Halloween is the perfect time for ghosts, goblins, and things that go bump in the night. But there’s one thing you definitely don’t want haunting your business this October: messy bookkeeping and unexpected tax problems.
One of the most common mistakes business owners make is assuming that because they own the business, they can simply transfer money from the business bank account to their personal account whenever they want.
Unfortunately, it’s not always that simple.
How you pay yourself depends on how your business is structured and how it is taxed.
Let's take a look at the different ways business owners may take money from their companies—and how to avoid turning your bookkeeping into a financial horror story.
Sole Proprietors: The Owner Draw
If you're operating as a sole proprietor, you generally don't pay yourself a salary or paycheck from the business.
Instead, you may take an owner draw.
For example, imagine your business bank account has $20,000 in it and you transfer $2,000 to your personal account. That $2,000 isn't a business expense. It's money you're taking out of the business for yourself, so it would generally be recorded as an owner's draw or a reduction of owner's equity.
Here's an important point: Your owner draw does not determine your taxable business income.
If your business earned $50,000 in profit but you only withdrew $20,000, you aren't necessarily taxed only on the $20,000 you took out. Your taxable business income is generally based on the business's results.
So don't let the amount in your personal bank account become the ghost that scares you at tax time!
LLCs: It Depends on How You're Taxed
Here's where things can get a little tricky.
An LLC is a legal structure, but an LLC can be taxed in different ways. That means there's no single answer for how every LLC owner should pay themselves.
Single-Member LLC: If your single-member LLC is taxed as a sole proprietorship, your withdrawals generally work much like the sole proprietor example above. You may take what is commonly called an owner draw.
Multi-Member LLC: If your LLC has multiple members and is taxed as a partnership, you may hear terms such as member draw or member distribution.
The basic idea is that the business is distributing money to an owner rather than paying that owner a wage.
Partnerships also have other potential payment arrangements, such as guaranteed payments, which can have different tax and bookkeeping treatment.
And just like with a sole proprietor, don't assume that your taxable income is based simply on how much cash you actually withdrew.
S Corporations: Don't Let This Become a Tax Nightmare
If you own an S corporation and actively work in the business, this is an area where you really need to pay attention. You generally can't simply take money out of the business whenever you want and label everything a shareholder distribution. As a shareholder-employee, you generally need to receive reasonable compensation through payroll for the services you provide to the corporation. After considering reasonable compensation and the company's circumstances, you may also receive shareholder distributions. The important thing to understand is that wages and distributions are not the same thing.
Your wages are compensation for the work you're performing.
Your shareholder distribution is a payment related to your ownership in the company.
The IRS pays close attention to situations where an S corporation owner takes distributions but little or no salary, so this isn't an area where you want to guess or take shortcuts.
Don't let an S corporation distribution turn into a tax monster!
C Corporations: Wages vs. Dividends
A C corporation is a separate tax entity from you as the shareholder. If you work for the corporation, you may receive wages through payroll. If the corporation distributes profits to you as a shareholder, that may be treated as a dividend.
This is different from an S corporation distribution.
With a C corporation, the corporation generally pays tax on its profits, and dividends paid to shareholders can then be taxable to the shareholders. This is commonly referred to as the potential for double taxation.
That's definitely something you don't want sneaking up on you at tax time!
So, How Should You Pay Yourself?
Let's make it simple:
Sole proprietor: Generally, owner draws
Single-member LLC taxed as a sole proprietorship: Generally, owner draws
Multi-member LLC taxed as a partnership: Member distributions and potentially guaranteed payments, depending on the situation
S corporation: Wages through payroll plus potentially shareholder distributions
C corporation: Wages through payroll plus dividends or other properly structured shareholder transactions
Your business structure, tax classification, ownership, and the purpose of the payment all matter.
Don't Let Your Bank Account Become the Haunted House
Here's one of the biggest takeaways: Don't use your personal bank account as a substitute for understanding how money moves between you and your business.
If you need money personally, transfer it properly and make sure the transaction is recorded correctly. And remember, money moving into your business is different from money moving out of your business. If you put your own money into the business, that could potentially be an owner's contribution, member contribution, shareholder contribution, or, in some situations, a loan to the business. Simply writing "owner draw" in the memo line doesn't magically make a transaction an owner draw.
The direction of the money, your entity type, how you're taxed, your ownership, and what the payment actually represents all matter.
Don't Let These Mistakes Haunt You
If you're new to business, take a few minutes before transferring money from your business account to your personal account.
Make sure you understand:
• How your business is structured
• How your business is taxed
• How you're supposed to pay yourself
• How those transactions should be recorded
• Whether you're dealing with wages, draws, distributions, contributions, or something else
Getting this right from the beginning can save you from a mountain of bookkeeping cleanup—and potentially some very expensive tax problems later.
Your business finances don't have to be scary.
A little knowledge, good bookkeeping, and the right guidance can help you feel more confident about where your money is going and how you're paying yourself.
Have a Business Finance Question? What business topic would you like to learn more about? Leave your questions in the comments!
And if you're looking for ways to gain more confidence in your finances, improve efficiency in your business, and create more freedom in your life, we'd be happy to help.
Visit abandp.com to learn more.
Don't let financial surprises haunt you this October. Take one small step today toward better bookkeeping and greater peace of mind!
