Why take money out of your business?

There are plenty of reasons to take money from your business and many ways to do it.

Some owners are hesitant to withdraw revenue, worrying that they are taking away profits. While it’s difficult to overstate the importance of thorough planning and correct structure, owners who never take any money out of the business may be harming it long-term.

Here are some common reasons you may want to withdraw income from your business.

To minimize risk

Proper financial management is critical to ongoing stability. A vital component of a sound business strategy is creating a sufficient buffer of funds outside the business that will not be in jeopardy should your company encounter an emergency.

Leaving funds in your business can be risky, as they can be vulnerable to potential creditors, lawsuits, or unforeseen events. That’s why many business owners choose to withdraw a percentage of every dollar of income generated.

When your company is healthy and operating well, you can use this money for things like investments in the company or buying back stock from other shareholders.

To save on taxes

The taxation of business withdrawals is complex and variable. Advantages, disadvantages, and processes will differ based on your entity structure (I’ll go into this in more depth later in this article). Broadly speaking, however, withdrawing money from your company can be an effective tax-saving strategy.

The most obvious benefit of minimizing taxable income is the opportunity to grow the business and reinvest earnings. Yet, there’s a second, less quantifiable benefit as well. Being engaged with and attentive to the financial management of your company will drive you to think more seriously about the direction of your company and how it will respond to cash flow issues.

Bear in mind that transactions such as these can negatively impact both you and your business, so it is crucial to take great care in their execution. As always, if in doubt, contact a tax professional.

Personal compensation

The costs of owning a business can seem overwhelming at times—especially for sole proprietors. Running your own company can be expensive, and that’s not to mention your investment of time.

Now, after hard work and a lot of patience, you are finally ready to take some of the profits out of your business to cover your personal expenses – and for YOU.

How do you do that the right way? The structure of your business entity is a determining factor.

Owners of S and C corporations may pay themselves a salary or through earnings distributions.

Partnership owners may use distributions or guaranteed payments. Guaranteed payments are essentially salaries, with one significant difference: there is no withholding for payroll or income taxes.

Finally, sole proprietors pay themselves using an owner’s draw (taking company money for personal use).

For shareholders of S and C corporations, there are incentives to skew their wages one way or the other for tax savings.

If you elect to pay yourself a salary, though, the IRS requires you to make sure that the amount is “reasonable.” That is to say; you can neither inflate nor deflate your salary beyond an amount approximate to what someone in your industry would receive for similar services in an unrelated company.

Many entrepreneurs choose to pay themselves a fixed percentage of profit so that their salary can grow as the business does.

What is the best way to take money out of your business?

To withdraw funds from your company without incurring penalties or tax consequences, you’ll need to understand the type of business entity you own. Are you a sole proprietorship? A partnership? An LLC? An S or C corporation? The answer will impact the structure of the transaction.

Each type of business entity has a different tax classification and will have different requirements for taking money out. You need to ensure the withdrawal meets these requirements and is not a breach of any other regulations.

Below, I will discuss ways you can approach taking money out of different types of business entities.

Sole proprietorships

In a sole proprietorship, there is no legal distinction between the business owner and the business entity. This can be a double-edged sword; for example, the sole proprietor keeps one hundred percent of the profits from their business but is also one hundred percent responsible for all losses and debts. Furthermore, business profits are subjected to taxation on the sole proprietor’s personal return.

When it comes to taking money out of the business, sole proprietors have the most uncomplicated process. They can make withdrawals at any time, simply by transferring from the business to their personal bank account or by writing a check from the business account. This is the aforementioned “owner’s draw,” and this transaction has no tax ramifications and is not a deductible business expense.

Partnerships

A partnership is precisely what it sounds like—a formal arrangement between two or more individuals, businesses, organizations, schools, or governments to manage and operate a business and share its profits. Like a sole proprietorship, partnerships pass all income on to the owners or investors. This is a “flow-through” or “pass-through” entity, a category that also includes S corporations.

Flow-through entities do not distinguish between the business owner and the business itself. So owners of partnerships report their income on their personal returns, even when there has not been a distribution.

S and C corporations

Both S and C corporations differ critically from sole proprietorships and partnerships in that they are separate legal entities created by a state filing. The key distinction between these two kinds of corporations is the form of taxation.

“C corporation” is the IRS’s standard corporate designation. Shareholders, or owners, of C corporations, can take money out of the company in two ways: salary and wages or dividends. These corporations pay income taxes on all profit, including profit distributed to shareholders.

Additionally, those distributions are taxed again as individual income on the shareholders’ personal returns and are not deductible for the corporation. That means any C corporation profits distributed to shareholders are ultimately taxed twice.

There are also advantages to owning a C corporation. There are no limits on the number or type of shareholders, no restrictions on the class of stock, more options for raising capital, and a flat 21% maximum tax rate.

S corporations, as previously mentioned, are flow-through entities, similar to proprietorships and partnerships—the key difference, again, being that S corporations are separate legal entities. Shareholders of S corporations may also take money out through salaries or distributions. While these distributions are not deductible for S corporations, either, in this case, they are also non-taxable for the shareholder who receives them.

S corporations are subject to certain limitations. For example, they can not have more than one hundred shareholders, all of whom must be individuals and United States citizens or residents. There are also restrictions on the sale or transfer of shares and the class of stock. But flow-through taxation and a 20% qualified business income deduction give this type of entity advantages, as well.

Limited Liability Companies (LLCs)

Limited Liability Companies are more complex. Their taxation may take several different forms. They are partnerships by default, but LLCs may elect taxation as either a C or S corporation.

Depending on an LLC’s classification, different rules may apply. The owner of a single-member LLC may withdraw money from the company as needed. All owners of a multi-member LLC must agree on the distribution arrangement. Finally, if the LLC so elects, it can be subject to the S or C corporation rules.

Intermingling funds

As a final note: there is one very important rule that applies across the board.

Regardless of what type of business entity you own, you must never intermingle funds. This is one of the most dangerous financial mistakes you can make. Paying personal expenses from the business checking account, or paying business expenses from your personal account, can leave an opening for the IRS or courts to question the integrity of your business or transactions.

It is essential to your success that you maintain a complete financial separation between your business and personal finances. Failure to do so can result in severe tax and legal trouble.

 

Would you like some help?

If you are a client and would like to book a consultation, call us at +1 (212) 382-3939 or contact us here to set up a time.

If you aren’t a client, why not? We can take care of your accounting, bookkeeping, tax, and CFO needs so that you don’t have to worry about any of them. Interested? Contact us here to set up a no-obligation consultation.