Amount of Withdrawals

April 13, 2006

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In order to avoid certain fraud restrictions when withdrawing funds from the business, small business owners need to be careful about authorization and documentation for these transfers.

Creditors may sometimes argue that large withdrawals (e.g., for salary) are indicative of fraudulent intent. However, provided these withdrawals are authorized, documented and occur on a regular basis, creditors will have a difficult burden in establishing intent, based on the size of withdrawals.

In particular, tax cases involving regular or C corporations frequently involve the issue as to whether salary is reasonable, because a corporation can deduct only "reasonable" salaries. Due to the time and effort an entrepreneur devotes to his business, courts in these cases deem as "reasonable" extremely large salaries taken by owners. This same reasoning also should extend to actual fraud cases.

In one case, the tax court found "reasonable" compensation of almost $900,000 for one year paid by a corporation to its only owner. This compensation consisted of a $200,000 salary, a $400,000 bonus, and a $296,000 lump sum retirement benefit.

The tax court relied on five factors in deciding whether the compensation was reasonable:

the employee's role in the business
a comparison of the compensation with what is paid to similar employees by other companies
the character and condition of the business
whether, in a regular C corporation, the compensation is really a "disguised dividend" intended to avoid the double tax on dividends
whether the compensation was consistently paid under a structured and formal arrangement

The fourth factor underscores why these tax cases arise. A regular or C corporation is a separate tax-paying entity. Dividends paid by a C corporation are subject to a double tax, because they are not deductible by the corporation and thus are taxed at the corporate level. Dividends also are taxed a second time, at the individual tax rates when they are received by the owner. C corporations sometimes attempt to disguise a dividend as salary, in an attempt at avoiding the tax at the corporate level, as the salary is deductible by the corporation. The salary is considered to be a disguised dividend, only to the extent the salary is deemed to be unreasonable.

While the same tax issue does not arise in the case of the subchapter S corporation or the limited liability company (LLC), the reasoning should extend to actual fraud cases. Payment of a reasonable salary is not indicative of fraudulent intent.

Note, too, that the fifth factor formally recognizes authorization and documentation as important factors in determining the reasonableness of the salary.

Between payments for salary, loans and leases, and other withdrawal strategies, it will seldom be a problem for small business owners to withdraw all of the vulnerable funds from the business in a manner that is "reasonable," and thus not found to be fraudulent.