As a small business owner, you have plenty of things to keep you up at night. One of the top stressors faced by business owners is bookkeeping, and one of the most common errors in a small business relates to how the owner compensates themselves.

Owners need to be careful about how they account for these payments because they affect their books and their taxes. The determining factor of how these payments are treated is business entity type. The next step is understanding the difference between the two most common forms of “owner compensation.”

Business owner draw: Sole proprietors, single-member LLC

In the beginning stages of a business, an owner will put up an initial investment, also known as a capital contribution, from their personal funds. To take payment, an owner will take draws, usually in the form of a check or transfer from their business bank account. The draw is recorded as a reduction of owner’s equity and decreases capital accounts. Owners must also record personal deposits and expenses as owner contribution or draw. These distinctions are important because personal expenses and deposits are not income or expenses of the business but any item affecting the business bank account must be properly accounted for.

A business owner’s draw does not affect personal or business taxes because the draw is a distribution of previously taxed business income or contributed capital. Self-employment tax must be paid on business profits from a business taxed as a sole proprietor. Business owners should not treat draws from a sole proprietorship as a traditional salary since they have already paid the tax on this income. Businesses taxed as a sole proprietor are not required to pay owner salaries. Positive cash flow is an essential requirement for taking a draw if you want to ensure the financial stability of your business.

Distributive share: Partner, multi-member LLC

The allocation of income, loss, deduction or credit from a business to LLC members (where there is more than one), or partner in a partnership is known as a distributive share. This amount is includable in the members’ income regardless of any cash distributions. The percentage of share is usually spelled out in a partnership agreement and always totals 100%. When no agreement exists, distributive shares correlate to each partner’s share of ownership. The calculations are based on the following factors:

  • Interests in the economic or taxable income of the partnership
  • Capital contribution
  • The rights of partners to partnerships assets should the company be sold or file for bankruptcy

The process for taking a distributive share requires an accounting of the total net income. That profit is then divided among the partners, according to their share or the partnership agreement. Individuals that receive a distributive share must pay self-employment tax based on their Schedule K-1. Partnerships and multi-members LLCs do not pay a salary to their owners. Instead, they pay a guaranteed payment which is reported on their Schedule K-1 and subject to self-employment taxes. Cash distributions from partnerships other than guaranteed payments are not included in members’ income to the extent that they have basis in their partnership interest.

Distributive share: S-Corporation

The allocation of income, loss, deduction or credit from an S-corporation to its shareholders is allocated in accordance with stock ownership of the S-corporation. These amounts are included in the shareholders’ income regardless of any cash distributions, and are not subject to self-employment taxes. The S-corporation is required to pay its shareholders a reasonable compensation for any services performed for the business. Distributions of previously taxed S-Corporation earnings are not included in shareholder income to the extent that they have basis in the S-Corporation.

Dividends: C-Corporation

C-Corporations pay tax themselves on any corporate taxable income. Distributions of remaining capital are taxable to shareholders as dividends. These dividends may be qualified dividends taxed at preferential tax rates. C-Corporations are also required to pay shareholders reasonable compensation for any services provided to the corporation, these wages are deductible by the corporation and taxable to the shareholder.

Kyle Meissner is a Certified Public Accountant with Cordell, Neher & Company, PLLC, a Wenatchee public accounting firm. Kyle may be reached at 663-1661 or