Welcome back to the second of our 4-part series, where we continue discussion of how business owners can withdraw money from a business with limited tax impact. In this month’s blog, we review the impact on Sole Proprietors.
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 this behavior can leave openings for the IRS or courts, causing them to question the integrity of the business entity or the transaction. 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.
At a very minimum, you should have a separate business bank account to accept all business income and to pay all business expenses. As a business owner, you can then transfer funds or write a check to yourself and deposit into your personal account to pay personal expenses.
A sole proprietor is taxed on self-employment income without regard for activity in the business bank account. A business is taxed on its income minus its expenses, so many businesses think their organization does not matter. Keep in mind that perception to an IRS auditor is everything. If an auditor sees that you are careful to not mix personal and business, they will tend to not dig as deep. Once an auditor sees disorganization or intermingling, they will become more aggressive about auditing ALL of your personal and business bank accounts.
A sole proprietor should never pay themselves a payroll wage or receive a W-2. Wages are appropriate only for C corporations and S corporations, not sole proprietorships or partnerships. A Sole proprietor is “paid” by taking owner draws from the business. As we discussed above – owner draws are not taxable income to the business owner. A business owner is taxed on the “net profits” of the business. Owner draws are the process of withdrawing the profits of the company that have already been taxed.
Next month, we will discuss the impact of taking money out of a business that is structured as a partnership.
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. Feel free to contact Jason Bailey or myself with any questions.
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