Drawing Vs Dividends: Is Owner’s Drawing the Same as Dividends?

The owner’s drawings and dividends are two different methods of withdrawing funds from a business.

Although both methods have similar impacts on a business and for business owners, they work differently.

Let us discuss what are owner’s drawings, dividends, and salary methods and their implications for business owners.

What is Owner’s Drawing?

Owner’s drawing, owner’s draw, or simply draw is a method of taking out money from a business by its owners.

Owners can withdraw money from the business at any time. For certain business structures, there is no restriction on owners to withdraw money from the business as and when needed.

Owner’s draw is a method of paying yourself as an owner of the business. Partners can withdraw money from the business as well using the draw method.

Note that a draw is only allowed for the owners (shareholders) of the business. It isn’t allowed for employees such as managers or directors of the business.

What Are Dividends?

A dividend is a portion of profit (and retained earnings) that a company distributes to its eligible shareholders.

In simple words, dividends are the portion of profit or reserves of a company that is distributed among its shareholders.

Small companies can be owned by a single large shareholder. Large companies can be owned by several shareholders (even millions). Therefore, each shareholder would receive a dividend according to the ownership percentage in the company.

Dividend declaration solely depends on the dividend policy of a company. A company is not legally bound to announce a dividend for its shareholders.

Also, the amount of dividend can change every year depending on the decision taken by the board of directors of a company.

Is Owner’s Drawing the Same as Dividends?

Dividends are paid out of the profits and reserves of a company. These are paid out of after-tax profits.

On the other hand, drawings can be taken out of the available cash of a business. Although an owner cannot withdraw more than the total equity of the company.

It means owners can draw out of profits or retained earnings of a business. When they take a draw for their personal uses, they use cash reserves. However, this draw should not exceed the available profit or reserves.

Although paid differently, both concepts present the same idea. Owner’s drawings is a commonly used term for small businesses while dividends are associated with listed companies or large private companies using profits.

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When to Pay Yourself with Drawings?

Taking funds out of a business requires several key considerations.

Most small businesses have a sole proprietorship, partnership, or LLC entity structure. These entities have a double taxation structure.

Therefore, when owners withdraw funds from these businesses, it does not affect their taxes. Reserves held with the business would get taxed at the corporate rate while funds withdrawn by the owners will be taxable at the individual’s applicable tax rate.

Tax regulators such as the IRS put restrictions on owner’s draws. It means they cannot withdraw profits unlimitedly to take unfair advantage of lower tax rates.

On the flip side, the draw method is simple and flexible. As an owner, you can take a draw as many times as you want.

Also, as long as you are paying taxes properly, you can withdraw money without any upper limit.

The major drawback of this method is to consider the tax implications.

When to Pay Yourself with Dividends?

A dividend is the distribution of funds from the available after-tax profits. A dividend payment would be made to all shareholders in proportion to their shareholdings.

Private companies should consider several factors when deciding to pay their owners through dividends.

Dividends are taxable income for shareholders. It means they’ll incur additional taxes when received by the owners.

Also, a company would decide to pay dividends (or distribute profits) only when it has accumulated reserves.

Therefore, a dividend policy is more suitable for companies that do not require to pay the owners regularly throughout the year as dividends are paid yearly.

A company deciding between dividends and owner’s draw should consider the equity and available cash first. Either way, it is the owner’s equity that will reduce after receiving dividends or drawings.

Drawings Vs Dividends for Different Entity Structures

Another way to decide between the drawings and dividends is to see the entity structure of a business. Each entity type favors one method over the other.

Sole Proprietor

Sole proprietorships pay taxes on profits regardless of the draw amounts. Therefore, an owner could draw as many times as possible.

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The maximum a sole proprietor can take is equal to the total equity.

Partnership

Partners do not withdraw salaries. Therefore, they can either take drawings or split profits in the form of dividends.

A suitable option for partners is the drawings method considering the tax implications and the entity structure.

A Limited Liability Company

An LLC works as either a sole proprietor or a partnership. Therefore, a suitable option for owners of an LLC is to use the owner’s draw method.

C Corporation

A C corporation is taxed twice. Once for its profits at the corporate tax rates and second for the owners when they receive dividends.

If owners choose only the dividends or drawings method, they’ll get taxed twice.

An appropriate option to withdraw funds from a C corporation is through a salary.

S Corporation

S corporations do not pay dividends usually. Therefore, owners can either use the drawings (distribution) method or use the salary method.

A wise choice is to use both methods to withdraw funds from an S Corporation.

Salary Vs Drawings Vs Dividends

We have discussed owner’s draw v dividends so far. For varying reasons, both decisions of draws and dividends have similar implications for a business.

At the end of the day, the equity of owners reduces by using dividends or draws.

An alternative approach for business owners is to pay themselves with salaries.

When a business pays a salary to its owner, it doesn’t reduce its equity. Rather, it reduces the taxable profits. In that sense, it reduces the taxes owed by a business as well.

It’s important to note that owners cannot set salaries without careful consideration. Tax regulators such as the IRS would set reasonable limits for owners withdrawing salaries from their own businesses.

Simply put, salaries or owners’ compensation packages should match their skillsets and should be market competitive.

Owner’s loan Vs Draw Vs Dividends

Another similar concept to the owner’s drawings or distributions is the owner’s loan.

For large companies, it is also called directors’ loans.

Directors of large and public companies pay themselves using salaries, compensation packages, bonuses, employee share schemes, etc.

Owners of private companies use salaries, distributions, and draws.

Often directors and owners draw more funds than accumulated retained earnings (hence the equity). It creates a negative drawings impact on the business.

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The business would record such overcompensations as directors’ or owners’ loans.

The owner’s loan will be adjusted against dividends or distributions when available.

Tax Implications of the Drawings Vs Dividend Decision

The decision to use the draw, dividends or salary method will also depend on the tax implications.

A C corporation pays corporate taxes on its net profits. It can distribute the profits as dividends to its owners. However, it cannot pay salaries to its owners as that’s against regulations.

When a C corporation distributes dividends, the owners must pay taxes on them as well. It means the owners of a C corporation would pay double taxes.

Other entity types such as an S corporation, LLC, sole proprietorship, and a partnership has a pass-through tax structure. It means these entities would pass on profits (and losses) to their owners.

It means owners receiving dividends would get taxed only once with these entities.

How Much to Pay Yourself? Important Considerations

Since most small businesses are incorporated as a sole proprietorship, LLC or a partnership cannot pay salaries to their owners.

Owners of these entities would consider dividends and drawings as their options. For other entities, owners can withdraw funds through all of these three options.

As a business owner, you should consider the following key factors before choosing the right option and deciding how much can you pay yourself.

  • Consider the retained earnings of the business. If there isn’t much available, you should refrain from putting the business under financial stress.
  • Consider the tax implications of your choice as discussed in detail above.
  • Evaluate the investment and growth opportunities of your business before declaring dividends.
  • Remember, your drawings and dividends will reduce equity. Therefore, carefully evaluate the impact on equity of your decision.
  • Finally, consider your personal expense requirements as well. You can avoid high-interest loans by using the available drawings or dividends from your business.
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