One of the services my firm offers is assistance in Entity Selection for startups. This is usually when we talk about various options available for the incorporator and what type of entity would be the best fit for the start-up in terms of liability exposure, record-keeping, and tax filing. This meeting usually results in setting up an entity, giving the incorporators guide-lines for record-keeping and help with choosing accounting software and set up, and so on, you get the drift?
So off they go with an Entity tucked away neatly under their arm, and the title music plays—you think? But no! Wait, here’s where the music stops with an ugly, teeth-tingling screech… The incorporator comes back at tax time and you look at all the bank statements, and you see the big thou-shalt-not of, “Commingling the Books.”
What is this commingling you ask?
Commingling happens when a business owner uses their business checking account to pay for both personal and business expenses. Personal expenses become subject to payroll taxes as compensation to the business owner.
You see, the Internal Revenue Service says that, “To be deductible, a business expense 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.” As per Reg. § 1.6001-1, the business owner needs to keep “contemporaneous” records to prove income and expenses.
It is therefore imperative that there is separation between personal & business expenses. I cannot stress enough about the need to keep diligent records as it not only makes your tax filing less stressful, but also gives you information you need to keep your business up and running profitably.
How should one clean up the commingling?
First thing to do is to find all the personal expenses. If you had many transactions in the year, this will take a long time. But thoroughness is important. The Internal Revenue Service flags expenses like that spent on travel, hotel, meals, groceries, clothes, cosmetics, entertainment, and such. Anything classified as “Miscellaneous” draws IRS attention too.
Once all the personal transactions are found, one has to be sure everything is classified as accurately as possible. The cleanest way to do this is to book these expenses as compensation and pay payroll taxes on them. Payroll taxes come at a price, and the process takes time and is complicated, especially if one has to go back & amend payroll reports. Many small business owners tend to classify these as personal loans, which are to be re-paid within a short period of time. Some tend to reduce the capital account without regard to capital gain issues or the basis the owner has in the business. Partnerships may classify these as guaranteed payments and pay tax on it.
Loans, even if to owners/shareholders, should have proper loan agreements with interest accrued/ paid; reduction of capital beyond the owner’s contribution or a negative capital account on the books is a huge red-flag; and partnerships should have proper approvals in their operating agreement regarding guaranteed payments.
As a small business owner myself (my tax practice), I face the challenge in drawing firm lines between work and life every day. But this is a habit one should cultivate as we go about our daily lives because fixing matters in retrospect is always more difficult. It all starts with being meticulous about one’s record-keeping and strict with not using business funds for personal use.
Quoting one of my most favorite Jungle Book characters, Colonel Hathi, “Discipline! Discipline was the thing! Builds character, and all that sort of thing, you know”. Discipline, my friend is the key to a smooth, and stream-lined business process.
Author: Manasa Nadig. I am Manasa Nadig, enrolled to practice and represent taxpayers with the Internal Revenue Service. I have been in the business of Tax Preparation & Tax Planning since 1999. My firm, MN Tax Solutions, LLC is based in Michigan, USA. Please connect with me on TaxConnections for more information about myself & the services provided by my firm.