Taking money out of a business is more complex than it may appear. Business owners must carefully structure financial transactions to avoid unexpected tax consequences and protect the integrity of their business entity. Without proper planning, even simple withdrawals can create significant tax liabilities or legal risks.

The Importance of Proper Structuring

When a shareholder loans money to a corporation, repayment of principal is not taxable. However, if this loan is poorly documented, the IRS may reclassify it as a nondeductible capital contribution, and repayments may be treated as taxable dividends. Such missteps can also increase the risk of courts “piercing the corporate veil,” exposing the owner to personal liability.

Avoiding the Danger of Intermingling Funds

One of the most common mistakes small business owners make is intermingling personal and business funds. For example, paying personal bills from a business account—or business expenses from a personal account—may seem harmless if adjustments are later made in the books. But this behavior invites scrutiny from the IRS and courts, undermining the business’s legal and tax standing.

When funds move between a business and its owner, the transactions may be classified differently depending on the situation. If an owner provides funds to a business, it could be a capital contribution, a loan, a repayment, or an expense reimbursement. If an owner withdraws funds, it could be a dividend, distribution, wages, reimbursement, or loan. Misclassifying these can turn otherwise tax-free movements into taxable income.

Personal Use of Corporate Assets

Using corporate property for personal benefit is another red flag. The IRS can reclassify expenses improperly deducted by a corporation as personal expenses. Similarly, if a corporation relies on assets owned personally by a shareholder, it may signal insufficient separation between owner and business.

Different Structures, Different Rules

The way money can be taken out depends on the type of business entity:

• Sole Proprietorships: Owners are taxed directly on business income. They cannot pay themselves wages or dividends but can freely withdraw money without additional tax impact.

• Corporations (C and S): Owners may receive wages, dividends, or distributions. Wages are subject to payroll and income taxes, and must be “reasonable” to prevent abuse.

• Partnerships: Owners may receive guaranteed payments or share in partnership income. Guaranteed payments resemble wages but are not subject to payroll withholding.

Wages and Reasonable Compensation

In corporations, wages are often used to compensate owners. However, wages must be reasonable—comparable to what an unrelated company would pay for similar services. C corporations may be tempted to inflate wages to create deductions, while S corporations may seek to minimize wages (since distributions avoid payroll taxes). Both strategies carry IRS audit risks if compensation is deemed unreasonable.

Dividends and Pass-Through Income

For C corporations, dividends are taxable to shareholders up to the company’s earnings and profits. In contrast, S corporations and partnerships pass their net income directly to owners’ individual tax returns, regardless of whether distributions are made. Importantly, S corporation distributions must follow the one-class-of-stock rule—distributions must align with ownership percentages, or the S corporation risks termination of its status.

Loans Between Owners and Businesses

Owners may lend money to their businesses or borrow from them. As long as loans are structured properly, with clear terms and documentation, these transactions are not taxable. But failure to respect formalities can lead to reclassification as taxable income.

The Bottom Line

Improperly handling money transfers between owners and their businesses can result in costly tax consequences and even personal liability. To safeguard both financial and legal interests, business owners should avoid commingling funds, respect corporate formalities, and structure transactions carefully.

Because each situation is unique, professional tax advice is essential. Advance planning—rather than after-the-fact adjustments—offers the best protection against IRS challenges and court actions.

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