Question

Isabel is a very successful locksmith who has incorporated her business as a C Corporation. The corporation pays her an annual salary of $80,000 (which is deemed to be reasonable). She is very pleased to have the limited liability of the corporate form to protect “her” business.

One night on the way to her regular Friday night poker game in the back of Billy Joe Ray Bob’s bookstore, she took $2,000 from the cash register thinking that it was “her” money. You remember BJRB (he is engaged to be married to Hannah his second cousin).

Write a memo to Isabel in simple English (i.e. avoiding tax jargon as much as it is possible), covering the following points:

1. Why it is not “her” money.
2. The possible tax treatments of the transaction (do not consider the possibility that she is a thief – issues such as these are better left to lawyers not accountants). I can see at least three possibilities; you might come up with more.
3. In your answer, consider the impact on both Isabel and the corporation.
4. Your recommendation as to which is the best tax treatment (considering both parties) and why.
5. Assume that the year is 2020.

Answer 1

Date: 14th September, 2020

To: Isabelle

Subject: Tax Implications of Money drawn from business

This memo is intended for use by Isabelle and focuses on tax implication of owner's withdrawal.

Facts of the case

Amount was withdrawn by you in the Friday Night Poker Game amounting to $2000. Such withdrawals are not permitted by law and may have legal implications. This memo is to explain you that the money withdrawn is not owner's money and there are tax implications of the same. Please look at the points below:

Legal status of C-Corporation:

A C corporation (or C-corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation. The taxing of profits from the business is at both corporate and personal levels, creating a double taxation situation. If you actively work for a C corp (even if you’re the majority owner), your only option for payment is taking a salary as a W-2 employee.If you don’t actively work for the company, you can receive dividends (which is different from an owner’s draw—a dividend is non-taxable).

Forms in which money can be drawn

Salaries

For shareholders who work in the business, a salary is the easiest way to disburse funds to an owner. Being a W-2 employee also has the advantage of allowing the shareholders to avoid paying taxes directly on their compensation; the corporation withholds and pays federal, state, and local taxes on salaried wages (along with the withholding amounts for Social Security, Medicare, and unemployment insurance) each time it writes paychecks.

Benefits and Expense Reimbursement

Typical benefits provided by closely held C corporations include family health insurance coverage, life insurance, lease payments for vehicles used at least partially for business purposes, smartphones and monthly telecom charges, laptops, and business-related travel and entertainment expenses.

To avoid both tax and corporate law violations, an expense picked up by the company should have a nexus to its business and the services provided by the employee-shareholders. For example, if an employee's duties rarely require business travel, that individual should not charge significant travel expenses to the corporation.

Obviously, charging purely personal expenses to the corporation—country club dues, children's private school tuition, housekeeping services—is not an advisable method for withdrawing money from a corporation. Blatant abuse of the IRS's business expense deduction rules expose the corporation and its directors and officers to tax and corporate law violations.

Stock Dividends

Dividends are the classic method of withdrawing funds from a C corporation, particularly for the shareholders who do not work for the company. Shareholders who own common stock in a corporation receive dividends at the discretion of the board of directors. The shareholders don't have a right to dividends, but the directors can occasionally determine that the corporation has generated excess earnings sufficient to pay a dividend. The directors must approve a common stock dividend in a formal resolution, and it usually consists of a specific dollar amount per share of common stock.

If a corporation pays dividends during a tax year, shareholders receive Dividends and Distributions (Form 1099-DIV) and include the totals on Interest and Ordinary Dividends (Form 1040, Schedule B) with their individual tax returns.

Return of Capital Distributions

Return of capital distributions (sometimes called non-dividend distributions) are non-taxable distributions from the corporation that refund to the shareholders any capital contributions they've made to the company. If the shareholders, for example, paid start-up expenses for the company out of their own pockets, return of capital distributions are a way to repay such contributions to the shareholders.

Directors approve return of capital distributions in a formal resolution, and each recipient's total appears in Box 3 of Dividends and Distributions. Return of capital distributions reduce the shareholder's cost basis in the stock and therefore increase the amount of capital gain the shareholder realizes when selling stock.

Shareholder Loans

A C corporation can lend money to a shareholder, but the terms of the loan generally require approval from shareholders holding at least a majority of the company's stock. If the corporation has outside shareholders and outside directors, they should participate in the negotiation and approve of the loan terms to minimize the risk of state corporate law violations.

To avoid creating tax liability, the loan terms should appear in a loan agreement and promissory note signed by the corporation and shareholder. The repayment terms and interest rate should reflect arm's-length negotiation between the borrower shareholder and the corporation (represented by a non-borrower shareholder or director).

Possible Remedies

If a C-corp business owner wants to “draw” money, above his or her salary, it must be taken as a dividend payment. The bad news is that the dividend payment is not a tax-deductible expense. If you want to take a draw from a C-corp, the better option may be to take it in the form of a bonus. A bonus would be a tax-deductible business expense for your business, and on your personal taxes, you may qualify for a flat bonus tax rate, which could be lower than your personal income tax rate. The other option is a loan from the corporation to the officer. This is possible, but again owing to the formal nature of corporations must be documented in the corporate minutes, have a promissory note, and acceptable interest rate.