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Taking Money Out of a Small Business
"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 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 (firstname.lastname@example.org) 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.