Profit Retention in a Sole Proprietorship
If you choose to structure your business as a sole proprietorship, your company's profit translates to the personal earnings that you report on your individual income tax form. It is entirely your own decision whether to retain these funds in your business account or withdraw them for personal use. Whatever you choose to do with your earnings and profit, you must still report these amounts as personal income and the revenue will be subject to personal income tax.
An owner's draw is the amount that a business owner takes out of his business account for personal use. A sole proprietor can take out as much money as he needs, although the amount that he takes out is limited by the amount that he has on hand, which will in turn is limited by how much profit his company earns. Sole proprietors are not even required to maintain separate business bank accounts, although having a business account makes it easier to track business transactions.
A business owner's equity is the value of her investment in her business. Profit that is retained in a sole proprietor's business account figures into her owner's equity as capital assets that add to her company's bottom line, making the business more valuable. However, profits that are retained in a sole proprietor's business account do not increase the value of business equity that might switch hands if she were to sell her business. She will keep these funds even if the business changes hands.
Profits that are retained in a sole proprietor's bank account provide working capital for the business to finance day-to-day operations and pay for expansion in the form of capital improvements. Because the finances of a sole proprietorship are so closely tied to the personal finances of the owner, a shortage of operating capital may necessitate accruing personal debt in the form of credit cards, credit lines or business loans. Retaining profit to use as operating capital improves a sole proprietor's personal credit and saves money on costly finance charges.
The practice of retaining profit in a sole proprietorship does not affect a business owner's tax liability. From the standpoint of the Internal Revenue Service, profit and loss from a sole proprietorship business is taxable as personal income whether the business owner withdraws it and spends it right away or keeps it in the business account for future use. She can, however, write off the retained amount if she uses it down the line for business-related expenses.