One of the must common mistakes business owners do is mixing business and personal expenses. When this happens you are putting yourself at risk for an IRS audit. To ensure you do not end up with a stressful audit, you should know how to define and separate business and personal expenses.
According to the IRS, personal expenses are not eligible deductible business expenses against taxable income. Instead, personal items purchased through the company account should be classify as fringe benefits that are subject to payroll taxes.
The IRS defines a fringe benefit as “a form of pay for the performance of services”. A personal expense is just as much a form of compensation as their salary. A business owner cannot deduct items such as a trip to a salon, new clothes, even if it is for an upcoming business meeting. The IRS would treat this a disguised compensation, witch would be subject to payroll taxes and potential penalties and interest owed.
Business expenses must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business.
Avoid triggering an IRS audit
Deducting personal expenses as business may trigger back taxes, penalties for claiming false deductions and interest if the filing deadline has passed. Unpaid balance after removing the false deductions will be treated as back taxes.
- Banking, never use your business credit or debit card for personal expenses
- Keep business and pleasure trips separate
- Do not write-off personal purchases such as games, computers, printers, etc. as a business expense unless you are using them to make a profit
- Always record any capital investments or withdrawals
- Don’t accumulated personal debt in building your business
How to correct mixed personal transactions
First, you should find all current tax year transactions that looks like a personal expense.
Then, classify these transactions correctly. You can treat as a fridge benefits compensation, and amend your payroll reports. You can also rebook these transactions as to a loan to the shareholder. Loans are expected to be paid back to the business. If your company is an LLC or S-Corp, you may have the option of treating the amount as a reduction of your capital account. Shareholders’ capital accounts must be large enough in order to handle this reduction.
On the other hand, Partnerships can treat these transactions a guaranteed payment. These are treated as taxable income just like a salary and should be approve in your LLC operating agreement from the prior year.
If you can neither reduce your capital account or can not make guaranteed payments, the best solution is to simply pay back the loan.
If you mixed business and personal expenses hire a bookkeeping service to reconcile and classify all transactions to the correct category prior to preparing your corporate taxes.
In addition, it is important to remember that a key reason business owners choose to form a corporation or LLC is so that they won’t be held personal liable for debts should the business be unable to pay its creditors. Courts might pierce the corporate veil and impose personal liability on officers, directors, shareholders, or members when there is no real separation between the company and its owners. One example is when an owner pays personal bills from the business checking account. Commingling assets, like diverting corporate assets for personal use is just another example. These are just a few reasons why you need to avoid mixing business and personal expenses.