Why Aren't Draws and Distributions Taxable?
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Draws and distributions to owners/investors are not subject to income taxes in pass-through companies like LLCs and S-Corps. This is why.
On a company's balance statement, draws and distributions are noted. A company's profit and loss (P&L) statement, on the other hand, is used to disclose its earnings.
Taking a draw or distribution has no tax implications since they are reported on the balance sheet rather than the company's P&L.
The majority of small company owners choose for one of the numerous pass-through organization types. A pass-through corporation, by definition, is not liable to income taxes at the entity or company level, as a C-Corp is.
Rather, each owner is taxed separately depending on their ownership percentage.
Profits earned by a pass-through company are taxed to the individual owners depending on their individual tax status. As a kind of remuneration, these owners often withdraw cash from the company in the form of periodic draws or dividends.
These draws and distributions are essentially a system that enables owners to withdraw extra cash from the company, assuming you have a successful business. As a result, owner withdrawals and distributions have no tax implications for the person.
For founders who are unfamiliar with a few fundamental accounting concepts, this notion may be perplexing. We must first examine a few fundamental accounting concepts in order to comprehend the idea of an owner-draw or distribution.
Every company has two main financial statements. The P&L, often known as an income statement, is one of the statements.
A balance sheet is the other statement. The profit and loss statement (P&L) is used to report a company's profit or loss for income tax purposes, while the balance sheet is used to report the company's equity.
In accounting, a chart of accounts is a list of all the accounts that a business has. Some line items on a chart of accounts are categorized as revenue accounts, while others are classed as expenditure accounts.
On the company's P&L, income and expenditure accounts are recorded. When you take income and deduct expenditures, you get net profit, which is part of the company's profit and loss statement.
Asset accounts are a kind of chart of accounts, whereas liabilities accounts are a type of chart of accounts. The balance sheet of a business shows the assets and liabilities of the company.
When you remove your obligations from your assets, you're left with equity, which is part of the company's balance sheet.
Every transaction in accounting involves a debit and credit transaction between two charts of accounts.
When you write a corporate check to pay a payment, such as buying some business books, you are taking money from a chart of account line item called cash (cash is an asset that resides on your balance sheet) to pay a bill that lives on your profit and loss statement. Bills are assigned to the relevant expenditure chart of account line item, in this case "Books."
To maintain things in balance, you lowered cash on your asset chart of account. As a result, equity has decreased. Because equity is the outcome of your assets minus your obligations, it must be decreased.
Because there is less cash in the company's bank account after paying the bill for the books, and because the company's obligation remains the same, the equity, which is the product of assets minus liabilities, is decreased by the amount of the books. Furthermore, since the money was utilized to cover a cost, your profit has been decreased.
Because profits are the product of revenue (which was unaffected by this transaction) minus expenditures, they must be decreased.
You decrease cash (an asset chart of account) and the owner's capital when you take an owner draw or a distribution (a special equity chart of account). Similarly, injecting cash into a company increases cash and increases the capital of the owner.
Both sides of the transaction are limited to the chart of accounts that exist only on the balance sheet as a consequence of an owner-draw or payout (money leaving the company) or a cash infusion (money entering the business).
Because we know that the P&L is used to calculate a company's tax obligation and that owner withdrawals, distributions, or infusions have no impact on the P&L, there are no tax implications for making an owner draw, distribution, or cash infusion in the regular course of business. The only exception is when the company is closed and there is a negative equity position, but that is a topic best left to your CPA.
As a result, as a lifestyle or microbusiness, all you have to do is make sure you have enough cash in the business checking account to pay all non-discretionary expenditures. All other funds are yours to take out as a periodic owner draw or profit distribution, or to leave in your firm as surplus cash or to utilize to cover discretionary expenditures in the hopes of expanding your company.
Are you paying yourself as a company owner according to appropriate accounting principles?