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« Write-offs for LLCs vs. C-Corps | Main | Dilution issues for Founders »

Taking draws vs. salary

Greg writes:

I'm in the start-up phase of an insurance company I am starting with a colleague. He has deeper pockets than me, so I was thinking of ways for us to begin this venture. Here is some advice I received:

I suggest you try for a 50%-50% deal for the venture. You will get an interest free draw on a monthly basis against your share of the future profits. He would provide the funding for the draws you would need, and you would reimburse him for the draws whenever a distribution of profits is made by the company. If possible, you would want the draws to be treated as advances of capital gains.

Would this type of setup be possible?

Possible?  Yes.  Desirable?  That depends...

You can take a "draw" which is for practical purposes a loan that the company gives to you today, which you will repay out of those future earnings.  It's not unlike how you might front a new sales person money in anticipation that it will take them some time to get ramped up before they start earning commissions, and then when they do, they pay that money back.

The benefit is that this money won't be taxed as income, provided that you do really pay it back.  By getting money today, and paying it back, it's just a loan.

But - and here's the whammy - if you *don't* pay it back, then you have to treat the draw as income at the moment that it's determined pay back isn't going to happen.  And that means you owe income taxes on all those draws as though there were actually W-2 type paychecks. 

The risk here is that it could be quite some time between now and when you actually can pay them back -- or determine that the company isn't going to make it or that you otherwise can't pay it back -- in which case you might have accumulated quite a hefty sum of debt that gets converted.  In that case, your tax obligation might be pretty darn high, especially if you were only taking enough money to live on, and didn't have the means to hold back cash just in case this happened.

First, I would consult with a tax professional about your situation.  Any CPA with a good reputation and small business experience will be familiar with what you are trying to do here.  Second, you need to ask yourself the hard question as to whether or not you expect to get real income from the business sooner rather than later, helping to minimize this tax-whammy scenario.  Then, armed with that knowledge, you and your partner need to sit down, perhaps with that CPA, and stamp out a plan that will work for everyone, where everyone knows the risks/rewards involved.

In short, the advice you received might well be what you should do in your situation, but be aware that the tax man cometh, and the tax man will taketh away.  This is not an uncommon arrangement.  But, consult a CPA so both you and your partner know what you're getting into.

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References (3)

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    Taking draws vs. salary - Blog - McStartup - tasty advice for startup companies
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    Taking draws vs. salary - Blog - McStartup - tasty advice for startup companies
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    Response: concrete Knives
    Taking draws vs. salary - Blog - McStartup - tasty advice for startup companies

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