When Do You Withdraw Profits From a Business?
Many successful entities are incorporated as either LLCs, partnerships or LLPs, Sub-S Corps or regular C Corporations. The kind of entity which you may have will have an effect on how and when you can withdraw the company profits.
Profits in an entity represents the excess of revenues less expenses for an accounting period. Profits, or net income in accounting terminology, is booked to retained earnings on the books of a corporation. It is the balance of retained earnings, or accumulated profits, along with the net book value of fixed assets, cash balances and other balance sheet items that make up a large portion of the net worth of any entity. Should a banker, an investor, creditor, a shareholder or any other unrelated party wish to view and analyze these financial statements, the very first question that anyone will ask is: How much is in retained earnings? Retained earnings represents the net worth of a company. It is the life and bread of any successful corporation as it determines what is available to any shareholder for withdrawal, what is available to any creditor if there were a liquidation and how successful the company is to any potential investor or supplier.
Knowing the importance of retained earnings in a company may help you understand the relevance of withdrawing profits from a successful business. Many share-holders or business owners feel it necessary to withdrawal such profits from a business for many reasons, but the most prominent reason is that they feel that, because they have already paid income taxes on these profits, these funds should be made available to them personally. Is this always sound reasoning?
In a Sub-S corporation, or a partnership, profits may be withdrawn in the form of dividends or shareholder's draws, whereas monies are taken as a deduction against retained earnings. Very often, these profits are withdrawn in advance of the fiscal year-end, in which the shareholder may have to pay taxes on these withdrawals as they represent profits in the business. There are many understandable reasons for this, including supplementing officer's payroll and lowering the payroll tax liabilities that go with taking a payroll check.
Very often, a shareholder may wish to invest in real estate or purchase a new home, and borrow the cash funds from the corporation for the down payment. Although taking such a distribution of profits or borrowing cash may be helpful to the business owner in the short-term, depleting these profits can become a substantial drain to the financial equity and potentially, the future success of the company. The Internal Revenue Service is also suspicious of these distribution draws, and will do everything in their power to make sure they get their share of taxes. The IRS, if they determine that a profitable S Corp has not been properly compensating the officers, can redetermine officer's draws as officer's payroll, and assess FICA, Medicare withholding taxes, along with penalties and interest.
Reinvesting profits and/or accumulating profits and cash in a closely held corporation is a healthy means of successful growth in a small business. Purchasing corporate assets such as equipment, paying corporate debts, depositing funds into corporate investment accounts such as mutual funds, certificates of deposit or money market saving accounts are all healthy examples of how profits should be retained in a closely held corporation.
By retaining these profits, the earning and borrowing power of the company greatly increases. The company also increases the net equity and retained earnings on the balance sheet, which helps any potential investor or lender make a favorable determination about the company.
There are many reasons why one would want to leave the profits in a business, but when is a withdrawal safe? When the company's financial situation is stable enough that, should an unfavorable situation occur, there would be enough funds and liquidated assets retained in the company to pay off all outstanding loans, accounts payable, all outstanding income taxes and liabilities and have money left over. This amount would represent the true liquidated value of the company, and these monies can be used as distribution to the shareholders, if they so choose to withdraw these funds. These profits can be withdrawn through dividend distributions or draws, officer's bonuses, repayment of officer's loans to the company, or payroll. Not withstanding any other borrowing needs by the company, it is always safer (and cheaper) to leave the profits in the corporation until you really need them.