One of the most common problems for startup founders is the commingling of funds: when you pay for personal transactions from a business account, or visa versa.
The solution to commingling funds is simple but tedious. You must identify and reclassify the transactions as fringe benefits or as loans from your company to yourself. You’ll reimburse yourself if you’ve used personal accounts to pay for business expenses.
We’ll break down the step-by-step process for implementing these solutions, explain why commingling funds is risky in the first place, and show you how to make separating funds easier in the future.
What is Commingling?
Commingling, in the context of business finances, refers to the mixing of personal and business funds. This typically occurs when:
- Business owners use company accounts to pay for personal expenses
- Personal funds are used to cover business costs without proper documentation
- Business and personal transactions are not clearly separated in accounting records
Commingling of funds can happen in various ways:
- Using a business credit card for personal purchases
- Depositing business income into a personal bank account
- Paying personal bills from a business checking account
- Using personal savings to cover business expenses without proper documentation
Understanding what constitutes commingling is crucial for business owners to maintain proper financial separation and avoid potential legal and tax issues.
What Are the Consequences of Commingling Business and Personal Funds?
Quite a few issues can arise if you mix your business and personal funds— from minor inconveniences to high financial costs and even legal trouble.
Tracking Expenses Accurately Is Difficult
How profitable were you last year? Last quarter? Mixing funds makes this information difficult to track. Future investors or creditors will want to know your financials, not to mention the confusion this will bring come tax time.
Claiming Tax Deductions is Harder
When running a business, saving the maximum amount of money with tax deductions is vital to maintaining financial health. However, you can’t deduct what you don’t document and shouldn’t deduct what you can’t prove was a business expense. Mistakenly taking personal expenses as small business tax deductions also opens you to risk during an audit.
You May Lose the Liability Protection Your Company Provides
Under normal circumstances, running business funds through your company protects your personal assets from creditors. If the company goes bankrupt, creditors are only allowed to liquidate the company, not personally owned assets.
However, commingling funds ends this protection in what lawyers call “piercing the corporate veil.” A pierced veil means creditors can take you to court, argue that your “business” and “you” are not separate, and come for your private belongings.
Related: Learn how liability protection defines the difference between Sole Proprietorships vs. LLCs
Is Commingling Funds a Crime?
Most of the time, commingling funds is an honest mistake, but there are scenarios where it can land you in serious trouble.
- If you’re part of a multi-member LLC or corporation, your fellow owners may consider commingling funds as a form of theft.
- Taking out a loan in the business name and spending that money for personal rather than business purposes is seen as fraud in the eyes of the law.
- In the legal, real estate, or financial services industries, commingling client funds with personal is illegal.
- Individuals with a fiduciary responsibility to clients, such as trustees or financial advisors, must separate client funds.
How Do I Correct Commingling Funds?
It’s understandable, even common, for entrepreneurs to find that their business has been commingling funds. And when your business is still young, the risks associated with commingling funds may feel far off.
But commingling funds can have severe consequences for your business or personal assets. So here’s how to fix the mistake:
Step 1: Find the Transactions
Comb your business financials and find every transaction that looks like a personal expense. This step can be time-consuming, especially if your business has a lot of transactions throughout the year. But it’s essential to be thorough to ensure you’ve caught everything.
Indinero’s online bookkeeping services are here to help with this tedious task.
Certain expenses are more likely to be flagged by the IRS: hotels, travel, meals, groceries, car payments, rent, cosmetics, clothes, and entertainment. Anything categorized as miscellaneous may pique the IRS’s interest as well.
Step 2: Re-Classify as Fringe Benefits or Loans
Once you have found your personal transactions, it’s time to decide how you would like them treated.
Fringe Benefits
The most straightforward practice is to amend your payroll reports and recategorize the commingled purchase as fringe benefit compensation.
The IRS’s Employer’s Tax Guide to Fringe Benefits defines a fringe benefit as a “form of payment for the performance of services.” In their eyes, this personal expense is just as much a form of compensation as their salary.
In other words, making personal purchases (like a haircut) on a business account is no problem if you include the spending in your payroll as a fringe benefit.
This process will result in taxable income to the shareholder. If this were the only transaction, the shareholder would receive a W-2 for that amount at the end of the year, even though they never actually received any cash. The company would then receive a deduction for the amount because it did not receive a deduction when it was first recorded as a shareholder loan.
Popular accounting tools will have features allowing you to note transactions as fringe benefits. If you’re not using one, create a written document detailing the time, purpose, and price alongside a note indicating the new classification.
A Loan From the Company to You
Fringe benefits may be the easiest way to deal with commingled funds, but they come with a significant drawback: The spending will now be counted as income, subject to income and payroll tax.
Avoid this issue by treating the situation as if the company had loaned the shareholder money. While changing the nature of a transaction after the fact isn’t technically allowed, tax professionals are known to do this. Proceed with caution. While rebooking the transaction as a loan is unlikely to raise red flags, it isn’t technically allowed, as any true loan should be part of a proper loan agreement.
Having an experienced tax expert on your side is best for this approach. If you’d like to outsource the tedium of this task while avoiding payroll and income tax along the way, indinero’s online bookkeeping services are here to help.
Additionally, 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 capital reductions are 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.
Step 3: Pay Tax on the Fringe Benefit or Pay Back the Loan
With the fringe benefit route, you’ll process a cashless bonus via your payroll provider. The gross amount of the bonus and proper payroll taxes and withholdings will be spent. You can have your payroll provider debit the payroll taxes but not process the amount, and you have effectively paid back your company for personal expenses throughout the year.
If treating this as a loan, simply pay back the loan amount with your personal funds.
What if I’ve Paid for a Business Expense With a Personal Account?
This one is a more straightforward solution. Simply reimburse yourself for the amount of the expense in the same manner that you usually pay yourself.
How to Avoid Commingling Funds in the Future
Fixing commingled funds can be a major headache, so it’s best to have a system for keeping your books in order. Separating personal and business accounts between different banks is the most effective method. By doing so, you’ll not only have separate credit and debit cards, but you’ll also have a better sense of separation between the funds.
Drawing the Line Between Personal and Business
If you’re new to running a business, you may wonder how to tell the difference between personal and business expenses. What are you allowed to deduct? We’ve written about small business tax deductions before, but simply put:
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.”
IRS
Legal Aspects of Commingling Funds
Commingling funds can have serious legal implications for business owners and professionals. While not always explicitly illegal, it can lead to various legal issues and penalties. Let’s explore the legal aspects of commingling funds:
Is Commingling Funds Illegal?
The legality of commingling funds depends on the context and the specific circumstances:
- Generally Not Illegal, But… For most small business owners, commingling funds is not inherently illegal. However, it can lead to legal complications and may be viewed as unethical or negligent business practice.
- Strictly Illegal in Certain Professions
- Lawyers: Commingling client funds with personal or business funds is explicitly prohibited by bar associations and can result in disbarment.
- Real Estate Agents: Mixing client escrow funds with personal or business accounts is illegal in most jurisdictions.
- Financial Advisors: SEC regulations prohibit commingling of client funds with advisor funds.
- Illegal in Specific Scenarios
- Using business loans for personal purposes can be considered loan fraud.
- In partnerships or corporations, using company funds for personal expenses without proper authorization may be viewed as embezzlement.
Legal Consequences of Commingling Funds
- Piercing the Corporate Veil
- Courts may “pierce the corporate veil,” removing the liability protection that separates personal assets from business liabilities.
- This can expose personal assets to business creditors or legal judgments against the company.
- Tax Implications
- Commingling can lead to inaccurate tax filings, potentially resulting in audits, penalties, and even tax evasion charges.
- Breach of Fiduciary Duty
- In partnerships or corporations, commingling funds may be seen as a breach of fiduciary duty, leading to lawsuits from other stakeholders.
- Bankruptcy Complications
- In case of bankruptcy, commingled funds can complicate proceedings and may be seen as an attempt to defraud creditors.
- Regulatory Penalties
- Depending on the industry, regulatory bodies may impose fines or revoke licenses for commingling funds.
Legal Protections and Best Practices
To avoid legal issues related to commingling funds:
- Maintain separate personal and business bank accounts.
- Use dedicated business credit cards for all business expenses.
- Implement clear accounting practices and regularly audit financial records.
- Consult with a lawyer or accountant to ensure compliance with industry-specific regulations.
- Document all transactions between personal and business accounts, treating them as loans or salary payments when appropriate.
By understanding the legal aspects of commingling funds and implementing proper financial practices, business owners can protect themselves from potential legal consequences and maintain the integrity of their business operations.
Checklist: Preventing Commingled Funds
Use this checklist to ensure you’re taking the necessary steps to avoid commingling personal and business funds:
- Open separate bank accounts for personal and business use
- Obtain dedicated business credit cards
- Establish clear accounting procedures for business expenses
- Set up a proper payroll system for paying yourself from the business
- Maintain detailed records of all business transactions
- Regularly reconcile business accounts
- Consult with an accountant or financial advisor to review your financial practices
- Educate all business partners and employees about the importance of separating funds
- Create a written policy for handling business expenses and reimbursements
- Conduct periodic audits to ensure compliance with financial separation practices
By following this checklist, you can significantly reduce the risk of commingling funds and maintain proper financial separation between your personal and business finances.
What are the signs of commingled funds?
Commingling of funds can be identified through several signs:
– Personal expenses appearing in business account statements
– Business income deposited into personal accounts
– Lack of separate credit cards for business and personal use
– Inconsistent or unclear record-keeping for business expenses
– Difficulty in distinguishing between personal and business assets
– Using business funds for personal investments or vice versa
– Paying personal bills directly from business accounts
If you notice any of these signs, it’s crucial to address them promptly to maintain proper financial separation.
How can I prevent commingling of funds?
To prevent commingling funds, follow these best practices:
1. Open separate bank accounts for personal and business use
2. Obtain dedicated business credit cards
3. Implement clear accounting procedures for tracking business expenses
4. Set up a proper payroll system for paying yourself from the business
5. Maintain detailed records of all business transactions
6. Regularly reconcile business accounts
7. Educate all business partners and employees about the importance of separating funds
8. Create a written policy for handling business expenses and reimbursements
9. Conduct periodic audits to ensure compliance with financial separation practices
10. Consult with an accountant or financial advisor to review your financial practices
What should I do if I’ve accidentally commingled funds?
If you’ve accidentally commingled funds, take these steps to rectify the situation:
1. Identify all instances of commingling by reviewing your financial records
2. Separate the commingled transactions and categorize them correctly
3. For personal expenses paid with business funds:
– Treat them as either fringe benefits (subject to payroll taxes) or
– Classify them as loans from the company to yourself (to be repaid)
4. For business expenses paid with personal funds:
– Reimburse yourself from the business account
– Ensure proper documentation for the reimbursement
5. Adjust your accounting records to reflect these corrections
6. Consult with a tax professional or accountant to ensure proper handling and reporting
7. Implement stricter financial practices to prevent future commingling
Are there any exceptions where commingling is allowed?
While it’s generally best to avoid commingling funds, there are a few situations where it may be permissible or unavoidable:
Sole Proprietorships: In this business structure, there’s no legal separation between personal and business assets. However, maintaining separate accounts is still recommended for cleaner accounting.
Initial Business Funding: When starting a business, owners often use personal funds. This is acceptable if properly documented as a capital contribution or loan to the business.
Emergency Situations: In rare cases, using personal funds for urgent business needs may be necessary. However, this should be immediately documented and reimbursed.
Small, Infrequent Expenses: Occasionally paying for minor business expenses with personal funds (e.g., buying office supplies) is common but should be properly recorded and reimbursed.
Even in these cases, it’s crucial to maintain clear records and separate the funds as soon as possible to avoid potential legal or tax issues.
How does commingling funds affect taxes?
Commingling funds can have several impacts on taxes:
Reduced Deductions: Mixing personal and business expenses can make it difficult to identify legitimate business deductions, potentially leading to overpayment of taxes.
Audit Risk: Unclear financial records due to commingling may increase the likelihood of an IRS audit.
Incorrect Income Reporting: If business income is deposited into personal accounts, it may be overlooked when reporting business income, leading to underreporting.
Payroll Tax Issues: Personal expenses paid by the business should be treated as compensation, subject to payroll taxes.
Tax Status Complications: Extensive commingling might lead the IRS to question the legitimacy of your business structure, potentially affecting your tax status.
To avoid these issues, maintain clear separation of personal and business funds and consult with a tax professional for proper reporting and compliance.
Can commingling funds affect my business credit?
Yes, commingling funds can impact your business credit in several ways:
1. Credit Utilization: Using business credit cards for personal expenses can increase your credit utilization ratio, potentially lowering your business credit score.
2. Payment History: If personal spending leads to late payments on business accounts, it can negatively affect your business credit.
3. Creditworthiness Evaluation: When applying for business loans or credit, lenders may view commingled funds as a red flag, indicating poor financial management.
4. Business Legitimacy: Extensive commingling might lead creditors to question the legitimacy of your business operations, affecting their willingness to extend credit.
5. Maintaining separate personal and business finances helps establish a clear credit history for your business, potentially improving your access to financing and better credit terms.
Conclusion
Commingling funds can be a serious problem. It opens you to personal liability for business debts and potential legal issues. Fortunately, there are solutions: classifying personal expenses as fringe benefits or as loans from the business to yourself, are the methods accounting professionals recommend.
Going forward, it’s best to maintain separate bank accounts for personal and business spending, as well as to keep your books diligently.
If you find yourself needing to fix things retroactively and don’t have the time to untangle the problem yourself, indinero accounting and tax services can manage the issue for you.
