When you own your own business or run a small business, it is easy to intermingle funds.
Intermingling happens when you don’t separate your business and personal accounts or when you do not keep proper records documenting transactions between personal and business accounts. The simple act of using your personal checking account to receive business deposits or pay business expenses can lead to many unintended consequences.
These consequences can be legal in that you can lose some of the liability protections afforded to corporations. They can also be financial consequences since the reclassification of your income and expenses can lead to unexpected back taxes that you will have to repay.
Fortunately, a bit of planning, forethought, and recordkeeping can help you keep your records straight and ensure you avoid surprises.
Recordkeeping and liability issues
The first problem with intermingling is recordkeeping: when all of your expenses and deposits mix together, it can be impossible to sort through what belongs where. From just an ease-of-compliance, filing, and knowing how your business is doing perspective, separating funds is essential.
But intermingling can create more significant liability issues.
One reason you may establish an LLC, or a Corporation is for liability protection. Creating an entity separate from yourself establishes a “corporate veil” that protects you personally from liabilities the corporation incurs.
If you intermingle funds, you risk the courts “piercing the corporate veil” and determining that the corporate entity is, in reality, not a separate entity. In this case, even if you have created an LLC or a corporation, you lose that liability protection.
If you use your personal accounts for business purposes, you are definitely intermingling. However, intermingling can happen even if you have separate accounts.
A shareholder/owner who deposits personal funds into or pays personal expenses from a business checking account can also be intermingling funds. For this reason, it is crucial to establish separate corporate and personal identities and formally track transactions between the two.
Court Case Example, Reginald Jarret, et al. (T.C. Summary 2008-94)
A taxpayer operated a tax preparation business as a sole proprietor. The taxpayer later incorporated, but continued to have clients make checks out to him personally and treated the funds received by the business as his own.
He also failed to create an employment agreement between himself and the corporation.
The court ruled that the taxpayer operated his business as a sole proprietor and removed all liability and legal protections that the corporation would have provided.
The court also found that the individual rather than the corporation earned the income. As a result, the taxpayer was subject to self-employment tax (that he owed for many past years).
Tax problems caused by intermingling funds
Like in the case above, intermingling can easily lead to unintended tax consequences. Corporate income is not subject to self-employment tax, while personal income is. So, like in the case above, if the court determines that the income accrues to the individual, not the corporation, you may end up paying back taxes.
Additionally, as a shareholder/owner, when you provide funds to or on behalf of a corporation, several tax treatments may apply, depending on the circumstances.
For example, providing funds to a corporation can be classified as one of the following transactions:
- A capital contribution.
- A loan to the corporation.
- Repayment of a loan from the corporation.
- Expense reimbursement
These classifications can have different tax treatments and consequences. To ensure that your contribution is classified the way you want and expect for tax purposes, you must record the transactions correctly.
When you, as a shareholder, purchase an item for the corporation from your personal funds, in theory, you contribute to the corporation. But a reviewer or auditor will classify the transaction based on circumstances surrounding it and how you structure it. So, without planning, your contributions may end up reclassified, which can lead to different tax treatment.
(By structure I mean how the transaction takes place. One way to structure a transaction is to pay for a personal expense using a corporate credit card or writing a check drawn on a corporate account. Another way to structure the same transaction is to first make a distribution to yourself and then pay for the expense from your personal account.)
Withdrawals present the same issue. If you take money from a corporation, you may classify the transaction as:
- Taxable dividend.
- Nontaxable distribution.
- Nontaxable expense reimbursement.
- Shareholder loan.
- Repayment of a loan from the shareholder.
Just as with the deposits, if you fail to structure transactions carefully and intermingle funds, you can run into tax consequences. A reviewer may reclassify your transactions based on their interpretation of the situation, leading to nontaxable transactions suddenly becoming taxable.
Court Case Example: Pappas, T.C. Memo 2002-127
In this case, the taxpayer managed several business activities, including real estate, entertainment services, and interior design. She incorporated her business in New York under the name Real Services, Inc.
She did not keep good corporate books and frequently used the corporate checking account to intermingle funds. Business deposits went into the account, but she made payments out of the account for personal reasons. Some of the examples cited in the case include birthday presents for family, tuition payments for her daughter end contact lenses for her friend.
The IRS audited the individual and determined that she owed taxes on the personal expenses. She argued that the corporation should be liable, not her, because the corporation received the funds and made the payments.
The court determined that the corporation was a sham and removed all protections. In the decision, the court specifically cited “the intermingling of corporate funds” and “failure to observe corporate formalities such as maintaining books and records, failure to pay dividends and siphoning off funds by the dominant shareholder.”
How to avoid intermingling of funds
Fortunately, the solution to intermingling is simple.
First, you will need to create separate corporate and personal accounts. Use your personal accounts for all personal activities and payments. Use the corporate accounts for all business activities and payments.
The next step is to ensure that you keep a record of all of your corporate financial activities. The best way to do this is to use software like QuickBooks to track and categorize every transaction. Every transaction includes payments to you or contributions from you. Through this bookkeeping, you establish a record of formality that a reviewer can read and use to verify that the business is a separate entity.
Finally, maintain a record of business decisions and create contracts, even with yourself as an owner. If you have multiple LLC members or shareholders in a corporation, be sure to have regular meetings where you take notes and keep the notes for the record. You should also have an operating agreement in place (even if you are the sole shareholder). This again helps establish that the owners are separate from the business and will protect you from liability. These records do not need to be long or complicated; they just need to exist.
Additionally, be sure to retain records for at least the statute of limitations, you will want to be able to substantiate your claims if you are ever questions.
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