Taxes 2022 Business Owners -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.
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 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 wag-es, dividends, or other distributions. A sole proprietor may take money out of the business bank account with no tax ramifications.
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 partnerships. Owners are treated as employees, payroll taxes and income taxes are withheld, and the corporation issues 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 incentives to skew wages one way or the other for purposes of tax savings. In a C corporation, wages are deductible by the corporation but dividends are not, creating an 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 computed and paid on the partner’s individual Form 1040.
Dividends are generally how a C corporation 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 is often called dividends, they are not treated as dividends under tax rules.
Flow-Through Income—S Corporations and Partnerships
Income from S corporations and partnerships flows through to the shareholder or partner’s individual tax return. Flow-through income is reported without regard 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 per- son’s cost basis reaches zero.
An S corporation is allowed to have only one class of stock. If an S corporation does not make distributions to all shareholders based on the percent of stock owned, this rule may be violated and the S corporation status may be terminated. The one-class-of-stock rule must be adhered to whenever making 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 corporation 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 business owner and no taxable event when a corporation or partnership makes a bonafide loan to a shareholder or partner. However, fail- ing to adhere to necessary formalities can put these transactions in danger, allowing the IRS to step in and reclassify the transactions, resulting in taxable income for the business owners.
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 is considered a disregarded entity and is taxed as part of the owner’s return: individuals (sole proprietorship, rental property, or farming) or divisions of the corporation or partnership. If the LLC makes an election to be taxed as a corporation, either the C corporation or the S corporation 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.
Many events occur during the year that can affect your tax situation. Preparation of your tax return involves summarizing 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.
- A significant change in income or Job change.
- Notice from IRS or other deductions. revenue department.
- Divorce or separation.
- Attainment of age 59½ or 72.
- Charitable contributions of property over $5,000, or other real estate.
- Sale or purchase of a business.
- Sale or purchase of a residence
Why We Appreciate Referrals
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Benefits of Using a Paid Preparer
With so many do-it-yourself tax programs available for sale, it is a legitimate question to ask why you should hire a paid preparer when you can create and file a tax return on a home computer.
Keep in mind that entering tax information into a computer program and making adjustments necessary to clear the program’s diagnostic error messages is no substitute for understanding tax law. The Internal Revenue Code and related Treasury Regulations contain over 10,000 pages of complicated provisions. Working with a tax professional who understands how the provisions affect your specific situation and how the rules interact can provide you with the best result on your tax return. Obtaining tax benefits is often a complex process involving properly executed and timely-filed elections. Simply entering amounts into an in- put program may lead to lost benefits. We find that in many cases we save new clients more than the cost of our services compared to returns they have prepared themselves.
Proper reporting and filing can also help keep you off the IRS radar.
Other Benefits Include:
- When your information is compiled and we’ve examined and discussed your unique tax situation, we take care of preparing the forms and file the returns electronically.
- We will explain details of how items of income and expense affect your return and will make recommendations on how to reduce your tax liability.
- If you receive any communication from the IRS or state revenue department, we are available to assist you with resolution.
- As professional tax preparers, we know the proper means of reporting income and deductions, the proper forms to use, and the proper entries to make. Using a paid preparer makes your return much more likely to be “accepted as filed,” meaning in most cases you will avoid the dreaded letter from the IRS triggered by a box that was not checked or a number entered on the wrong line.
- We can discuss with you the tax effects of any changes in income anticipated for the coming year, to help eliminate the guesswork involved with figuring out what your tax situation will be in future years.
- We can make recommendations for changing withholding at work to help put you in the position you want to be in when it comes time to file next year’s return.
Our clients frequently contact us for assistance in dealing with tax issues such as the following.
- Pension or IRA distributions.
- A significant change in income or deductions.
- Job change.
- Start-up or sale of a business.
- Purchase or sale of a home or other real estate.
- Divorce or separation.
- Self-employment or contract work.
- Large charitable contributions.
- Children in college.
As professional tax preparers, we are bound by rules of ethics to keep all of your information confidential. We take great care in handling your information, including names, addresses, birth dates, and Social Security Numbers, and items of income and deductions. We have safeguards in place to protect the security of your physical documents as well as the security of electronic information used to process and file your returns with the IRS and state revenue agencies.
We adhere to strict rules regarding any disclosure or use of your personal information. We will not disclose or use any of your personal information obtained during the tax engagement for purposes other than preparation and filing of your returns unless we obtain specific written authorization from you in advance.
Checklist of Common Errors When Preparing Your Tax Return
The IRS created the following checklist based on common filing errors.
- Did you choose the correct filing status?
- Did you enter the names and Social Security Numbers for everyone listed on your return exactly as those names and numbers appear on each person’s Social Security card? If there have been any name changes, be sure to contact the Social Security Administration at www.ssa. gov or call them at 800-772-1213.
- Did you enter your income on the correct lines?
- Did you calculate deductions and credits correctly, put them on the right lines, and attach the necessary forms or schedules?
- Did you figure the tax correctly?
- Did you sign and date the return?
- If you filed a paper return, did you use the correct mailing address from your tax form instructions?
- If you are due a refund and requested a direct deposit, did you double-check your routing and account numbers for your financial institution?
- Did you make a copy of the signed return and all schedules for your records?