before continuing with this article. These other articles augment this lesson and I encourage you to read all of them in order to have a true understanding of the meaning ‘Owner’s Draw in Business’.
- Sole Proprietorship Taxation – explains how self-employed individuals are reported via Schedule C on their Form 1040
- Self-Employment Tax – this article educates the reader about self-employment tax and the formula used to calculate the amount owed on earnings
- Capital Accounts – in general self-employed and partnership types of business operations use capital accounts to track the owner’s basis in the business
- Dividends and Distributions – these forms of payment are made to owners of C-Corporations and S-Corporations. In addition the term distributions is used with trusts and some forms of partnership.
Business Operation and Transaction
When businesses start the typical legal format is a self-employment operation – a one person business. Over time this business expands into higher legal forms of operations such as partnerships or limited liability company or even as an S-Corporation. As an owner your job from day one is to track your basis or what is commonly referred to as your capital account. This account accumulates how much you have earned, how much you take out for yourself and how much of the account has had income taxes paid.
The amount you transfer from the business to yourself is referred to as a ‘Draw’. The usual form of transfer is a business check that is deposited to your personal account but there are other forms of draws. Before I explain these other forms I first need to explain the business process or flow of money.
When the product is sold or service rendered the customer pays their invoice. From these proceeds the business owner pays the respective expenses and the amount left over is the profit. This profit increases the capital account of the owner as illustrated here on the balance sheet’s equity section:
So basically the owner has already paid income taxes on the contributed capital when he earned it in the past. Over the years the business has earned money denoted by the historical earnings as of the beginning of the year. As the owner files their respective tax return he pays his income taxes and self-employment taxes on these earnings. So in effect the first two lines of information have been taxed completely. Now the Earnings – Current Year have not been taxed for tax purposes as the owner has yet to file his tax return.
After reviewing his tax obligation he determines that he needs to pay about 33% of his current earnings as taxes (both income and self-employment combined) as an estimated tax payment to the IRS. The owner determines that he needs to pay $6,150 (a little more than 33%) as an estimated payment. Instead of writing himself a check, he writes a business check to the IRS for the amount due. This transfer of money to the IRS is considered a ‘Draw’ on the business. Remember, a draw is a transfer of earnings from the business to the owner or to some other party on behalf of the owner.
Take note, it is a transfer of earnings. The business may transfer some of the original capital back to the owner which is legal but this is not referred to as a draw but a reduction in the contributed capital. This is uncustomary as most businesses try to retain as much capital as possible to expand operations.
Alright back to our tax payment. This payment is now recorded as a draw and the resulting equity section will look like this:
For those you not familiar you may pay the tax directly to the IRS via a direct debit from your business account; go here: IRS Direct Payment. This is the method I use to make my payments; it is fast and easy. When I’m done I simply save a copy of the pdf file to my computer.
A draw is recorded to the equity section for that particular owner. In a partnership the owners each have a separate capital account that is recorded in the equity section as one sum amount per line but a separate spreadsheet is kept to record the respective amounts at the individual ownership level.
A ‘Draw’ is defined as any transfer of earnings of a small business to the owner or a third party on behalf of the owner. Draw is the typical term used for self-employed operations, partnerships and limited liability companies.
Now let’s continue with this example and follow some typical situations. The business continues to make money and now the owner’s wife needs some money in the family’s checking account to pay the personal bills. For this case, let’s say the business has earned $33,741 and the owner has paid $12,200 in estimated tax payments and he decides to take a draw to his personal account for $10,000. How does the equity section look now?
In accounting, the draws are usually against the current year income to date. Sometimes though, the draws will exceed the actual earnings to date. What do you do now? There are two ways of handling this. First and the method I prefer is to record the draw against Historical Earnings and not current earnings because the report format tells the owner he is now using money earned in the past for personal use. To me it is an alarm that you are not earning enough in the current year to meet your personal needs. The second method and used by most accountants is to continue recording the draw amounts against current earnings and at year end, any draws in excess of current earnings is adjusted to the Historical Earnings resetting that balance.
Both methods are acceptable.
Now let’s explore a very common form of draw. Often the business owner uses his business bank account as his savings account too. So over time the cash builds and the historical earnings accumulate into a rather large sum. Remember, taxes are paid as you go so any equity that exists in the business is already taxed and paid for income tax purposes. Now the spouse calls and says, ‘Hey the washing machine is broken and we need a new one, but there isn’t enough money in the account today’. So the business owner agrees to use a business check to purchase the washing machine. How do you address this?
Well, remember the definition of a draw: Any transfer of earned value to the owner or to a third party on behalf of the owner. OK, so the payment to the appliance outlet with a business check is a payment on behalf of the owner to a third party which is a ‘Draw’. So this check is recorded in the personal draws line of the equity section.
This form of transfer should be rare and not the common routine. However, most business owners actually make small purchases constantly using the businesses’ debit card and so all these personal transactions are recorded as draws. I once had to record a year’s worth of 7-11 transactions whereby the owner purchased his cigarettes and coffee each day on the company card. It is really annoying. It is much better and easier to just use your personal card and transfer the money weekly or monthly. Yes I know; owners don’t want the spouse to know exactly how much money is spent on personal items. So a decent solution is to have a business credit card strictly limited to personal items for the owner and this is paid monthly just like a draw. It solves both problems.
OK, I know many accountants and others even the IRS will tell you not to do this. But it isn’t illegal nor against the tax code. For the tax code, as long as you separate personal transactions from the business transactions and this easily identifiable; it is acceptable. For legal purposes, lawyers will tell you that you shouldn’t do this in order to separate the business from your personal life as in piercing the corporate veil or just plain good ole business operations.
In general, what you do with your earnings is your own personal affair. As an accountant I can suggest that you save it or use the money for investment purposes; but if you want to gamble it away or purchase doughnuts, as long as you are aware of what you are doing; it isn’t any of my business. For proper business accounting; as long as you record the transactions to your draw account, no court in this land will find this illegal or immoral. They may say it is imprudent; but it isn’t illegal.
So for the sake of sound accounting and business practices; a simple regular weekly or every two weeks transfer of money to your personal account from the business is the best way. If you desire to make it more difficult for the spouse to discover some personal spending, then keep a separate business credit card for personal expenses and when the card is paid each month, the transaction is recorded as draw against the current earnings. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.