Most business owners understand when they start their business that they must keep their business and personal interests separate. This is the reason that many business owners choose to set up their business as LLCs or Corporations. Taking this step protects their personal assets from any action that may occur as a result of business functions. However, sometimes a business owner does not draw a clear line between their personal and business expenses. This is referred to as commingling of funds and can lead to administrative problems and difficulties for the business owner when it becomes necessary to separate assets and expenses.
Why is this important? As explained in this article, there is a business concept called the “corporate veil” which is essentially a liability shield between the business and the business owner. When business and personal funds are commingled, this is called piercing the corporate veil. When this occurs the business personal assets become liable through the business. Besides the legal reason, there are also important tax reasons for not commingling funds.
How am I commingling funds?
First, you must understand what you might be doing to commingle funds. This starts to happen when you treat business funds as personal money. For example:
- Transferring funds between business and personal accounts without proper documentation
- Withdrawing money from your business account for personal expenses without proper documentation
- Writing business checks for personal expenses
- Depositing business checks into your personal account
- Having only one bank account
What do I need to do to avoid commingling?
According to the IRS, personal, living, or family expenses are not deductible business expenses. Instead, these personal expenses actually become a taxable fringe benefit that is subject to payroll taxes. If the IRS discovers that there are personal expenses out of the business account, they may call these expenses disguised compensation and your business may have to pay taxes and penalties on these funds.
The temptation is there to deposit the business check into your personal bank account because you have earned that money and then also use that personal account to buy supplies or equipment for your business. This is commingling of funds. Be sure to have two accounts – one for business and one for your personal use as a first step. Then, deposit the check into the business account. Purchase the supplies and equipment for the business from that account. If payment is due to you, treat yourself as an employee. Take a draw from the business as a payroll check with appropriate taxes paid. Remember that carefully tracking your business income and expenses can benefit you at tax time, as many of your properly documented business expenses may be tax-deductible.
Can I fix this if I have been doing it wrong?
It will take some time and diligence on your part as the business owner, but you can take steps to un-mingle the expenses and get yourself and your business on the right track. First, go through all of your business financials and flag them as business or personal. Certain expenses like travel, meals, and entertainment are red flags to the IRS, so pay special attention to those and only include them as business expenses if they truly were related to business operations. Next, classify the expenses correctly and if necessary, amend payroll reports to indicate that some personal expenses were actually fringe benefits. If you loaned yourself money out of business funds rather than taking a draw, pay that money back to the business. There are a few ways to do that and a tax professional or accountant can help you with this.
Finally, if you have commingled funds, once you have straightened this all out and have all of your expenses and income properly classified, do not let it happen again. Keep expenses separate and set yourself up to take a draw from your business to cover personal expenses.
To learn more about managing your business and personal funds, contact Gallati Professional Services.