Five common scenarios where an owner might take an owner’s draw instead of a salary.

1. Maximizing Tax Efficiency (Avoiding Payroll Taxes)

• Scenario: The owner wants to reduce self-employment taxes (Social Security and Medicare).
• Explanation: In an S Corporation, only the salary portion is subject to payroll taxes (15.3% for Social Security and Medicare). Owner's draws or distributions are not subject to these taxes. Owners often balance a reasonable salary with distributions to minimize payroll taxes while staying compliant with IRS guidelines.

Caution: The IRS requires that the salary be "reasonable," and excessive distributions with an unreasonably low salary can lead to penalties.

2. Cash Flow Management

• Scenario: The business has uneven cash flow, and the owner prefers flexible withdrawals rather than a fixed salary.
• Explanation: A salary requires regular payroll taxes, which may strain a business during lean months. By taking an owner's draw, the owner can adjust withdrawals based on the business's available cash, giving more flexibility in managing cash flow.

Caution: While this approach can help with cash flow management, it’s important to ensure that the owner is still taking a reasonable salary over time.

3. Preserving Working Capital in Low-Income Years

• Scenario: The company had a low-income year or a year with losses, and the owner wants to minimize fixed expenses (like salary).
• Explanation: In low-profit years, the owner may choose to take minimal or no salary to keep expenses low and withdraw funds via an owner’s draw only as needed. Since the owner's draw doesn't create a payroll tax liability, this can help preserve the company's working capital.

4. Profit-First Approach to Compensation

• Scenario: The owner prioritizes profit and personal compensation only after ensuring the business is financially stable.
• Explanation: Some owners prefer to run the business with the mindset of drawing profits only after all other expenses (including staff salaries, operational costs, etc.) are covered. In this case, they might take distributions at the end of the year based on the remaining profits rather than a fixed salary throughout the year.

5. Handling Periodic or Seasonal Income

• Scenario: The business experiences seasonal fluctuations or periodic income.
• Explanation: If the business does not have consistent, year-round income, the owner might choose to take draws during peak seasons when profits are higher. A fixed salary could strain the business during low-revenue periods, while flexible draws allow the owner to adjust compensation based on actual profits.

Important Considerations:

• IRS Scrutiny: The IRS is strict about ensuring that S Corp owners take a reasonable salary before taking draws. An unreasonably low salary combined with large distributions could trigger an audit.
• Payroll Taxes: While draws can reduce payroll tax liability, taking too little salary can result in penalties for underpayment of payroll taxes.