One of the questions a self-employed person will have to face is how to take money out of business. This question partly depends on the tax structure of the business. In this article, I will discuss the right way to do it as a sole proprietor versus a corporation. If you are a S-corporation the corporation rules will apply to you and if you are a LLC taxed a sole proprietor the sole proprietor rule will apply to you.
If your business is a wealth building tool, how much you take out should be carefully planned and should be a part of your wealth building plan.
Taking money out of your business as a sole proprietor:
Being a sole proprietor means there is no legal structure separating you and your business. However, just because there is no legal separation does not mean that your business is not a separate entity. Even if you are a sole proprietor you should still be conscientious about taking money out of your business.
As a sole proprietor, taking money out of your business is not illegal but it can be compared to going to your mom’s house and eating all the cookies on her table without asking. While your mom will not take you to jail, it is quite disrespectful. Your business should be treated as a person of its own and any withdrawals you take should be a formal agreement between you and your business.
The right way to get permission from your business is by having a formal agreement. As a sole proprietor you do not pay yourself a salary rather than taking a salary you take what is called a draw from your business. A draw should be taken out based on a pre-arranged agreement. This pre-arrangement could be a percentage of profits or a fixed amount every month.
What I see most sole proprietor do is to randomly take money out of their business anytime they need it. There is no accountability and at the end of the year they are surprised there is not a lot of cash left in the business. Disrespecting your business is the worst way to build wealth.
Taking money out of your business as a corporation:
The upside of forming a legal structure separate from the business is that you have the advantage of taking money out of your business in multiple ways. For instance you can take money out as:
- Salary
- Dividends or distributions
- Reimbursements
- Loans
- Return of capital
Corporation – paying yourself a salary
As a corporation you are required to pay yourself a salary. The IRS considers paying yourself a reasonable salary a big deal. You must take money out as salary before you pay yourself dividends or distributions. The upside of putting yourself on payroll is you are able to take advantage of deferred tax through retirement savings.
Restrictions for corporation
The restrictions for taking money out of your business are more stringent for corporate structures. If you do not have a formal process, you could be accused of mingling funds in the court of law and your business will be considered a sole proprietorship.
For example, Let us imagine a day you had a little too much to drink. On your way home you ran into a child who suddenly ran across the street to get his/her basketball. If you are in the habit of taking money out of your business, the lawyer can convince the judge that your business assets should be treated as your personal assets which means they get to clean up all your business and personal assets. Keeping things separate protects you. This also applies to divorce cases or any other reason you need to go to court.
Lastly, the IRS frowns upon the informal process of taking money off of your business especially if you are underpaying taxes on your withdrawn funds. Businesses that do this have a harder time during an IRS audit process.
As a corporation always remember to:
- Formalize the process: you should maintain documentation of any agreement you form with your business
- Take wages: Just like any employee, pay yourself regularly
Think of it as treating your business as a person of its own and not just an extension of you.