Divorce your Personal Expenses from your Business Operations

Accounting2Easy divorcebusiness-expenses

It is quite common for small business owners to pay for personal expenses out of their business account.  However, upon discovery, the IRS will often respond by imposing civil penalties in addition to the appropriate tax on the disallowed expenses. Additionally, interest will accrue on the assessed tax and penalties.

Internal Revenue Code Section 162(a) states as follows:

“In general There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including—

  1.  a reasonable allowance for salaries or other compensation for personal services actually rendered;
  2.  traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and
  3. rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.”

The important terms to understand from the above section of the US Tax Code when assessing whether the cost is a valid business expense are “ordinary and necessary.”

In IRS Publication 535, the Internal Revenue Service offers additional details and clarification of “ordinary and necessary” stating:

“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. An expense does not have to be indispensable to be considered necessary.”

While the definition of ordinary and necessary within the tax code can be viewed as vague by some, it does offer some guidelines to help determine if the incurred cost is, in fact, an ordinary fee based on the facts and circumstances of each case.

Based on our extensive understanding of the law, an ordinary expense is the type of expense that would typically be incurred in a similar business.  Any necessary expense is one that is directly required to achieve the mission of the business.  

Disallowed Personal Expenses

Below is a list of the personal expenses we see commonly billed as business-associated fees:

  1. Automobile expenses: Listing all of the cost of a personal vehicle as a business expense when the business doesn’t use an automobile or when the auto is partially used for commuting or personal travel.
  2. Credit card charges: Running up small personal charges on company credit cards.  We often see this reflected in the credit card being paid in its entirety by the business with insufficient accounting for personal charges on the card.
  3. Charges at large retailers: Mixing of personal and business accounts at large retailers like Costco or Sam’s Club offer some different business and personal products and services. Business owners who are not properly tracking their expenses can blend their individual charges with business charges without detection.
  4. Meals: billing meals without justification.  Small business owners rarely keep sufficient records to explain meals expensed to the business.
  5. Travel expense: charging airfare, hotel fees or meals for family members on the company account or simply billing entire personal trips under the cost of the business.
  6. Fitness or country club dues.
  7. Personal telephone: Charging the entire cell phone family plan.
  8. Personal home upkeep: billing home utility bills, the cost of maintenance fees or in-home staff such as housekeepers.
  9. Professional services:  billing legal personnel or accounting services for issues that are not related to the small business, such as divorce attorneys.
  10. Wages to family members:  Issuing payments to family members who are not actually working, or paying for college tuition out of the business.
  11. Contractor payments: Issuing payments to contractors for home remodeling or the upgrading of other assets out of the business account.
  1. Validating Small Business Costs and Expenses

Documentary proof, such as receipts, canceled checks, or bills must be retained. Documentary evidence, according to the IRS, will typically be considered adequate if it shows the quantity, date, the place, and the essential reason for the expense. Additionally, you generally must include a written statement describing the business-related purpose for the expense, i.e., a receipt from a restaurant is sufficient to validate a business meal if it has listed on it the name and location of the restaurant, along with the number of people served, the exact date and exact amount of the associated expense.

  1. Due to the increasing number of online retailers, ever more businesses are paying for expenses with their credit cards.  Although credit card statements do show that something was purchased, these statements alone do not sufficiently support deductibility.

While there are several forms of small business, each has its own rules. S Corp owners may remove income from the business in the form of:

  • distributions (when issued by an S corporation out of their earnings, these earnings are similar to the dividends issued by C corporations),
  • wages,
  • as repayment of loans, 
  • and reimbursed expenses

By carefully detailing records, you can avoid a catastrophic situation where the IRS reclassifies distributions as wages. Should the IRS decide to do so, the results could include payroll taxes as well as late payment and filing penalties. Avoid difficulties by observing these suggestions:

Distributions should be recorded in the corporate minutes each time a dividend payment is made.

All distribution payments should be recorded as the dollar value per share multiplied by (to the nearest whole dollar) the amount of shares held (number).

  Paying personal bills through your business and calling them distributions is a big no-no.

   Pay yourself reasonable wages.

 

 

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