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Subject: |
Taking Money Out Of A Small Business |
| Date: |
2009-03-09
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Taking Money Out Of A Small Business
By Cliff Ennico
www.creators.com
"I'm starting a small business with a good friend of mine, and we've
just formed a limited liability company (LLC) that we own 50/50. Your
column last week on putting money into a company was terrific, but we
want to know how to take money out of the company in the most
tax-advantaged way possible, and without changing our 50/50 ownership
of the business."
Generally, there are three ways (and only three ways) that you can take
money out of a business if you are one of the owners. Either:
- the company pays you
compensation for your labor;
- if you have loaned money to
the company, the company repays your loan; or
- the company makes a
distribution of profit to you (this is called a "dividend" for a
corporation, or a "distribution" for a partnership or LLC).
It's a lot easier to illustrate
these concepts than explain them, so let's use an example. You and I
are 50/50 owners of an LLC. You are the "worker bee" that runs the
business, while I am a passive investor who loaned you $20,000 to get
the business started. During our first month in business:
- we had $10,000 in gross
sales; and
- we had $2,000 in operating
expenses, leaving $8,000 in the LLC checking account.
Let's say we meet and agree to
leave $2,000 in the LLC checking account as a "reserve" to pay next
month's expenses, as we don't know what our sales will be next month
(always a prudent thing to do, by the way, especially in these
uncertain economic times). That leaves us with $6,000 in the LLC
checking account. We want to pay this to ourselves, but how?
Because you are the "worker bee" that runs the business, you should
receive some compensation for your hard work. Let's say we agree that
the first $2,000 of "net profit" (the $6,000 in the LLC checking
account) belongs to you, and that you can take out this amount each
month as compensation (called a "draw" in LLC language). That leaves us
with $4,000 in the LLC checking account.
Because I've loaned $20,000 to the LLC, I intend to see that money back
someday, with interest. Let's say we agree that the next $2,000 of "net
profit" will be used to pay down my loan — if the loan bears 6 percent
simple annual interest and it's been exactly one year since I made the
loan, the first $1,200 of the $2,000 would be interest on the loan
($20,000 x .06), which is taxable to me, and the $800 balance would be
considered a return of my principal, which is not taxable to me. The
outstanding balance of the loan has now been reduced from $20,000 to
$19,200.
The remaining $2,000 of "net profit" we decide to take out as a
"distribution." Unlike compensation and loan repayments, distributions
of an LLC's profits must be made "pro rata" — in accordance with our
percentage ownership of the LLC. Since we own the LLC 50/50, you must
take $1,000 and I must take the other $1,000.
If we do not divide the distribution evenly, then there's a risk that
the person receiving the larger distribution will find their percentage
ownership of the LLC reduced significantly (a process called
"dilution"). If you take a distribution of $1,500 and I take one of
$500, your extra $1,000 will be treated as a return on your capital
investment in the LLC, which will reduce your percentage ownership of
the LLC by the amount of $1,000 divided by the fair market value of the
entire LLC on the date the distribution was made. If the LLC is worth
$100,000, your additional distribution would reduce your ownership by 1
percent ($1,000 divided by $100,000).
When it comes time to pay our
taxes at the end of the year, here's how each of us will report the
money we took out of the LLC checking account during the first month of
operation:
- you will report $3,000 as
income (your $2,000 compensation plus your $1,000 distribution); and
- I will report $2,200 as
income (my $1,000 distribution plus the $1,200 portion of the loan
repayment that is treated as "interest" for tax purposes — the other
$800 is not taxable because it is a return of my principal).
Even though we remain 50/50 owners
of the business – you can't make any decisions without my approval, and
vice versa — the amount of income each of us reports to the IRS will
vary depending on how we characterize our withdrawals from the LLC
checking account — as either compensation, loan repayments or
distributions.
Planning distributions, "draws" and loans to an LLC is a particularly
complex process, and I've merely touched the tip of the iceberg in this
article. Be sure to retain a good accountant when setting up your LLC
so that any withdrawals you and your partner make don't cause
unexpected headaches come tax time.
Cliff Ennico (cennico@legalcareer.com)
is a syndicated columnist, author and former host of the PBS television
series 'Money Hunt'. This column is no substitute for legal, tax or
financial advice, which can be furnished only by a qualified
professional licensed in your state. To find out more about Cliff
Ennico and other Creators Syndicate writers and cartoonists, visit our
Web page at www.creators.com.
COPYRIGHT 2009 CLIFFORD R. ENNICO. DISTRIBUTED BY CREATORS SYNDICATE,
INC. Permission granted for use on DrLaura.com.
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