In my experience as a Chartered Accountant over the past 20 years, one of the areas that causes the greatest confusion for new clients is drawings. In particular the question of “… if I pay taxes on dividends from my business, why don’t I pay tax on drawings?”.
So in this short article we are going to look at this question. If you would like the quick answer, it’s no. If you would like to know why … then please read on.
What Are Drawings?
Drawings are the withdrawal of equity (also called capital) from a business that an owner has built up over a period of time. Drawings transactions are disclosed through the statement of financial position (or balance sheet).
Now let’s take this apart a little so we can better understand what we are dealing with.
Drawings, Equity and No Tax
This is the key reason why income tax is not paid on drawings from a business; the owner is withdrawing capital or equity (these two words mean the same thing in accounting speak) from the business back to himself. Generally, most tax jurisdictions do not tax the movement of capital, although gains on capital are often taxed. Along with their favourite form of tax … that being on income.
In our case we are not dealing with either gains or income with drawings. However, we do need to be a little bit careful here and make sure we are dealing with capital contributed already and/or income credited to the owner by the business and for which tax has already been paid. And not trying to draw income from the business and treating this as “drawings” and so avoiding the payment of income tax.
So how do we ensure that drawings are really drawings? Well, that will have to wait for another article, which I will hopefully link around here, where we look at the drawings account and proper debits and credits. This article will look at how different business structures and in particular companies and the treatment of salaries and dividends through this type of account.
Just a short article today looking at the simple but important question of do you pay income tax on drawings from a business. The quick answer is no, no income tax is due on drawings because it is not an income or gain back to the owner, but rather the movement of capital already invested into the business, be it a sole trader, partnership or company.