One of the most common problems we see from startup founders who are first moving away from DIY accounting is a wide range of “personal transactions” being made with the business accounts. This is known as “commingling your books” and is a huge no-no as well as one of the most common ways businesses find themselves on the barrel end of an IRS or state audit.
According to the IRS, personal expenses are not eligible business expenses deductible against taxable income. Instead, if you were to purchase personal items through a company account, they should be fringe benefits that are subject to payroll taxes.
What is a fringe benefit?
The IRS's Employer's Tax Guide to Fringe Benefits defines a fringe benefit as “a form of pay for the performance of services.” In their eyes, this personal expense is just as much a form of compensation as their salary. (For more on fringe benefits, be sure to check out The Ins and Outs of Fringe Benefits - What Is Non-Taxable? on HR and payroll provider, Justworks' blog.)
You cannot deduct items like a haircut, trip to the salon, or new clothes as a business expense, even if it is to look fresh for an upcoming business meeting. In this scenario, once the IRS caught this kind of spending, they would treat this as disguised compensation, which would be subject to payroll taxes and potential interest and penalties owed down the road.
Suggested Reading: 7 Accounting Tips for New Small Businesses
Where this can get tricky: Making personal purchases (like a haircut) on a business account is not a problem as long as you include the spending in your payroll as a fringe benefit. But because so many fail or forget to do so, it is much cleaner and simpler to keep everything as separate as possible.
Drawing the line between what’s personal and what’s business:
If you’re just starting a business, you may be wondering how to tell the difference between personal and business expenses. In a previous post, my inDinero teammate writes about what first time founders need to know about claiming small business tax deductions where she explains how the IRS defines what qualifies as a business expense:
“The tax law requires business expenses to be ordinary, or common and acceptable in your trade or business, and necessary, or helpful and appropriate for your trade or business.”
She goes on to elaborate on the importance of diligent record keeping and emphasizes how much easier tax season is if your business is organized and has a stellar bookkeeping system in place all year round.
However, for many early stage businesses that ship may have already sailed. The following step by step guide explains what you can do if you’ve mixed personal expenses into your business spending accounts, and are hoping to rectify the situation in retrospect.
Un-Mingling Personal Expenses From Your Business’s Books to Avoid Tax Penalties & Interest:
Step 1: Find the transactions
Comb through your business financials and find every transaction that looks like a personal expense. This step can be time consuming if your business has a lot of transactions throughout the year, but it’s incredibly important to be thorough here to ensure you’ve caught everything!
Focus on these red flag areas the IRS is known to pay extra attention to: hotels/travel, meals/groceries, personal car payments, personal rent payments, home office expenses, cosmetics/clothes, entertainment etc. And to the same point, anything categorized as miscellaneous will very likely pique the IRS’s interest so be sure you categorize as much of your spending as possible.
Step 2: Classify your transactions correctly
Once you have found all the personal transactions throughout the current tax year, you need to identify how you would like them to be treated.
As described earlier, the best practice is to amend your payroll reports and book the purchase as a fringe benefit compensation. This is the only sure-fire way to clear this issue completely but the process is time consuming and costly. Another way this could have been avoided is if the company had simply loaned the shareholder the money in order to pay for their haircut (or other personal item) themselves. While changing the nature of a transaction after the fact isn't technically allowed, rebooking the transaction as to a loan to shareholder in this situation would likely not raise any red flags. This total “loan to shareholder” amount is expected to be paid back from the founder to the company since it was improperly recorded on the business financials.
Tax professionals have been known to do this, but proceed with caution and with an experienced tax expert on your side: This is a gray area and not technically allowed as any true loan should be part of a proper loan agreement (with interest accrued).
If your company is an LLC or S-Corp, after classifying the transaction as a loan, you may have the option of treating it as a reduction of your capital account. While reduction of capital are typically tax free (depending on the partner or shareholder’s basis in the company), smaller businesses usually do not have large enough capital accounts to handle this.
Additionally, Partnerships (LLCs) can treat this transaction as a guaranteed payment. These are treated as taxable income just like a salary and should be approved in your LLC operating agreement from the prior tax year.
Suggested Reading: How to Choose Your Small Business Entity
Step 3: Pay back the loan
Assuming that you cannot make guaranteed payments or reduce your capital account, often times the best solution is to simply pay back the loan to shareholder. This can be done in several ways:
- Simply pay back the loan amount with your personal funds. This is definitely the easiest way to fix this, but is not always available to those who are in startup mode.
- Process a cashless bonus via your payroll provider. This option has the company process a “bonus” in order to repay the loan. The gross amount of the bonus, will be the loan amount plus proper payroll taxes and other withholdings. The net amount will simply be the total amount of the loan. You can have your payroll provider debit the payroll taxes but not process the net amount, and you have effectively paid back your company for the personal expenses throughout the year.
This process will result in taxable income to the shareholder. If this was the only transaction, at the end of the year the shareholder would receive a W-2 for that amount even though they never actually received any cash. The company would then receive a deduction for the amount at this time because they did not receive a deduction when it was first recorded as a shareholder loan.
This is not a mistake you want to repeat
As a founder, CEO, or owner of a small business, it can be hard to tell where your work world ends and personal life begins. From the process outlined above, it’s pretty clear that mistakes like commingling your expenses are easier to prevent in the moment than having to go back and fix them later on. As mentioned before, having a reliable system for keeping your books in order makes these issues all the more preventable and solving one-off blunders a smoother, more streamlined process.