What Happens When You Pay Yourself in a Small Business?

Most Common Scenario

What Happens When You Pay Yourself in a Small Business

The typical scenario based on my experience is that at some point the business owner takes money out of business to use for personal expenses or pay themselves. It is critical to mention that this example and the accounting treatment that’s behind it, is applicable to a Limited Liability Company (LLC) or Sole Proprietorship. Now, here is what happens: Sales are coming in and the business owner needs to take money out of the business to pay himself for expenses that are not related to the business (e.g., house rent, groceries, personal phone etc.). First, make sure you track all your expenses, then start thinking about how to record them.

How do you record this? 

Let’s say that the business owner took $25k this year and paid himself or herself. From an accounting standpoint, this is not an expense.

Why?

Because the business owner, did not use the money to pay for expenses related to the business. The business owner made a draw to pay themselves. Pass through entities like LLCs and Sole Proprietorship, do not deduct or consider “salaries” the cash a business owner pays themselves. This is considered an owner’s draw.

Still Confused?

Let’s look at it this way.  If you are a sole proprietor or an LLC with no employees, the cash you pay yourself is a draw from the business (S Corp deduct salaries as expenses, but that is a different story for a different post). 

Accounting Treatment

The accounting treatement for draws is:

  • Balance Sheet: 
    • Cash: $25k
    • Equity Section: Owner’s Draw: $25k

What does this mean?  Hey! I took out $25k this year to pay myself. I took it out of cash, and it is also reflected in the Owner’s Draw section of the Balance Sheet. 

NOTE: This is recorded in the Balance Sheet, not the Income Statement or Profit and Loss. 

Think about the income statement as sales and expenses made for business purposes.
Think about the balance sheet as a storyteller on what happens with cash.

What Is Taxed?

You pay taxes on the net income (bottom line of your Income Statement or Profit and Loss Statement. This becomes your “personal” income for the year. 

If at the end of the year you make a net income of $51K, this is what you pay taxes on. Not the $25K that you paid yourself.  Think about it this way, you and your business are the same from a tax perspective. Your business’ bottom line/income becomes yours. 

Does it make sense? Cash you take out from the business is considered an owner draw, not salary, thus, it is not a business expense. It is classified on the Balance Sheet, not the income statement. Finally, you pay taxes on the net income or net profit and loss, not the cash draws you made to pay yourself. 

Still confused? Check out the below video to see how it can be done in QuickBooks Online and this article from Business Daily too.

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QuickBooks Online – How to classify an owner payment / salary as an Owner Draw or Pay

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