If it's your business, you may feel perfectly justified if you ever withdrew cash for personal use. Depending on the business structure you set up, the withdrawals may land you in hot water. Even if it's all legit, it's important to make a journal entry for cash withdrawn for personal use, just as you would for paying bills or invoices.
The journal entry for cash withdrawn for personal use goes in an account called Drawing or sometimes Withdrawals. If you take $20 from the till to go out to dinner, you debit Drawing for $20 and credit Cash for $20.
The legal structure you choose affects your ability to make withdrawals. In a partnership, for instance, your partners have a say in where the money goes. Forming a limited liability company or a corporation protects your personal assets but only if you keep business and personal finances separate.
With a sole proprietorship, it's a lot simpler. There's no legal border between you and your company so you're free to spend money as you choose. Keeping your personal and business finances separate, though, makes it easier to track business expenses and easier to prove to the IRS they were business expenses.
For a sole proprietorship accounting sample, suppose you have $15,000 in your business bank account. You had an unexpected home repair so last month you withdrew cash for personal use, totaling $2,300, to pay for it.
- You debit Drawing for $2,300 and credit Cash for the same amount.
- On your balance sheet you reduce your Cash assets account by $2,300 and do the same for Owners' Equity.
- Withdrawals to pay yourself aren't an expense so you don't report it on the income statement.
Even if you're a one-person business, there are advantages to setting up a corporation or an LLC. One of the advantages is that the business's finances are separate from yours, so business debtors can't lay claim to your personal assets. That protection fails if you treat business accounts like your personal piggy bank.
You can still withdraw money but it's safer to do it formally. One way is to pay yourself a regular salary, just like any other employee. Instead of making a journal entry for cash withdrawn for personal use, you treat it as a payroll expense.
The alternative is to schedule regular withdrawals rather than random ones, as if you were issuing yourself dividends. Even for a sole proprietorship, there are advantages, because regular withdrawals are easier to budget for. You credit these to the Drawing account.
One advantage to scheduled withdrawals accompanied by a "withdraw money for personal use" journal entry is that you don't lose track. If you don't record withdrawals in your ledger when you give yourself money, you may forget. That's going to pose a problem when you review your profits and expenses for the quarter.
How you decide to pay yourself may affect your taxes. It doesn't with a sole proprietorship because all the business income is taxable personal income even if you never withdrew cash for personal use.
With an S corporation, however, how you pay yourself makes a big difference. Making distributions to yourself gives you a better tax deal than accepting a salary. If you work for the corporation, however, the IRS requires it pay you a reasonable salary and take out payroll taxes.
This doesn't prevent you from withdrawing money as distributions. You can mix distributions and salary as long as your salary falls within the "reasonable" range for your industry. It can be on the low end of that range, but you're less likely to get into trouble if you don't go below that.