By: Jeffrey Heybruck
We’ve seen a lot of confusion around the concept of an owner taking a draw from the company, what the benefits are and when it makes sense to do so. Lots of terms get conflated, such as “draw,” “distribution” “basis,” and others. We’ve heard several interpretations that are simply incorrect, such as “If I take a draw I don’t have to pay taxes on it.” (Take it from us, Uncle Sam will always get his beak wet.)
First of all, we are not CPA’s or tax advisors. A good CPA is one of the first relationships a business owner should develop, so take anything we’ve said here to your tax accountant and confirm what is best for the business.
Let’s look at the concept of a “draw.” An owner draw is a different way for owners of a limited liability company (LLC) or partnership to receive cash from their business. It should not be confused with the typical salary. We often hear “Draw” and “Distribution” used interchangeably. Dividend distribution is a different method reserved for C-corps so we won’t discuss that here.
Be sure to have enough tax withheld to cover the liability.
Owner draws are not taxed per se. The income that generated the cash flow that the owner is considering taking as a draw is taxed as ordinary income at the owner’s individual tax rate, but usually not subject to federal income tax withholding. As a result, the owner will pay the same amount of tax whether she takes $1 out of the company or $1 million. Receipt of the cash by the owner does not impact the taxability of the LLC income. As such, business owners may be responsible for making estimated tax payments throughout the year to ensure that they have enough tax withheld to cover their liability. Most Lucrum clients get a distribution from their company(ies) to cover these estimated taxes; some even cut the check directly to the IRS or NCDOR from the company.
An owner’s salary, on the other hand, is considered compensation for services provided to the business. Salary is subject to federal income tax withholding and Social Security and Medicare taxes (self-employment tax) and is taxed at the owner’s individual tax rate. Salary also contributes to the owner’s Social Security earnings. The IRS requires business owners to pay a “reasonable salary” and if audited, obviously wants fewer draws and more salary (more payroll tax). In the simplest terms, it would look very bad for an owner to take a salary of $12,000 and distributions of $120,000. Any IRS agent would easily spot an owner who is trying to take distributions at a lower effective tax rate on their income.
The IRS requires business owners to pay a “reasonable salary.”
Depending on circumstances and tax implications, there can be benefits to a draw. Some factors to consider include:
- Tax liability: An owner draw may provide a lower tax liability compared to an owner salary because it is not subject to self-employment tax. However, the owner may still be responsible for making estimated tax payments to cover their federal income tax liability.
- Social Security benefits: An owner salary contributes to the owner’s Social Security earnings, which can impact their future Social Security benefits. An owner draw does not contribute to Social Security earnings.
- Business health: Taking an owner draw can affect the financial health of the business since it reduces available cash, and therefore should be timed appropriately.
An important concept when taking draws or distributions is the member’s Basis, or equity balance. Members will have a defined amount of Basis, calculated by their initial financial stake in the company taking into account profits and losses since that time, net any draws. It is possible for a member to draw enough to reduce their Basis to zero or even negative. For the purposes of this article, suffice it to say that is to be avoided. Taxes get much more complicated, and it is often easier to simply consider it a loan instead of a draw. Your accountant can assist you with determining your Basis, which we would recommend keeping track of.
Many Lucrum clients who take completely legal but aggressive depreciation deductions (bonus or Section 179) have a situation where they have little to no basis due to their artificially low income levels due to writing off the cost of equipment purchases. These clients are usually in the contractor trades that require a large investment in trucks and equipment. In these situations, if the distributions are not reclassed to a loan, any draws in excess of basis would be taxable to the owner.
The bottom line is, in the right circumstances owners find benefits in taking draws. As long as the owner is taking a “reasonable salary” and in good standing with their basis taking a draw of company profits can result in a net lower tax bill. If you’re unsure about the subjective aspects of this, or need any other accounting help, reach out to Lucrum. We’ll help you have confidence in the numbers.