Donna Bordeaux explains that pass-through entity owners pay taxes on reported profit, not on what they withdraw. You owe tax on $400,000 in earnings whether you take that money out or leave it in the business. Distributions are equity transactions that don't change your taxable income.
Foreign. Hi, I'm Donna Bourdeaux with Calculated Moves. I often get a lot of questions about pass through entities and how taxation actually works. And there are a lot of folks with a lot of misinformation. So let's clarify. First off, a pass through entity, meaning that you have tax return information for a business that is flowing through your personal tax return. For most of the folks in the country, that will be the case unless you operate under a C corporation structure. So let's just assume for a moment that you are a pass through entity. When we talk about pass through entities, you will pay income taxes on your income that you earn less the expenses that you pay. Notice that when I said that, I did not say you will pay taxes on how much money is in your bank account at the end of the year. You will not. So let me give you two examples of two separate businesses so that you can see the difference. First off, let's say that I have a business. I made a half a million dollars and I had a million dollars worth of expenses that were paid. When we talk about income and expenses, we're generally talking about a cash basis taxpayer. So that means you received the money and you paid out the expense. If that's the situation, there would be $400,000 worth of profit left over. That profit, if it's in a pass through entity, means that it would be taxed you personally. You'll pay taxes on $400,000 worth of profit in that example. Now let's say that in my business I make that $400,000 and I use every penny of it all throughout the year to support my life, so and to pay all my bills. So I take that money out and at the end of the year, the checking account just has $100 left in it for the business. All right. Now my friend has the same exact business still makes the $400,000, but has a spouse who is supporting all of their personal bills and other expenses. So they don't use the money. They leave $400,000 in the checking account of the business at the end of the year. Who pays more in taxes? All right, trick question. We pay the same. We pay taxes based on the income, less the expenses. It does not matter how much money is left in the bank. We don't pay taxes on the cash balance of our checking account. It's not income and it's not expense. If we take the money out of the business, that's an equity position transaction. So we're taking a draw or a distribution that does not have any effect on taxes. I'll put a little asterisk there. If you do take out more money than you earned, there may be tax consequences for taking out that excess funding. But in normal situation you pay taxes on income, less expenses. It doesn't matter if you left the money in the business or took the money out. Alright, so hope that helps answer for you how distributions and draws are handled. Distributions and draws are basically the same thing. A draw relates to a sole proprietorship, while a distribution relates to an S corporation or partnership. So I hope that helps you clarify how taxes work with a pass through entity. I'm Donna Bordeaux with Calculated Moves. It.
