- The why, the what, and the how of withdrawing money from your business
- Identify the type of business entity you own
- Withdrawing money from an S Corporation:
- Withdrawing money from a C corporation:
- Limited Liability Companies (LLCs)
- Avoid intermingling funds
- You can and should withdraw money from your business for personal use
Knowing how to withdraw money from your business is important if you want to enjoy the rewards of your work.
Withdrawing money from your business account for personal use is called a distribution. It does not have to be complicated but it is also not as simple as just dipping into different cash jars of your company and taking out as much money as you want. Your business needs cash as well, and withdrawing money without a plan can damage your business and your reputation.
And this is what I will talk about in this article: how to identify not just the right method of withdrawal, but also the method that is right for you and your company.
Let’s dive in.
The why, the what, and the how of withdrawing money from your business
It is crucial that you are clear on the following three questions if you want to find the most optimum way to withdraw money from your business:
- Why do you need to withdraw money from your business?
Identifying the reasons why withdrawing funds from your business is necessary.
- What is the type of your business?
The type of business entity. Ownership structure. The tax classification of your business.
- How can you take it out?
Finding the options with the least adverse impact on your business.
Identify the reasons you have to withdraw money
Owners may need to withdraw funds from their companies for a multitude of reasons. But I have observed that they are hesitant to follow through with what they want, simply because they are worried that doing so will take a bite out of the profits.
This can’t be any farther from the truth.
If you have a sound business plan and a strong financial structure, withdrawals from your business will not have a major impact on your profits. On the hand, owners who never withdraw money from their businesses may end up harming the bottom line in the long run.
Let’s look at some of the reasons that justify taking money out of your business:
The ultimate goal of running a business is to make money. After all the hard work you have put in and all the investments that you have made, it’s natural to want something in return that justifies your troubles.
How you do that depends on the type of business you own.
- If you are a sole proprietor, you make money from the profits your business makes. You may choose to pay yourselves a fixed percentage of your business profits. As your business profits go up, so does your compensation.
- If your company is a partnership concern, then you must have certain contracts or agreements in place that prescribes disbursement of profit or guaranteed payments.
- The owners of S and C corporations may receive a salary or distributions of earnings. However, if you are planning to pay yourselves a salary, keep in mind that the IRS requires such compensation to be fair and rational. This means you can’t inflate your salary beyond what someone in your industry would make for similar services in another company.
Savvy entrepreneurs and business owners understand the importance of cash withdrawals as an effective tax-saving strategy.
The more you minimize your taxable income, the more you can save money and reinvest in your business. But there is also a second benefit as well. If you are well-tuned with the financial aspect of your business, you will make more conscious decisions in cash-flow matters and the general direction about your company.
Unfortunately, taxation is too broad a subject to be explained in a handful of words, but the crux of the matter is this: If you withdraw funds from your business with an explicit intention of saving taxes, you need to be well-versed with taxation laws governing your company.
If you have any doubts or confusion, it’s better to leave the execution to a financial or a taxation expert. After all, you would rather not make the wrong move and have the IRS come barging through your doors.
Minimize business risk
Minimizing business risk is a vital component of sustained business growth.
Many entrepreneurs and business owners consider it risky to leave funds in their business and make their companies vulnerable to potential creditors, lawsuits, or unforeseen events. Business owners choose to withdraw a percentage of income because of that.
If you go down this route, you can use this money for things like investments in the company or buying back stock from other shareholders if your company is healthy and operating well. You can also create a sufficient buffer of funds outside the business that won’t be at risk, should an emergency occur.
Now that you understand the “why”, next up is to understand the “what” and the “how” — which usually go hand-in-hand.
Identify the type of business entity you own
The type of business you own will have a major bearing on how best to withdraw money. Different tax classifications apply to different types of business entities, as do the requirements for withdrawing money.
For instance, rules for withdrawal of funds for a sole proprietorship will be different from those for a partnership or an LLC or a C corporation, or an S corporation. Updating yourself with the tax requirements applicable to your company before withdrawing funds is vital to avoid incurring penalties and tax ramifications.
So, how to withdraw money from a business account for personal use? Here is how:
Start with understanding what taxation laws are applicable to your business.
The IRS defines a sole proprietor as “someone who owns and operates an unincorporated business all by themselves.” If you are the only owner and haven’t incorporated your business, you will be the sole recipient of the profits and the sole bearer of losses. You can’t pay yourself a salary and treat it as your business expense. However, you can withdraw a part of your accumulated profit — known as an “owner’s draw” against the profit — any time you want. There is also no limitation on how many times you do it. You can do it weekly or monthly or whenever you need to take out the money.
Withdrawing funds from a sole proprietorship is also the simplest. The law doesn’t distinguish between the business owner and the business entity — known as a “pass-through” or “flow-through” taxation parlance — and considers the business income and personal income of the owner as one and the same.
So, as a sole proprietor, you can transfer money from your business account into your personal account at will. Although this won’t be deemed a deductible business expense, there are no tax consequences of the transaction either. Since you are withdrawing a part of the profit, you won’t be liable for personal income taxes.
A business partnership is a formal arrangement between one or more individuals or entities. Partners share the profits generated, and many of the same rules for sole proprietorship apply to partnership firms. Just like a sole proprietorship, a partnership is also a flow-through entity, and the law considers the business incomes and personal incomes of the partners the same. The partnership classification may also include S corporations in some instances.
As in sole proprietorship, you can draw a part of the profit out of your partnership business any time you want. However, there are a few caveats that must be mentioned here.
You must check first what percentage of profit your partnership agreement stipulates when withdrawing funds for your personal use. Profit percentage may not always be in proportion to your capital contribution.
Any time you withdraw more than your percentage share of the accumulated profit, it may be considered a “short-term loan”, and you may need to sign a promissory note as prepared by your partner/s. Not informing your partners about such a withdrawal may be deemed as fraud, should they choose to.
But remember that this is only required if you withdraw more than your share of accumulated profit. You need not worry about anything if you keep the withdrawal amount at or under your share.
S and C corporations
This is where things start to get complicated. S and C Corporations are created by a state filing, and the law looks at them and their owners/partners as separate legal entities. What distinguishes the S corporations from the C corporations is the ownership structure of the company, how they are incorporated, and the taxation laws that apply to them.
- IRS designates any new company as a C corporation by default. But an S corporation can only be formed by filing IRS Form 2553.
- S corporations only have one class of stock and cannot have more than 100 shareholders — and they must be US citizens, whereas there are no such restrictions on C corporations.
- Owners of S corporations enjoy “pass-through taxation” — they are liable to pay taxes only on profits, but in C corporations dividends on stocks are taxable by law in the form of personal income taxes.
Withdrawing money from an S Corporation:
If you are a partner or a shareholder in an S corporation, you can withdraw funds or pay yourself out through salaries or distribution. While these are not tax-deductible, you also don’t have to pay any taxes on the amount you get. The laws pertaining to withdrawals from partnership also apply here.
You cannot withdraw more than your salary without informing the other shareholders and signing a promissory note. The additional amount that you take out will be considered a loan, and you will have to treat it as such.
Withdrawing money from a C corporation:
If you are a shareholder or an owner of a C corporation, you can take money out from the company either in the form of salary and wages or in the form of dividends. C corporations are liable for taxes on all profits, including those distributed to shareholders as dividends.
However, the IRS deems dividends distributed to shareholders as their personal incomes and tax them again. Dividends are not tax-deductible of C corporations anywhere and are ultimately taxed twice.
Limited Liability Companies (LLCs)
Withdrawing from an LLC is the most complicated — in part due to the various forms in which taxation legislation applies to them. Partners of an LLC may taxation rules of a C or an S corporation.
If you’re a sole owner of an LLC company, you may withdraw money as and when needed, but if you have partners, then everyone should be on the same page regarding the distribution arrangement. The type of taxation (S corporation or C corporation) elected by the partners will further determine the applicable withdrawal and taxation rules.
Avoid intermingling funds
Regardless of the type of corporate entity you control, you must always maintain separate finances. Paying personal costs from your business’s checking account or vice versa, also called “intermingling of funds”, is one of the riskiest moves you can make. You may land in a legal soup with the IRS, and they can drag you or your company to court because of this.
Keeping your company and personal accounts fully separate is vital to your success. Failure to do so may have substantial tax and legal ramifications.
You can and should withdraw money from your business for personal use
Withdrawing money for personal use is, after all, the point of having a business, to begin with. The business exists to support you. Also, there are a lot of good reasons why you don’t want to keep money in your business – this is an important risk mitigation strategy.
The only challenge – there are rules. So, read a blog post, follow a few simple steps, and then go enjoy the rewards of running a business.
Can I take money from my business account for personal use?
Absolutely. The whole point of your business is to generate money for you to use personally. A withdraw of money from your business account is called a distribution.
It is important that you track distributions because this has tax implications. It is also very important that you separate your business accounts from your personal accounts.
What is it called when you take money from your business?
This is called a distribution.
What happens if you use business money for personal use?
Well, the short answer is you pay yourself. The long answer… well… its complicated. Taking money out of the business can have tax consequences so you want to be sure you have a strategy and you are doing it the right way.