Sometimes there’s a disconnect between the practice owner and bookkeeper regarding why the bookkeeper chooses to categorize a transaction a certain way.
Generally, the categories that tend to get mixed up the most are what we call "tax-compliant categories." This means that the category has to be used a certain way in order for a practice owner's books to stay in good standing with the IRS.
We’d like to give Heard customers context and reasoning behind why our bookkeepers choose the categories that they do, especially when it has to do with tax compliance. This way, practice owners can make informed decisions when choosing to recategorize transactions.
First off, bookkeepers choose certain categorizations because of the following:
- They want to prevent Owner’s Distributions from being over or under stated, which would result in the practice owner paying too little or too much for an overall tax payment.
- They want to prevent inaccuracies in a practice owner’s books that may subject them to a tax audit.
- They want to prevent certain transactions from being included in a practice owner's profit and loss statement, which would result in an inaccurate quarterly tax estimate, and an inaccurate financial snap shot of how the practice is doing.
- For example, federal and state tax payments are actually personal expenses, not business expenses. This means that they shouldn't be included in a practice owner's books.
With those reasons in mind, here are a handful of tax-compliant categorizations that tend to confuse people. These descriptions capture the basics of the categorization, but they may not apply to every situation in someone’s books.
Money Transfer vs. Owner’s Distribution vs Owner’s Investments
- If the money's being transferred from one business bank account to another business bank account, it’s a Money Transfer.
- If the money's being transferred from a business bank account to a personal bank account for personal purposes, it’s an Owner’s Distribution.
- If the money's being transferred from a personal bank account to a business bank account for the purpose of keeping the practice up and running, it’s an Owner’s Investment.
Credit Card Payments vs. Owner’s Distribution vs Owner’s Investment
- If it’s a payment on a personal credit card, then it will be an Owner’s Distribution because it’s intended for personal purposes.
- For example, if a bookkeeper sees that the payment is for a bank account that’s not connected to Heard, they may assume that it’s a personal account and therefore, a personal credit card payment.
- If it’s a payment from a business bank account on a business credit card, then it’s Credit Card Payments.
- If it’s a payment for a business credit card that’s made from a personal checking/savings account, then the transaction needs to be categorized as an Owner’s Investment.
- If it’s a payment for a personal credit card that’s made from a business checking/savings account, then the transaction will be categorized as an Owner Distribution.
Federal Taxes vs. Owner’s Distribution
- Federal and state tax payments aren't business expenses— they're considered a personal expense because it's the individual tax payer that makes the tax payments, not the business. Therefore, these payments shouldn't be in a practice owner's books and their Profit & Loss statement. This is why bookkeepers categorize tax payments as Owner's Distribution.
Retirement Contribution vs. Owner’s Distribution
- If money’s being transferred to a retirement account, or withdrawn for the purpose of putting in a retirement account, then it’s a Retirement Contribution.
- A bookkeeper may categorize this transaction as an Owner’s Distribution if they see it going to an account that’s not connected to Heard (like a 401K or IRA). Since they’re not familiar with the intention of the transfer or the account itself, it’s helpful to add a note explaining it’s for a Retirement Contribution so they’ll know for the future.
- For S corps, Payroll: Employee Benefits are used to categorize an S corp owner’s retirement contributions, since S corps have retirement plans through payroll that can be deducted.
Why are Owner’s Distributions different for S corps?
- Owner’s Distributions for S corps are categorized differently from Sole Props or LLCs because of the business structure of an S corp—the practice owner is a separate legal entity from their practice, and they may have shareholders who invest in the business as well.
- S corp owners can take out an Owner’s Distribution on top of their “reasonable salary”. The Owner’s Distribution amounts are subject to income tax, which is why it’s crucial to make sure that the Owner’s Distribution amounts are correct.
- If an S corp owner is paying a personal expense from the business account, the transaction needs to be reclassified as an Owner’s Distribution, as a way of taking out money to fund the personal expense.
- We encourage practice owners to not mix personal transactions with their S corp business to avoid any piercing of the corporate veil (which is when a corporation’s limited liabilities is taken away from them) and prevent the IRS or state tax authority from going after a corporation’s assets.
Travel expenses, Meals and Entertainment vs. Owner’s Distribution
- The expenses that can be considered related to the business because it’s being spent in a business setting, don’t always apply to S corps. For example, if a Sole prop practice owner travels to a conference for their practice, they can write off some of those travel expenses. However, an S corp practice owner may not.
- The business-related expenses must be considered necessary and ordinary to the business. This means that a coffee purchase during one's lunch break doesn't count as a business expense. It's a personal expense and categorized as an Owner's Distribution.
Other Expenses vs. Owner’s Distribution
- Other Expenses are any business expenses that are out of the ordinary and can’t be put in a different category. This category should be used sparingly, as it’s often targeted for tax audits. If used, it should also have a note specifying what the expense was for.
- If the expense was non-business related, then it’s an Owner’s Distribution. There may be a situation where the bookkeeper can’t determine how the expense is business related, which is why they may put the expense as an Owner’s Distribution.
- If the practice owner is an S corp, then any personal expenses will automatically fall into the Owner’s Distribution category.
Therapy Income vs. Owner’s Investments
- If income earned from giving therapy services goes into a business bank account, it’s Therapy Income. However, the caveat is that W-2 income should never be included in Heard. Only 1099 income that the business has earned through services should be provided.
- If money intended to keep the practice up and running goes into a business bank account (i.e. to pay for operating expenses), it's Owner’s Investments.
- In some cases, earned income was deposited into the practice owner’s personal account and then transferred to the business account. Transactions like these would look like an Owner’s Investment to a bookkeeper, and they would categorize it as such. In this situation, it’d be beneficial to leave a note explaining that it’s actually income, so that the bookkeeper isn’t understating income.