Episode 40: The Right Way To Take Money From Your Business

Announcer:
This is the WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes.

Tom Wheelwright:
Welcome to the WealthAbility® Show where we're always learning how to make way more money and pay way less taxes. This is Tom Wheelwright, your host, founder and CEO of The WealthAbility®. There is a right way and a wrong way to take money out of your business.

Tom Wheelwright:
So today, you're going to discover the right way. How to take money out of your business, pay the least amount of tax, and protect yourself from lawsuits. Now, how you're taking money out depends on how your business is formed. See, the worst thing you could do is be a sole proprietor.

Tom Wheelwright:
If you're a sole proprietor, like most people start out as sole proprietors. A, you're not protected at all from lawsuits, right? Because you're the business. And B, your paying maximum taxes. Not only are you paying tax at the highest individual income tax rate on all of the income, you're also paying, 100% of your income is subject to social security and or Medicare tax.

Tom Wheelwright:
So you got double taxation just by being a sole proprietor. We don't think of being a sole proprietor is double taxation, but it really is, income taxation and social security taxation.

Tom Wheelwright:
The opposite end of that spectrum, of course, is the C corporation. This is what the big guys do. The big companies are all C corporations. They're C corporations primarily because that's the easiest way for them to trade on the stock market. However, there are tax advantages and tax consequences to being a C corporation as well.

Tom Wheelwright:
So let's say you go, okay, I don't want this horrible taxation as a sole proprietor. I'm going to go completely opposite. I'm going to be a C corporation. So in a C corporation, the corporation pays its own tax at a very discounted rate of 21%, now you're going, that's awesome. Maximum tax rate for individuals, 37%. Maximum tax rate for corporations, actually, it's a flat tax of 21%. Going, this is awesome, right? And no social security tax paid by the corporation.

Tom Wheelwright:
Okay, so how are you going to get money out of the corporation? Well, here's what most people do. They go, I'm just going to pay myself a salary and that'll be a deduction to the corporation. That's right. It will be. And you'll be taxed on it at your highest individual tax rate, up to 37%, and all of those wages, entire salary you took out is subject to social security taxes.

Tom Wheelwright:
So, Oh wow, I'm just like, I'm in trouble if I'm a sole proprietorship and I'm in trouble if I'm a C corporation, what's worse is, let's say you go, okay, so I'm not going to take it out of my C corporation a salary. So how are you going to get it out? Well, another way to do it would be to distribute it, right?

Tom Wheelwright:
Just take a dividend, just take a dividend. No big deal. Right? Except that a dividend in the US is not deductible to the corporation. So you've already paid tax at 21% at the corporate level, and now what you're doing is paying tax again at the individual level. Yes, it's a reduced rate. You're going to be paying tax at the capital gains rate. It's still though subject to capital gains tax and potentially subject to Medicare tax, what we call the net investment income tax.

Tom Wheelwright:
So you could still have a tax rate of upwards of 40% by distributing it. All right, so does that mean I don't be a C corporation? Not necessarily. Let's say that your goal is to leave a lot of it in the company to build the company. Then you absolutely want to be a C corporation. You're going to leave the money in, it's going to keep building the company and you're going to pay at a 21% rate as opposed to your personal income tax rate of up to 37%.

Tom Wheelwright:
So let's say yes, but what if there's $100,000 or $50,000 that I do want to use for say, a real estate investment? All right, here's how we do it. You borrow it, you borrow. Remember, loans are never taxable because you owe the money back, so it's not income to you. So you borrow the money. Now, here's how you borrow it.

Tom Wheelwright:
We don't have you borrow it into your personal name, rather we have the corporation lend it to your limited liability company or limited partnership that is going to do the investing. That way it's always protected, for asset protection purposes, it's never coming into your hands so it's never available for anybody to Sue you personally, right? And you've got a loan to that other company to the new limited liability company say, not taxable.

Tom Wheelwright:
The interest that you pay to the C corporation is deductible as long as you're using it in that real estate business, it's deductible it's a real estate expense. And the interest income is taxable to the C corporation at, you guessed it, 21% so doing a loan, if you need to take money out of that C corporation, then you do it through a loan and preferably not to yourself as the shareholder, rather lend it to the company that's going to do the new business or the new investment.

Tom Wheelwright:
Now that's the C corporations. We're talking about two ends of the spectrum, the sole proprietorship, where you're going to pay 100% self employment tax, 100% income tax on all of your money and the corporation, the C corporations, what it's called for sub-chapter C of the Internal Revenue Code, the C corporation, where you're only going to pay a 21% tax, you just can't take the money out. If you take the money out as a distribution, it's going to be subject to a second level of tax. If you take it out of salary, it's going to be subject to personal income tax at your higher rate and social security tax. So if you have to take much money out outside of what you're living on, now, any money you're going to take out to live on, just take it as salary most of the time. That's the best way. Sometimes a dividend is okay, but most of the time you're going to want to take it out a salary.

Tom Wheelwright:
So sit down with your accountant, walk through the numbers. If you're a C corporation, I need to take some money out. What's the best way to do it? Again, what we're trying to do is minimize income tax and we're trying to minimize social security tax. Now, there's one other thing we're trying to do. You're going, well, why don't I just pay for personal expenses out of my business? No, do not do that. That's the worst way to get money out of your business. The worst way to get money out of your business is to pay personal expenses from your business account.

Tom Wheelwright:
Why is that? Very simply, you potentially lose all of the benefits of having a corporation in the first place. The primary reason to have a corporation isn't for taxes, it's to protect yourself from creditors. It's so that if the business is sued, all they can get as the business. Your business is your riskiest asset, always. Your business is going to be your riskiest asset. That's the one that's going to potentially generate the most lawsuits, so you want to protect all of your other assets that you hold outside of your business from somebody who sues the business.

Tom Wheelwright:
If you start commingling funds, which means that you start to pay personal expenses out of your business account, now you jeopardize the very existence of the corporation for legal purposes. Don't ask me, don't rely on me. Talk to your attorney. I will tell you, every asset protection attorney in the country, in the world will tell you this. Do not commingle assets. That's the worst thing you can do.

Tom Wheelwright:
So, what you are not going to do, the wrong way to take money out is pay for personal expenses. The right way is either through a loan, or depending on what your tax rates are, sit down with your accountant through a distribution or a salary. Now, the more you can leave in to a C corporation, the better off you are because in a C corporation, again, 21% tax rate.

Tom Wheelwright:
Now you say, look God, that's too hard. I want to take most of my money out of my corporation because that's really what I'm living on, and so I really don't want to leave it in there, so what do I do? Well, now you're going to be an S corporation. As long as your business is a regular operating business, you're probably going to be an S corporation.

Tom Wheelwright:
Now you may be a limited liability company taxed as an S corporation, that's a whole different discussion. Ask your attorney and your accountant about that. So why an S corporation? Well, remember as a sole proprietor you had no asset protection and you paid social security tax on 100% of your income.

Tom Wheelwright:
As an S corporation, while you still pay income tax on 100% of the income earned by the S corporation, there's no social security tax within the S corporation. Just like a C corporation, no social security tax paid by the corporation. So how does the government get its social security tax? Well, simply when you take a salary from your S corporation, then on that salary there's going to be social security taxes. So what do you want to do? Minimize the amount of salary you take.

Tom Wheelwright:
Now, it still needs to be a reasonable amount, basically what you would pay somebody else to do your job, but all of the money that's really being earned by the company itself, and not by you as an employee of the company, that should be taken out as a distribution most of the time, listen carefully. Most of the time that should be taken out as a distribution.

Tom Wheelwright:
Why is that? Because in an S corporation, you as the owner are taxed on 100% of the income of the corporation, whether it's distributed or not. The corporation doesn't pay any tax. You pay the tax at your ordinary income tax rates, so you've already paid the tax. In other words, it's already taxable when you earn it. So when you distribute it, there's no second tax. That's the beauty of an S corporation compared to a C corporations. C corporation, two taxes, one at the corporate level, one at the individual level as a dividend.

Tom Wheelwright:
S corporation, one level of tax. Only the income tax, no tax on the distribution. And the distribution is not subject to social security taxes as long as you're paying yourself a reasonable salary. So again, sit down with your accountant and talk about what's a reasonable salary, discuss what would make sense here.

Tom Wheelwright:
And then the rest of the money, you probably are going to want to take out as a distribution. Now, there is an exception to that rule. And the exception is, if that money that you're taking out didn't come from either you putting money in, either you loaned it to the company, or you contributed to the company and it didn't come from income of the company, instead what it did was the company borrowed money from somebody else.

Tom Wheelwright:
Now, if that's the case and you distribute that money, you could have a capital gain when you distribute that money out of the corporation. So I'm going to make it really simple. Sit down with your accountant. This is a great time of year to do this. Sit down with your accountant and go through, okay, how should I be taking money out of my company?

Tom Wheelwright:
I've got money that's kind of built up over the year. I want to take money out of the company, how should I do that? Most of the time it's going to be a distribution. Sometimes to some extent, it's going to be salary. And once in a while, it's going to be a loan. And that once in a while is because a loan will never result in capital gain.

Tom Wheelwright:
So if you borrow money from the corporation, you're never going to have capital gain. So if you're in a situation where you might have capital gain, then you want to borrow the money. Now of course, you're going to need to listen to this podcast several times. That's why we record them. That's one of the reasons that they're there so that you can listen to them over and over again and sit down with your accountant and listen to the podcast with your accountant so it prompts, okay, what about this? What about this? What about this?

Tom Wheelwright:
Now, again, the worst way to take money out of an S corporation, is to pay for personal expenses. Again, you would be commingling funds, which means that you could lose the protection of the corporation when it came to the… if there was a lawsuit against the corporation, you could end up having to pay money for that adjudgment out of your own personal assets.

Tom Wheelwright:
So the whole point of the corporation is to protect you in case the business gets sued. So do not ever, ever, ever use business money to pay for personal expenses. You have a big personal expense comes up, great. Borrow the money. I suggest to everybody you should have a line of credit with your corporation, with your company. Have a line of credit.

Tom Wheelwright:
It's easy then to borrow against that line of credit. Okay? If you need to, you can always at the end of the year decide, rather than being a loan, it's okay if it's a distribution. I had enough income, I'm not going to have any bad tax consequences if I take it as a distribution, and distributions are better just because you don't have to keep track of the loan.

Tom Wheelwright:
So when you're taking money out, I suggest you start in an S corporation. What you do is you set up a line of credit between you and your corporation, and you always, always, when you're taking money out except your salary, you take it out as a loan against that line of credit. Then at the end of the year, you and your accountant can sit down together and decide, okay, should we convert some of that loan to a distribution or do we need to leave it as a loan and now we need to pay interest on that loan?

Tom Wheelwright:
So that's how we do it if you're an S corporation, now, if you're a partnership, one little distinction, let's say you have a limited partnership. In this case, what you really want to do is always take the money as a distribution. You never want to pay salary where you can't actually, technically a partner can not get salary. You don't want to pay salary, you just want to take a distribution. You're not going to have a tax on a distribution 99.9% of the time, okay? It's very rare to see that in a partnership.

Tom Wheelwright:
So if you're taxed as a partnership, okay, for whatever reason, that money can go in and out contribution distribution, you don't need to be worried about that. Just don't call mingle funds. Okay? Don't be paying for personal expenses out of your partnership account. Now, the opposite by the way, is okay, you can pay for business expenses out of your personal account. And then what you do is you submit an expense report just like you would for a big company.

Tom Wheelwright:
You've submitted an expense report to your company. You actually do submit an expense report. You sign it, you attach the receipts, you submit it to your company and the company reimburses you. That's how you do it when you have your own company. Because remember, you want to think big, act small and do things the way the big guys are going to do it. Okay, so you're going to be careful with it, at the same time, you're going to go, okay, if I had some expenses from my employer, how would I get that money back? I'd submit an expense reimbursement claim, right? That's what I would do. So that's what you're going to do with your own business.

Tom Wheelwright:
Now, how you set up entities and what type of entity. That is a completely different discussion. What I wanted to go through today is to understand that there's a right way and a wrong way to take money out of your company and the wrong way, the absolutely wrong way is to pay for personal expenses out of your business account, because it will hurt you from a tax standpoint. It will kill you from an asset protection standpoint. Best way, absolutely best way is if you can take it as a distribution, if you're an S corporation or partnership without causing any tax consequences. And most of the time you can. If you're a C corporation, make sure you have that discussion with your account.

Tom Wheelwright:
In fact, let's do this. Promise me right now that you will sit down with your accountant the end of this year and you will go through, this is how I need, this is the kind of money I'm going to need during the year. What do we call that? That's called a budget. What a great idea. Actually have an idea of what you're going to need for the year, and I'm going to need this for my personal expenses and then the rest of it is going to be for investments.

Tom Wheelwright:
So how do I take my money out to avoid any bad tax consequences? Like how do I avoid social security taxes as much as possible and still be within the law? See, because we don't want to do anything that's outside the law. We want to sleep at night. We don't want the IRS to be coming after us, so we do it right within the law. The way to do that, follow the rules.

Tom Wheelwright:
That doesn't mean you don't have choices. Remember, in taxes in the United States and in most countries, you have a choice of what type of an entity you use. You have a choice of whether your distributions are salary, distribution, or loan. You have that choice. However, when you take that money out, it needs to be recorded. Remember, first person on your team is your bookkeeper. And your bookkeeper must understand how to record that money that's coming to you.

Tom Wheelwright:
You're taking money out. The bookkeeper needs to know how am I supposed to record that? That is not the bookkeeper's job to figure that out. You have to decide that with your CPA, so when you do that, here's what happens. You get it in your mind. Remember, reducing your taxes is a daily exercise. You want to change your tax. All you have to do is change your facts.

Tom Wheelwright:
When you change your facts so that you're taking money out of your company in the most tax advantaged way possible and protecting your company from lawsuits, you will always have way more money and always pay way less taxes. Thanks. We'll see you next time.

Tom Wheelwright:
What if you could discover a simple way to double your profitability in the next 90 days without adding any new clients? As a listener of my podcast, I want to give you for no charge, my five step process for doing just that.

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You've been listening to the WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes. To learn more, go to wealthability.com