How to record payments to yourself when you own your own business

One frequent problem I see in people's accounting records is how they record money they take out of the business as their "paycheck." I'd like to explain how to do this correctly.

 
The answer depends on your business structure, but first you have to understand that your taxable income is NOT the money that you withdraw from your business account over the course of the year. It is the net profit or loss of the business, which may or may not be the same as your cash flow. (For example, if you are making liability payments, the interest may be recorded as an expense, but the amount going towards the principal cannot be an expense. So if they are large amounts, your P&L statement may show a profit, even if you feel like you aren't making any money.)
 
Here are the two options for recording money you receive from your business:
(1) If you are an S-Corporation, a C-Corporation, or an LLC that has filed Form 2553 (the S-Corp election), then you should be on payroll along with your other employees. There are distinct tax advantages to being/filing as an S-Corp if you earn a certain income; we recommend you consult with your CPA about whether this is right for you, and if so, how much you should be paying yourself.
Your paycheck will show up on your Profit & Loss statement under "payroll expenses." If you would like to split out your paycheck from the rest of the employees, create a sub-account to track your wages.
 
(2) If you are a sole proprietor, partnership, or LLC, then the money you take out of the business is NEVER a taxable expense. Instead, you are taxed on your net income, as I explained above. To record money you take out of your business, usually you'll want to use an equity account, so your draws show up on your balance sheet, not in your expenses.
However, if you prefer to see your draws as an expense on your P&L for business management purposes, you should create a separate account to track the draws, so they don't get mixed in with deductible expenses when tax season comes around.
Also, if you receive normal paychecks as the owner of an S-Corp, you may withdraw funds from your business in addition to your normal pay. You should track these with an equity draw account, as I described above.