Taking Money Out of a Business: The Dos and Don’ts
The IRS pays close attention to any transactions between businesses and individuals, including the company’s owner, partners, and any shareholders. These transactions may be classified into one of several categories, some of which trigger a taxable event.
With the expert guidance of a reputable accountant and proper planning, many of those taxable transactions can be reclassified in a tax-favorable way for the company or the individual receiving funds.
We’ll address how taxpayers can do that, as well as how the IRS classifies transactions when money is taken out of a business.
How the IRS Classifies Transactions Between Owners (or Shareholders) and Businesses
When a company’s owner provides funds to the business, the transaction will be classified as one of the following:
- A capital contribution
- A loan to the business, or repayment of an outstanding loan with the business
- An expense reimbursement
- A purchase
When a company’s owner, partner or shareholder takes money out of a business, the transaction may be classified as one of the following:
- A taxable dividend or profit distribution
- A nontaxable distribution
- A nontaxable expense reimbursement
- Taxable wages
- A loan to the shareholder or owner
- Repayment of an outstanding loan to the owner or shareholder
Each of these transactions must be properly classified using the right reporting and accounting tools. If they aren’t, the IRS may reclassify transactions in such a way that adds to the company’s or shareholder’s tax burden.
It’s Critical to Avoid Intermingling Personal and Business Funds. Here’s Why:
The most common reason cause of tax compliance violations – at least among SMBs – is intermingling personal and business funds. As such, it’s one of the biggest don’ts for small business owners.
What does it mean to intermingle personal and business funds? Separate accounting trails should be set up for personal and business transactions. If personal funds are used to pay for business expenses or if business funds are used to pay personal expenses, the funds are being intermingled.
It’s critical for small business owners to avoid doing either. Even if done innocently and even if the company’s books make this division clear, intermingling funds may have devastating taxation and legal consequences. For example, intermingling funds may pierce the corporate veil and expose the owner to liability.
Taking Money Out of a Business: Considerations For Each Type of Transaction
As the business owner, you’ll eventually want to take money out of the business. This could be in the form of wages, guaranteed payments, dividends, or even loans. Again, this has to be done carefully to prevent the IRS from reclassifying the transaction as taxable, as the rules regarding each type of transaction will vary with corporate tax structure. Here’s a summary of how to proceed:
- Wages – Wages are paid to owners or shareholders for services rendered. When wages are paid out, income taxes and payroll taxes are both withheld and reported on a W-2 issued to the taxpayer.
Wages should never be paid out to an owner running a sole proprietorship (nor should dividends or other distributions). From the IRS’s perspective, there is no distinction between a sole proprietorship and the owner, so they can take money out of a business account without tax ramifications.
With a C-corp structure in place, though, wages are deductible and therefore offer a tax advantage to owners. However, the IRS requires owners to pay “reasonable wages” to dissuade owners from leveraging this deduction too far. For wages to be considered reasonable, they must be similar to the wages expected for an identical position at other companies.
- Guaranteed Payments – Guaranteed payments are relevant to partnerships only and play a similar role to corporate wages. However, there’s a big difference. Income and payroll taxes are not withheld from guaranteed payments. Instead, they are reported, computed, and paid on the taxpayer’s Form 1040.
- Dividends – Dividends are the primary means through which a C-corp distributes profits to shareholders. Dividends paid out as cash distributions are considered qualified dividends, so they’re taxed on a capital gains schedule rather than an income tax schedule. In the vast majority of cases, this represents a tax advantage.
- Loans – When a shareholder pays back a loan to a business, or when a business makes a bona fide loan to a shareholder, neither are considered a taxable event. However, it’s important that these transactions are reported using proper accounting practices, otherwise the IRS may reclassify them as taxable.
Considerations For Flow-Through Income (S-corps and Sole Proprietorships)
Income generated by S-corporations and partnerships is passed through to the shareholders. This means S-corps and partnerships are not considered taxpaying entities. Instead, the company’s income is reported on the owners’ or shareholders’ individual tax returns. Cash distributions paid out by an S-corp are not taxable until the taxpayer’s cost basis reaches zero.
LLCs and Choosing a Corporate Tax Structure
LLC owners have some flexibility in how they are taxed, but only in some cases. Here’s how the IRS handles LLCs:
- If owned by a single person and if no preferred corporate tax structure is selected, the LLC is taxed as if it was a sole proprietorship.
- If owned by multiple people and if a preferred corporate tax structure isn’t selected, the IRS will default to taxing the entity as a partnership.
- Otherwise, the LLC’s owner(s) may elect to be taxed as a C-corporation or S-corporation.
Depending on what tax structure an LLC owner opts for, the relevant tax stipulations and planning options will apply.
How a Business Tax Expert Can Help Companies (and Shareholders) Avoid Excess Taxation
Corporate taxation is a convoluted concept, but it’s one that business owners must have a grasp of to avoid costly mistakes. Given the high degree of complexity and the high stakes involved, many owners partner with a business tax expert to ensure they have every base covered.
Here’s a few ways that a reputable tax professional can help business owners:
- Prevent intermingling of funds – A business tax expert can help their clients avoid funds intermingling from the outset by establishing a completely separate accounting chain for business purposes. Separate accounts, separate reporting instruments, separate everything. A tax expert can also help business owners continue capitalizing their company without breaching the corporate shield.
- Help owners classify transactions for tax reasons – As we’ve reviewed, there are several ways to classify transactions between businesses and owners/shareholders. It’s essential for business owners to observe the right processes when entering into a transaction so they are classified properly. Specifically, this means reporting the transaction to the IRS the right way and recording the transaction in the books the right way. A Houston TX tax expert with business accounting experience can help with both.
- Assist LLC owners with choosing the right tax structure – LLCs are a popular choice for new business owners, as they provide a liability shield and give owners flexibility in how their taxes are planned out.
Determining the right tax structure for an LLC – whether S-corp, C-corp or something else – requires long-range thinking and planning, as the decision will have long-term tax ramifications. A tax expert can help their clients forecast their tax planning scenarios in order to identify the most cost-effective approach.
Taking Money Out of a Business is Fraught with Taxation Complications, but They are Largely Avoidable with the Right Planning
The point of starting a business is to eventually take money out of it. Doing so, though, can be complicated from a tax perspective. If the right accounting and reporting measures aren’t taken, it could have lasting tax or legal consequences for the owner.
That’s why company owners are strongly recommended to consult with a Houston TX business tax expert before taking money out of the company. This will ensure all appropriate steps are taken to avoid a surprise tax bill from the IRS.
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