Elena Muñoz, implementation manager, and fractional Controller; discusses this question in this video. Don't feel like watching? Read on below!
As a business owner, taking a distribution can be both a blessing and a burden if you aren’t prepared for the tax implications it carries. You may be wondering to yourself, “How do distributions affect my taxes?” This is a great question as it's important to understand the implications in advance to prevent unintended taxable events.
In this article we walk through the main considerations of an owner’s distribution, so you can take the appropriate steps to arm yourself with correct information. There are many variables that impact the tax implications of an owner’s distribution, or what would be owed; however, the most crucial factor that dictates a taxable event is your entity structure and tax classification, since each one has a unique tax treatment when taking a distribution.
Below, we look in detail at the tax implications of the 3 most common small business entity tax classifications.
I am a Single Member LLC/Sole Proprietor
If the business is classified as a single-member LLC or as a sole proprietor, the short answer is the distribution is NOT taxable. In this case, the distribution is considered an owner’s draw and is not subject to tax because the business owner reports their taxable business income (including draws) for each tax year as part of their individual federal and state tax return. The business owner is required to pay tax on the net profit of the business – which is aside from whether distributions are taken or not. Another consideration of this tax classification is that the net profit reported is subject to self employment tax.
I am an S-Corp or Partnership
If the business is a pass-through entity such as an S-Corp, Partnership, or an LLC that is taxed as an S-Corp or Partnership, it would be a comparable situation in that distributions of profits should not create a separate taxable event. All distributions from the business are an accumulation of profit, which is reported as taxable income of the business on your personal federal and state tax returns. However, with a pass-through entity, an owner could find themselves distributing more than the basis they have in the business. At that point, they would be considered in excess of basis, and any distributions would be taxed. With an S-corporation election you might think you have hit a tax savings jackpot; however, be aware that S-corporations do we require all owners and officers to take a reasonable salary that is subject to normal payroll taxes. Unfortunately you cannot take all personal income out of the business as distributions.
I am a Corporation
If your entity is a corporation, distributions are taxable. The corporation pays tax on a separate business tax return, and when a shareholder takes a distribution, the shareholder then reports that distribution on their personal tax return as a dividend. Since dividends are subject to tax, this creates a scenario called double taxation – a corporation pays tax at the entity level, and everything that’s distributed is a dividend to that owner. With this entity structure, tax is always owed on a distribution.
These three structures are only the most common. Your specific structure may vary, which could impact this decision in a different way. Additionally, no matter the structure, owners need to be mindful of how many distributions they take. We covered how entity structure plays a significant role in this equation and should be the starting point to identify your unique situation. In your research to understand this question further, we always recommend reaching out to your CPA or financial advisor for additional clarity.
Looking for additional ways to save on taxes? Marcus Dillon, President, and owner of DBA (Dillon Business Advisors) walks through tax savings you may be missing, which will support your efforts to maximize savings and reduce your tax liability.
Looking for additional advice and answers to your questions? Explore our "Questions we get asked" blog further or talk to our specialists about working with DBA by clicking below.