Withdrawal Methods

 

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A small business owner should always seek to keep at a minimum the amount of assets within the business entity vulnerable to a creditor by withdrawing funds from the business. Be sure to use formal and regular withdrawals, backed in writing.

Funds can be withdrawn thorough:

• distributions of earnings to the owners (i.e., dividends)
• payments of salary to the owners for services rendered
• payments to the owners for loans and leases that the owners have extended to the entity
• the contractual obligation of guaranteed payments
• sales of accounts receivable

In general, the Uniform Fraudulent Transfers Act's constructive fraud restrictions can cause significant problems for small business owners, because if certain conditions are met, transfers are automatically deemed to be fraudulent, irrespective of the transferor's intent. Similarly, the restrictions imposed by state limited liability company (LLC) statutes and corporation statutes on distributions to owners on account of their ownership interests can cause these same problems because these restrictions are based on the UFTA's constructive fraud concept.

Further, when proving solvency, the balance sheet version of the constructive fraud test as applied by these statutes is even more severe than the UFTA's balance sheet test.

However, distributions to owners for salary, loans and leases avoid this problem, as the constructive fraud provisions under the UFTA or the state corporation and LLC statutes do not apply to these distributions. In particular, because these distributions are for return value, the UFTA's constructive fraud does not apply. Also, because the distributions are made to the owners, other than on account of their ownership interests, the restrictions imposed by state LLC and corporation statutes also do not apply.

In short, distributions for salary, loan and lease payments, as opposed to distributions of earnings, are much more likely to be valid, especially when the entity is experiencing a financial crisis. Only the UFTA's actual fraud concept will apply as a restriction in making these distributions.

The impact of self-employment tax may affect the choice of withdrawal methods (i.e., whether the withdrawals are structured as distributions of earnings, salary, or payments for loans and leases). This tax is the Social Security and Medicare tax imposed on earnings from self-employment. Essentially, the tax is comprised of the rate that, outside of self-employment, employees pay plus the matching rate that employers pay, for a total of 15.3 percent.

Clearly, the self-employment tax is significant. How the self-employment tax affects the choice of withdrawal methods depends on whether the entity is a corporation or an LLC.

In general, all of the earnings of the LLC are subject to the self-employment tax, irrespective of whether or how these earnings are distributed. (One exception may be payments from loans and leases).

Current proposed IRS regulations would exempt distributions (other than for salary) to owners who work for the LLC fewer than 500 hours per year. However, the proposal has faced opposition, and its enactment is in doubt. In short, the self-employment tax represents one of the few situations where the corporation may enjoy an advantage over the LLC.