How are owner draws taxed (and what it means for consulting founders)

You take money from your business every month. Payroll, personal expenses, maybe a quarterly distribution. It feels straightforward until tax time rolls around and you realize the IRS views your withdrawals very differently depending on how your firm is structured.

This is also the point where many founders realize finance isn’t just bookkeeping or tax filing. It’s a set of rules that need to run correctly every month, whether you’re paying yourself or not.

Here's what most consulting founders don't realize: taking less money out doesn't automatically mean paying less tax. The entity you chose when you filed your paperwork determines whether your owner draws get hit with self-employment tax, treated as salary, or classified as distributions. Get this wrong, and you either overpay by thousands or attract unwanted IRS scrutiny.

Owner draws are taxed based on your business entity. Sole proprietors and partnerships pay self-employment tax on all profits regardless of what they withdraw. At the same time, S-corp owners must pay themselves a reasonable salary first, then can take tax-advantaged distributions.

How sole proprietorships and partnerships handle owner draws

If you haven't elected S-corp status, your draws work differently than you might expect.

When you operate as a sole proprietor or partner in a consulting firm, the IRS doesn't distinguish between business profits and your personal income. All net profit from your Schedule C (sole proprietor) or K-1 (partnership) gets taxed as ordinary income plus self-employment tax. That's 15.3% on top of your regular income tax bracket.

The confusing part? Your owner draws don't trigger this tax. The profit does.

Let's say your consulting firm netted $150,000 last year. You took $90,000 in owner draws throughout the year and left $60,000 in the business account for operating expenses. You still owe self-employment tax on the full $150,000. The draws are just you moving money you already own.

Think of it like this: the IRS taxes what your business earned, not what you personally spent. Your draws are simply withdrawals from an account that's legally indistinguishable from your personal finances. Taking smaller draws doesn't reduce your tax bill by one dollar.This is also where many founders start questioning what their bookkeeping service actually covers. If the numbers are technically “done” but don’t help with decisions or taxes, the value is thinner than it looks.

This structure works fine when your firm is small and profits are modest. But as your consulting practice grows and net income climbs past $100,000, that 15.3% self-employment tax starts to sting. That's when founders start exploring the S-Corp election.

How S-corporations change the owner draw tax picture

S-corp status splits your compensation into two categories with very different tax treatment.

Once you elect S-corp status, the IRS now sees you wearing two hats: employee and owner. As an employee, you must pay yourself reasonable W-2 wages for the services you perform. As an owner, you can take distributions from the remaining profits.

Here's why this matters:Your W-2 salary is subject to the full employment tax (15.3%, split between the employer and employee portions). But your distributions avoid that tax entirely. They're only subject to ordinary income tax.

Let's use real numbers. Say your consulting firm nets $150,000 again. As an S-corp owner, you might pay yourself a $90,000 salary (reasonable for a consulting principal managing client work). That salary faces normal payroll taxes. The remaining $60,000 can be distributed, saving you roughly $9,180 in self-employment tax (15.3% of $60,000).

But there's a catch -The IRS requires "reasonable compensation" for owner-employees. You can't pay yourself $30,000 and take $120,000 in distributions just to dodge payroll taxes. The IRS actively audits S-Corps that underpay salaries, and penalties aren't fun.

What counts as reasonable? Generally, the market rate for someone doing your role. If you're the primary consultant delivering client work, managing projects, and bringing in revenue, your salary should reflect that. Check industry benchmarks, compare to what you'd pay someone else to do your job, and document your reasoning.

S-corp status isn't right for everyone. It adds complexity (payroll processing, separate tax returns, compliance requirements) and costs (accounting fees, payroll services). The tax savings need to outweigh these expenses. For many consulting firms grossing above $100,000 in profit, the math works. Below that threshold, probably not.

The costly mistakes consulting founders make with owner compensation

Understanding these common errors helps you avoid both overpayment and IRS attention.

1. The biggest mistake? Taking only distributions without paying yourself a salary as an S-Corp. Some founders elect S-corp status, then try to take everything as distributions to maximize tax savings. The IRS knows this game. Their computers flag S-corp returns showing zero or minimal wages. Audits follow, along with back taxes, penalties, and interest.

2. Second mistake: not understanding your entity type in the first place. I've talked with consulting founders who think they're LLCs (a legal structure) when they need to know their tax election (sole proprietor, partnership, S-corp, or C-corp). Your LLC can be taxed as any of these. The legal structure and tax treatment are separate decisions.

3. Third mistake: ignoring multi-state complexity. If you serve clients across state lines, you might have filing obligations in multiple states. Some states don't recognize the S-Corp election. Others have different rules for nonresident income. Doing your taxes wrong across three states compounds your problems quickly.

4. Fourth mistake: mixing business and personal expenses without documentation. Yes, technically, your sole proprietorship assets and personal assets are the same. But the IRS still wants clean records. Sloppy bookkeeping makes audits painful and tax prep expensive.

What should you do instead? - Start by confirming your actual tax entity (check your filed paperwork or ask your accountant). - Understand the rules for that structure. If you're netting significant profit and still operating as a sole proprietor or partnership, run the S-corp math with a tax professional. If you're already an S-corp, make sure your salary passes the reasonableness test.

And honestly? If your consulting firm is growing, handling multi-state clients, or approaching six figures in profit, stop trying to navigate this alone. The cost of getting owner compensation wrong far exceeds the cost of proper tax planning.