As a business owner, you need to know the ins and outs of owner distribution. This is essentially how you get paid, and you should really know the proper way to do it. When you’re careful with how you handle payouts, you ensure a future for your business and you also treat yourself well.
What Is an Owner Distribution?
Distributions are payments made in capital or income to an owner of a company throughout the year. This can be in the form of cash, products, or company stock. This is essentially a way that a business owner receives pay or salary from their business.
Being the owner, they can take as big or as small of a distribution as they want. Naturally, the amount should not be so much as to cut deep into the profits and funds of the company. Once received, an owner has full charge over what they want to do with it. These owner distributions can be for personal use, deposited into business accounts (if cash), or funneled back into the business.
Owner distributions paid out in the form of cash dividends are taken from your equity reducing your company share. Stock distributions, on the other hand, do not deplete your equity in the company. This means that they may come from the profits that the business has accrued or from money that you previously invested into the company.
Where Can I Find Distributions on My Financial Statements?
You would think that because distributions are paid out, they would be considered a form of a cash out listed on your profit and loss statement. However, that is not the case. See, these distributions don’t affect how much profit your business makes or how much taxes you’ll have to pay as a business. This is because they are taken from retained profits or cash initially invested into the business. So, instead of P&L statements, you’ll see owner distributions listed in cash flow statements and on your balance sheet.
In the balance sheet of your tax return, the distributions a business has given to its owners or shareholders are all listed. Section M-1 shows all the distributions given that year.
On the side of business owners, you can see these owner distributions on form K-1. This form is from the business, and you need it for personal tax preparation purposes.
What Is the Difference Between an Owner Draw vs Distribution?
Owner draw and owner distribution essentially refer to the same process – that is a payout from a business to a business owner or shareholder. The IRS uses the term owner’s distribution on their tax forms. This means that they consider the term “owner distribution” as the more official term. Owner draw is called that because an owner draws or withdraws cash, stock, or property, from their company.
The terms used vary depending on the type of business entity you are dealing with. For instance, owner draw is usually associated with Sole Proprietorships, Partnerships, and Limited Liability Companies that are structured as the two aforementioned business entity types. On the other hand, owner distribution is connected to C and S corporations, and LLCs that are structured as such. Partnerships can also use the term distribution. Note that it’s important to make this distinction in terms between business entity types for the purpose of tax reporting. Distributions and draws do not contribute to business income tax deductions. However, the IRS will want to see proper document filing.
What Are the Rules for Owner’s Draw vs Distributions?
Depending on the business type, there are unique rules regarding owner draws versus distributions. Generally, distributions should always adhere to the terms of the initial business agreement. A change in compensation is justified as the company becomes more profitable. Any pay via owner distributions should always be recorded, though.
Sole Proprietors
In a sole proprietorship or sole tradership, the business and the owner are virtually indistinguishable from one another. As such, sole traders are not considered employees and do not receive a paycheck as an employee would. They don’t get FICA tax deductions and need to pay income and federal/state taxes. Sole proprietors or LLCs with one member take a draw from their business. These drawdowns from the capital of the business do not show up on tax returns.
Partners
In a partnership, partners also do not receive a regular salary as payment. They receive distributions from partnership profits. Furthermore, they are taxed on their partnership income tax return based on their share of those profits. The language of the partnership agreement or LLC operating agreement governs how profits are distributed in a partnership or LLC. A partner’s distribution is recorded on Schedule K-1, and show up on the tax return of the owner.
LLC Members
You can also consider members of limited liability companies as owners and not employees. They don’t receive an employee salary. If an LLC has one member, this person is considered a sole proprietor for taxation purposes. As such, they take a draw. The government treats LLCs with multiple members similarly to partnerships. These owners take a distribution.
Because the federal government does not recognize LLCs, they must follow state regulations regarding distributions. Typically, LLCs can only change their agreements on an annual basis.
Both multiple member LLCs and an S corporation shareholders take a distributive share. These amounts are listed on Schedule K-1.4.
Corporate Shareholders
In a corporation or S corporation, owners are called shareholders or stockholders. These shareholders take a distributive share in what the government calls “dividends”. This can be in the form of cash or stock. A board of directors decides when and in what amount the company will pay out these dividends.
C and S Corporation Owners
You can look at corporation and S corporate owners who also run the business as employees. In this case, they would receive a regular salary and pay the appropriate employment tax. These owners can also receive an owner distribution.
Note that the salary must be deemed reasonable by IRS standards. The IRS has guidelines about paying yourself that business owners must follow. Otherwise, if they deem your compensation to be unreasonable, you could be taxed and penalized.
When Do You Have to Do a Distribution?
The timing of distributions can vary depending on the type of business and the jurisdiction in which it operates. However, some common factors that can determine the timing of distributions include:
- Financial performance of the business: Distributions are often made when the business has generated enough profits to pay out to its owners or shareholders.
- Agreements in governing documents: The company’s governing documents, such as its articles of incorporation, bylaws, or shareholder agreement, may specify the frequency and amount of distributions.
- Tax considerations: You are allowed to pay out distributions at specific times of the year to either align with tax filing deadlines or to minimize the tax impact of distributions on the business or its owners.
How Do I Pay Myself in a Distribution?
This depends on the business type. As long as you aren’t incorporated, you can make a draw yourself if you are an owner. However, remember that you need to indicate any withdrawals as owner distributions and take them on a regular schedule for tax reports. It may be helpful to indicate a specific account for owner draws for easier tracking.
Withdrawals can be made by debiting the owner’s account and crediting the cash account. Remember, these draws or distributions will be taken out from the owners’ equity. So, when the year ends, the sum of the withdrawals in the draw account will be subtracted from the owners’ equity account.
How much can I take?
If you are a sole proprietor, you have the freedom to take as much from the business as you like as an owner distribution or draw. This means you need to strike a balance to maintain business profitability, account for expenses, and get paid. You can get an idea of what is fair pay by looking at similar industries and positions. Evaluate your net income. Weigh it against all expenses, remembering to factor in taxes and any business loans you may have availed.
For the other business types, make sure to adhere to business agreements regarding these distribution amounts. Also, remember to keep in line with IRS regulations and guidelines.
Conclusion
Find a happy medium between pay and business equity. Any personal withdrawal will reduce your cash assets because you are withdrawing capital. You don’t want to risk going bankrupt, so take only what is absolutely necessary. An accountant can assist you in determining how much you can take from the business while still meeting your investment objectives.
As always, you are also free to reach out to us here at EcomBalance for any questions you might have about how to sort out owner distributions and owner draws to keep your books clean and the IRS happy..
