Information to help small business owners:
NOTE: THIS IS STILL A WORK IN PROGRESS — Please be patient.
Taking Money Out of a Business
When taking money out of a business, transactions must be carefully structured to avoid unwanted tax consequences or damage to the business entity. Business owners should follow the advice of a tax professional to make sure financial transactions are controlled and do not cause unanticipated taxation or other negative effects.
For example, a shareholder of a corporation can make a loan to the corporation, and subsequent repayments of principal are not taxable to the shareholder. This may seem straightforward. However, if the loan and repayments are not set up and processed properly, with specific documentation in place, the IRS can reclassify the funding as nondeductible capital contributions and classify
the repayments as taxable dividends, resulting in unexpected taxation. A weak loan structure can also create a danger zone where a court can “pierce the corporate veil,” resulting in personal liability for the business owner. These negative effects can occur in several different situations.
When a business owner provides funds to the business, it can be classified as one of the following transactions.
• Capital contribution.
• Loan to the corporation.
• Repayment of a loan from the corporation.
• Expense reimbursement.
On the other hand, when an individual takes funds from
a business, the transaction can be classified as:
• Taxable dividend or distribution of profits.
• Nontaxable distribution.
• Nontaxable expense reimbursement.
• Taxable wages.
• Loan to the shareholder.
• Repayment of a loan from the shareholder.
Failure to tightly control the nature of the transactions can have negative effects on the business
and the business owner.
Intermingling (co-mingling) Funds is a No No!
One of the most dangerous financial mistakes a business owner can make is to intermingle funds, such as paying personal expenses from the business checking account, or paying business expenses from the owner’s personal account. This can be done with the best of intentions with the business
owner making adjustments in the books to separate the business and personal transactions, but the lax and unprofessional behavior can leave openings for the IRS or courts to question the integrity of the business entity or the transactions. Failure to maintain complete financial separation between a business
and its owners is one of the major causes of tax and legal trouble for small businesses.
A sole proprietor is taxed on self-employment income without regard for activity in the business
bank account. A sole proprietor should never pay himself or herself wages, dividends, or other
distributions. A sole propri- etor may take money out of the business bank account with no tax
There are many events that occur during the year that can affect
your tax situation. Preparation of your tax return involves sum- marizing transactions and events
that occurred during the prior year. In most situations, treatment is firmly established at the
time the transaction occurs. However, negative tax effects can be avoided by proper planning.
Please contact us in advance if you have questions about the tax effects of a transaction or event,
including the following:
• Pension or IRA distributions.
• Significant change in income or deductions.
• Job change.
• Attainment of age 59½ or 70½.
• Sale or purchase of a business.
• Sale or purchase of a residence or other real estate.
• Notice from IRS or other revenue department.
• Divorce or separation.
• Charitable contributions of property in excess of
Taking Money Out of a Business
Taking Money Out
One way for a business owner to take money out of a corporation is through wages for services
performed. Wages are appropriate only for C corporations and S corporations, not for sole
proprietorships or partner- ships. Owners are treated as employees, payroll taxes and income taxes
are withheld, and the corporation is- sues Form W-2, Wage and Tax Statement, to the business owner
after the beginning of the year.
For C corporations and S corporations, there are incen- tives to skew wages one way or the other
for purposes of tax savings. In a C corporation, wages are deduct- ible by the corporation but
dividends are not, creating incentive for a C corporation shareholder to inflate the wages for
higher deductions. In an S corporation, wages are subject to payroll taxes but flow-through income
is not, creating an incentive for artificially low wages. Both C corporations and S corporations
are required by law to pay “reasonable wages,” which approximate wages that would be paid for
similar levels of services in unrelated companies.
Guaranteed payments to partners are the partnership counterpart to corporate wages. One major
difference is with guaranteed payments, there is no withholding for payroll taxes or income tax.
These amounts are com- puted and paid on the partner’s individual Form 1040.
Dividends are generally the means by which a C corpo- ration distributes profits to shareholders.
Amounts up to the C corporation’s “earnings and profits” are taxable to the shareholder. Although
flow-through income from S corporations or partnerships are often called “divi- dends,” they are
not treated as dividends under tax rules.
Flow-Through Income—S Corporations and Partnerships
Income from S corporations and partnerships flow
through to the shareholder or partner’s individual tax
return. Flow-through income is reported without re-
gard for whether or when the income is distributed to the shareholder or partner. Distributions of
cash to an S corporation shareholder or partner are not taxable to the individual until the
person’s cost basis reaches zero.
An S corporation is allowed to have only one class of
stock. If an S corporation does not make equal distribu- tions to all shareholders, this rule may
be violated and the S corporation status may be terminated. The one- class-of-stock rule must be
adhered to whenever mak- ing distributions from an S corporation’s bank account.
A corporation or partnership can receive loans from shareholders or partners, and on the other hand
a cor- poration or partnership can make loans to shareholders or partners. There is generally no
taxable event when a corporation or partnership repays a loan from a busi- ness owner, and no
taxable event when a corporation or partnership makes a bona-fide loan to a shareholder or partner.
However, failing to adhere to necessary formal- ities can put these transactions in danger,
allowing the IRS to step in and reclassify the transactions, resulting in taxable income for the
Limited Liability Companies (LLCs)
Taxation of an LLC falls into either a default category, or the LLC makes an election on the manner
of taxation. A single-owner LLC owned by an individual is considered a “disregarded entity” and is
taxed as a sole proprietor- ship by default. If the LLC makes an election to be taxed as a
corporation, either C corporation or the S corpora- tion rules apply. An LLC owned by more than one
in- dividual is taxed as a partnership by default. As with a single-owner LLC, a multiple-owner LLC
may make an
election to be taxed as a corporation.