Dealing with personal expenses incurred by business owners

From time to time, we see personal expenses of business owners charged on business debit and credit cards, and questions come up about tax deductibility and further treatment of such expenses.

This is the topic of our discussion today.

My name is Alexander Larson and I am a certified public accountant with the accounting firm called Glasgow Knight Financial. You can find us on the web by going to www.GlasgowKnight.com.

Before we discuss the tax treatment of personal expenses incurred by business owners, let us raise three legal concerns that we recommend such business owners address with their attorney:

putting personal purchases on a business credit card may violate the terms and conditions of your credit card agreement,
using corporate or partnership funds for personal use may be in violation of the state law where the business was formed, and, finally,
claims of fraud, theft, embezzlement, or breach of fiduciary responsibility may be raised against the business or its owners, especially in the corporate setting with multiple shareholders.

Now, let’s talk about the deductibility of such expenses. The tax law is very clear on the issue that only “ordinary and necessary [expenses]… paid or incurred in carrying on [a] trade or business” are deductible for income tax purposes. What this means is that payments out of business accounts for expenses that are personal in nature (those that are not related to carrying on a trade or business) are not tax deductible.

In addition to not being tax deductible, these expenses are generally recharacterized as distributions out of the business and are treated as follows, based on the tax type of the business.

Sole proprietors (filing on the Form 1040, Schedule C)—these payments are not deductible as stated above and have no further tax effect on the owner. These payments are recharacterized as nontaxable owner draws. We call these sole proprietor draws as one-step distributions. It’s relatively simple.

Partners in a partnership (entities that file Forms 1065), are subject to a two-step process: payments of personal expenses are recharacterized as partner distributions to the partner who incurred them. At first these payments are treated as non-taxable amounts that reduce the partner’s “investment” in the partnership (called partner’s adjusted basis in the partnership; basis in the partnership down to zero). Once this basis is fully exhausted, further payments of personal expenses are taxed to him or her as long-term capital gains. Hence, the two-step process.

For example, $52,000 worth of personal expenses charged by a partner on the partnership’s credit card for meals, entertainment, and automotive expenses not related to the business of the partnership would be taxed as follows. Let’s assume that this partner’s basis in the partnership before the charges is $32,000. Of the $52,000 of personal expenses, the first $32,000 will be treated as return of his capital, not subject to any taxes. Then, step two, the remaining $20,000 will be taxed on the partner’s personal return as long-term capital gains (assuming he has been a partner for longer than 12 months).

S corporation shareholders are subject to a similar two step process with minor caveats and exceptions and different terminology but similar principles and tax results.

Shareholders of C corporations (companies that file Forms 1120) have got it the worst—payments of personal expenses of those shareholders go through a three step recharacterization process.

First, payments of personal expenses are treated as taxable dividends (taxed to the shareholder at their individual income tax rates) to the extent the company has enough previously taxed earnings, called earnings and profits of a C corporation. So, step one—dividend income. Step two—further payments of personal expenses or cash dividends are treated as return of capital to the extent of the shareholder’s basis in his or her stock. So, step two—no individual tax. Finally, step three, any excess personal payments or cash distributions are taxable to the shareholder as long-term capital gains on his or her tax return. So, step three—long-term capital gains.

To sum it up, personal expenses out of a C corporation are first taxable at ordinary income tax rates (as dividend income), then not taxable at all to the extent of the shareholder’s basis in company’s stock, and finally, taxable again as long term capital gains.

In conclusion, let’s summarize by saying that personal expenses incurred by business owners and paid out of business accounts are:

Prone to legal complications on the banking, credit card, and corporate sides,
Not deductible in computing the business’s taxable income, and
Generally recharacterized as distributions to the owners who incurred them taxed according to complex multi-step rules explained above.

If you would like to get additional information on this topic or talk to us about other tax or accounting matters, please reach out to us by going to www.GlasgowKnight.com. We would be very happy to assist.

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