–The Treadmill Whisperers are paying WAY too much on their taxes. Unfortunately, they don’t know that. A group of fitness enthusiasts who met in college decided to launch their service based business back in 2018. Since then, they have built a strong reputation as the best company for repairs and recalibrations of fitness machines and equipment in their region.
Business is booming, but they lack a big picture financial strategy. None of the owners are trained financial experts, so there is a lot they don’t know – and are missing. They look at their money as if they are color blind – they don’t know how to group their money into the correct categories to make sure it goes to the right place. Without a CFO who sees financial colors, they are losing money and don’t even know it – such as unnecessarily paying taxes twice.
You see, the IRS is color blind too. When The Treadmill Whisperers filed their taxes last year, they paid a total of $80,000 in “red” money (a non-official term I made up that equals taxes owed to the IRS). The IRS responded with, “Great! Thanks, we’ll take all your ‘red’ money.” The Treadmill Whisperers could have only paid $40,000 of “green” money if they filed an S Corporation election. The IRS accepts both “red” and “green” money, and doesn’t care which one they are paid; they are happy to take more than needed.
When you don’t have a good understanding of your business finances, you are just as color blind as the IRS. You don’t know what you are missing. Stop winging your finances and allow a Fractional CFO who sees vibrant financial colors to bring clarity to your financial mystery. Let me be your financial ophthalmologist, bringing into focus the areas where your finances need some help, from process inefficiencies to poor budgeting to over or under paying taxes.
Book a consultation with me today to improve your financial eyesight.
What is a pass-through entity and how can it help my business tax situation?
The Treadmill Whisperers is a fictitious company legally classified and filing taxes as a C Corporation. When filing as a C Corporation, the entity is being taxed (federally) on its profits. Then those (already taxed) profits are distributed to owners as dividends, where they are reported on the individual shareholders’ tax returns and taxed a second time. In other words, The Treadmill Whisperers are being taxed twice.
To avoid this double taxation, the company can elect to be taxed as an S Corporation, and would then become a pass-through entity.
A pass-through entity is one in which the business itself is not subject to federal income tax. Instead, the company’s profits and losses “pass through” to the owners (or shareholders) and are reported on their individual income tax returns, regardless of whether those profits are distributed as dividends. This eliminates the corporate-level tax.
Partnerships, LLCs (in most cases), and sole proprietorships can also be pass-through entities.
How does S Corporation pass-through taxation work?
Many small businesses elect to file taxes as an S-corporation, which is referred to as a pass-through entity. To be clear, the S Corporation label is a tax election, not a type of legal entity. C Corporations, LLCs, sole proprietors, limited partnerships, and LLPs can all elect to be taxed as S-Corporations. You do have to file for this specific election; it does not happen automatically.
Most people have and are familiar with the W-2 tax forms. This is a form that provides you with your income numbers to file your tax return.
A business creates a K-1 tax form, which is the company’s net profit version of a W-2. The key difference is that the K-1 is a document used to communicate the owner’s share of the net profits and losses to claim on their personal income tax return. It is an informational form only, just like the W-2. There are different types of income that are taxed in different ways, so this form can be complicated.
With a pass-through entity, even though you file a tax return for the business, usually no taxes are paid on that federal income tax return. Instead, the net profit flows through, down to the individual level.
Owners then take the K-1 and record that information on their personal return as a source of income. They will add any other wage income from this company or other companies, as shown on their W-2 forms. The total tax amount is then calculated at the level of the individual, not the company.
Since the net income flows through to the individual owners of the company, where taxes will be paid, taxes are only paid once (at individual level) instead of at both the company and individual levels.
What is an owner’s draw and when can it be accessed?
Most owners know they can pull cash from their company as a salary. In addition to that salary, owners can also tap into what’s called an “owner’s draw.” An owner’s draw is when you remove profits which you’ve already paid taxes on.
Since you, as the business owner, pay taxes on net income in the year you earn it, you don’t pay any taxes when you remove those profits through your owner’s draw. Here’s how it works:
Let’s say you pay yourself as an employee and are the sole owner of the business. You have two theoretical pockets of cash you can remove from the business. One pocket is already taxed (prior income, which you can access through Owner’s Draw), one is not yet taxed (this year’s salary). Proper and accurate accounting can ensure that you are taking money out of the right pocket.
At the end of every year, the businesses’ net income (after all expenses have come out) flows into your owners equity account on the balance sheet. An Owner’s Draw is an account within that section of the balance sheet. The owners can take money out of this, as much as the profits allow. It’s already taxed because you paid it in the year you earned it. It was then deposited into the owner’s draw pocket.
A C Corporation is the default when it comes to taxes and doesn’t have this benefit. The only way to get net profits out of a business that is taxed as a C Corporation is to pay the shareholders a dividend. Those dividends must then be claimed as dividend income on their individual return where taxes are paid a second time.
Don’t live with financial color blindness
The IRS will always get their taxes. If they don’t get their tax money at the company level, they get it at the individual level. But you are certainly not required to pay them twice! You want your dollars in the right places so you know what’s been taxed, and what hasn’t. Double taxation is avoidable!
Don’t pay more taxes than needed. Book a consultation with me today to bring clarity to your finances and get help implementing processes and procedures that will save you money. I can also share how to balance your salary with owner’s draw decisions. There’s nothing to lose – except maybe some unnecessary tax payments.
