When people first go into business, they often don’t know how they’re going to get paid. A lot of people are used to getting a paycheck, so when they go into business for themselves, they’re not quite sure how they’re supposed to be compensated, how often they’re supposed to be compensated, or what amount they’re supposed to be compensated. What they inevitably end up doing is writing a check to themselves and saying, “Okay that’s my paycheck.” I see this a lot in my practice, especially with my first-time clients; they’ll write out a check and call it salary. The truth of the matter is that those payments are considered owner’s draws. An owner’s draw is… well, let’s break it down. The owner is drawing money out of the business, or rather, they’re taking the profits out of the business before year is done. What’s important is that draws are not considered a tax deduction, so don’t expect to get a tax break for paying yourself when you’re a sole proprietor or in a partnership.
When I first started my record store and the promotion company, I often ended up writing checks to vendors to pay my personal bills. I’ll give you an example. When I owned Madd Waxx Records, I found myself needing to run and pay my electric bill for my apartment or to go buy groceries because I was hungry. A lot of the time, the money I had available to me was in the business account, so of course, what did I do? I wrote a company check to Duke Power, or used the company debit card at the supermarket. Since those two purchases were not an expense for my business, but an expense for me, they were recorded as owner’s draws on my books and I was required to pay taxes on those amounts.
So many people ask me in my practice, “Well, I wrote the check from the business account, why can’t I deduct this?” The truth of the matter is, it’s probably because it’s a draw rather than a business expense. You have to be very cognizant of what, when, and how you’re drawing money out of the business. Ultimately, when your cash flow allows, you’re going to plan draws and have a better grasp on how much and when how to take money. This type of planning will allow you be prosperous and enjoy life, which is the major goal of many entrepreneurs.