How to explain to Sole Prop: Owner Draw not Deductible ?

I'm having a brain block. New client has a Schedule C. The prior tax returns show that he has deducted "owner draws" Obviously, you cannot do this. How do I dumb this down and explain it in simple language for someone who isn't well versed in taxes. ? Or, will a simple "this is illegal" do the trick. If anybody knows the specific IRC code that relates to this, that would be awesome as well.

Thanks

You tell him it's just moving money from one pocket to another (i.e. one account to another). Owner contributions and distributions are not income or a deduction for a sole prop.

That most likely won't sink in, so you ask him "when you first started this business, and you capitalized it, did you recognize the cash that you put into the business account as income?"

He'll most likely respond "no". Ask him to explain why he didn't.

“See these draws here? When you deduct them it’s as if you’re getting wages or a salary. So we have to issue you with a W-2 and put it on this line here on your tax return. It takes time to issue the form and send it to the IRS. Your bill will go from a florin to half a crown and the IRS will charge penalties for late filing.”

Pause while his mouth goes to twenty past eight.

“You know we can get around the penalties by just not deducting the draws.”

Pause for face to go to ten past ten.

“Or we can consult IRC section 61 and various court decisions, including one or two that went to SCOTUS.”

Clock face is now at quarter past nine and, both face and hands have become rather distorted.

Seriously, I have had some success with a variation of the first part. One particularly successful case involved a shop owner with employees. She’s a smart lady and she understood the effect that her issuing a W-2 to her employees had on them. Once she realized that her drawings are akin to a wage, she understood the concept.

I threw in the bit between twenty past eight and ten past ten just for fun. That would likely convey the wrong message to your client.

I have seen that too when I picked up a new client. For some reason they were ill advised or ignorant! So basically I tell them that the business and the sole prop are one entity and you can NOT pay yourself a salary. I just add back the draw amounts to gross to make sure it matches the books.

I remember one fellow who was taking $2K per month out as a draw so he would tell me that he did not make any money in the business, no need to file a business return. So then I ask how is he paying his bills and then the full story comes out!

I have had some idi**s get a W2 issued in their name from a payroll company. I call the payroll company and ask them what were they thinking. They goofed and they must rectify!

Picked up a client several years ago who has a nice Schedule C business - he was trying to refinance his mortgage and his mortgage guy (client of ours) referred him to us as he was showing a loss on his Schedule C and couldn't figure out why. Turned out the tax preparer was deducting his draws as a business expense on Schedule C along with some other shady stuff. Needless to say, we amended that return and have had him as a client ever since.

When you work for an employer, the paycheck you get every Friday is not deductible. Owner draw is the same thing.

“Hey, we can just pay 100% of your income out as these draws and then you would never pay any tax. I could have all taxpayers do that and no one would ever pay tax again.”

Starting to see why this doesn’t work?

^^ LOL, that's hysterical. I like that one.

Another concept that works in person is to show them on paper what it would look like if they make $50,000 each year in net profit and did not take ANY distributions for 10 years and lived off of savings or spouse income instead.

I write it out and I explain that they would still pay tax on the $50,000 net profit each year.

But then, after 10 year, I ask them if they can take the $500,000 draw tax free.

Most of them will say, "yes, because I already paid tax on the net profit each year".

Bingo.

Some will hesitate and then I will explain to them (visually on paper) that there is no tax on the $500,000 because they already paid tax each year on the $50,000.

Either way, now they can see that the draw is irrelevant for tax purposes (disclaimer, we know that is not always true - but that's complicated).

This has worked well for me.