“Keep your business and personal money in separate accounts.” That is one of the most fundamental pieces of advice any accountant, lawyer or business coach will tell you. It is relatively uncommon for certain things to be almost universally agreed upon, but this is one such rare instance. And, it is very sound advice. One reason is the cost savings when it comes to accounting costs by not needing your accountant to spend time separating the information. Perhaps more importantly, if you commingle or misappropriate business funds, you run the risk of running into trouble with the IRS.
What? How can mixing business and personal expenses lead to IRS issues? The answer is because, just like anything else, there is a right way and a wrong way to get money out of the business to take care of personal expenses.
The money that comes into a business is meant to be used strictly for business purposes. That means it can only be used for paying for supplies, business rents or utilities, payroll, and anything directly related to the operation of the business.
That money is not to be used to pay your mortgage, groceries, anything for your kids, personal vacations, or anything else that has nothing to do with the business. If you work from home, you can take a reasonable portion of certain household expenses such as phone, power, internet, or auto related outlays.
Sometimes, however, it is necessary to take money out of the business in order to cover some personal expenses…
The wrong way
Lots of people who own small businesses don’t know how to properly handle the task of taking money out of the business. They simply make payments for their personal expenses out of the business checking account or use the business credit card for those personal expenses. Some even head over to the ATM machine and take cash out of the business for no other reason than to have some pocket cash. None of those methods are even close to proper.
The correct way(s)
If you need to access money for personal reasons, there are two accepted methods for doing so:
- Putting yourself on salary
- Writing a check to yourself in the form of a distribution
You should always create some sort of separation between business and personal expenses, and taking either of these steps does so without drawing any unnecessary attention to the transactions. It also creates a paper trail which keeps you in a good position if/when it comes to…
What trouble can follow
So what’s the worst thing that can happen if you don’t keep your business and personal money and expenses separate? If you continue to treat your business as your personal piggy bank? Bottom line is that if you are ever looked at for any reason by the IRS, a whole lot actually. The first that that would happen is that you would have to undergo an audit, during which the burden would lie on your shoulders to establish the expenses in question as valid business expenses. It is your responsibility to show proof in the form of receipts or invoices that can support your claims. If you cannot, then the fun really begins. If you happen to be a C-Corporation, then the tax return would be recalculated with all of the expenses added back. What makes this particularly troublesome is that C-Corps are taxed at higher rates than individuals. Not only that, but you will be assessed interest and penalties on the unpaid portion of the newly calculated tax liability.
If the business is a partnership or an S-Corporation, the expenses will still be added back to the tax return, but it gets a little more dicey from there. Since those business formats flow through to the personal 1040 income tax return, you not only have to have your individual return recalculated, but the additional income may in fact cause you to be phased out from deductions and/or credits that were originally claimed. From there, your new income tax liability will be computed and you will again be charged penalties and interest on the unpaid portion of this new figure.
Additionally, you will now be on the IRS’s radar and the chance for future review and audits will increase. On top of that, if you needed to raid the business accounts to support your personal lifestyle, then you will be in even greater trouble once the interest and penalties start piling on.
The bottom line
There are very severe consequences for not following the proper protocols when dealing with business funds. All of this can be avoided very easily. All it takes is an extra step in taking a distribution of income from the business or taking payroll to accomplish the simultaneous tasks of having money to pay personal expenses while staying out of trouble with the IRS.
Basically, if you do things the right way, you never have anything to worry about.