Entrepreneur saves $22,000 by reclassing excess distributions.
Angie M Grainger
It's common for small businesses to take money out of the business when they need it, but if you take out too much, you could end up with an expected tax bill!
During the pandemic, many small businesses received government loans to help them get through. Some used the money to simply keep the business afloat, however many businesses used that money to make investments and some used it for personal reasons.
Even if the loan wasn't a forgivable loan—such as the PPP loans—there were several other types of loans business owners could take at very low interest rates.
The common phenomena that business owners experience when they get a large influx of money like this, is the feeling of abundance! This feeling tends to spark overspending or over investing. This money was not an influx from sales or positive cash flow. In fact, the negative cash flow was just hidden by the lump sum that masked the leak!
When cleaning up their books, it became clear that this entrepreneur had received loans for the business, but had also significantly increased their distributions.
When we finally got the books done, we could see that the owner took out about $100,000 more in distributions than they had in profits.
What the owner didn't realize is that when you take out more money than you have in profits, you could get taxed on these distributions at ordinary income rates.
We were able to scrutinize the distributions and all of the money that went in and out, which allowed us to determine that some of this should have in fact been treated as a loan—not a distribution. By properly classifying some of it as a loan, the owner saved over $22,000 in taxes.
However, the IRS knows that this strategy could be just a tax avoidance tactic and could reclass it back to a distribution if it's not legitimate. But as long as there are legitimate reasons and support for a loan—such as a written shareholder loan agreement and regular repayments—they should be in good shape.
We helped the business owner become more aware of the cash flow in their business and put in systems where they could monitor it better, while also establishing a regular payroll to reduce the amount of money movement in and out of the company.
Setting up your cash flow right might seem hard, but it doesn't have to be. Find out how you can become more aware of your cash flows today by speaking with the personal finance CPAs. Book a call with us today.