Dealing With Personal Expenses Incurred by Business Owners

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

Before we discuss the tax aspects of the matter, let us raise three legal concerns. Since we are accountants and not attorneys, we cannot advise on legal issues. However, we should mention the following three points and have our clients discuss them in further detail with their attorneys:

putting personal purchases on a business credit card may violate the terms and conditions of the credit card agreement, which may lead to some serious consequences on the banking side of the business;
using corporate or partnership funds for personal use may be in violation of the state law where the business was formed;
claims of fraud, theft, embezzlement, or breach of fiduciary responsibility may be raised against the business or its owners, especially in the corporate settings with multiple shareholders.

Internal Revenue Code Sec. 162, Trade or Business Expenses, allows deductions for expenses that are “ordinary and necessary… paid or incurred during the taxable year in carrying on any trade or business.” What this means is that payments out of business accounts for expenses that do not meet the definition above are not deductible in computing the business’ taxable income. In a nutshell, personal expenses are not tax deductible.

Here are a few examples of personal expenses that we’ve seen in our practice: all kinds of payments not connected with carrying on the business such as the payments for the personal residence, personal effects (clothing, groceries, meals), services of personal nature (massages, physical therapy, gym memberships, payments for daycare expenses), maintenance and upkeep of personal autos, non-business related travel, entertainment, and many others.

One note on business meals. In addition to the requirements of Sec. 162 (see above), meals are deductible by a business only when an owner, partner or shareholder, or any bona fide employee of the business who incurred the expense can produce contemporaneous documentation (checks, receipts, credit card statements) and stating who was present at the meal, why they were there, what bona fide business matters were discussed during the meal, where and when the meal took place, and how much it cost. The requirement to provide this written supporting documentation can be found in Sec. 274(d) of the Internal Revenue Code.

Returning to the tax accounting aspects of personal expenses paid out of business accounts, in addition to not being deductible, these expenses are generally treated as follows (based on the tax set-up of the business):

Sole proprietors (Form 1040, Schedule C reporting)—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.
In a partnership context (Form 1065 reporting) payments for personal expenses are recharacterized as partner distributions to a partner who incurred them (unless special kinds of payments are being made, such as for medical expenses, the topic which is outside of the scope of this blog entry). To the extent partners have enough previously taxed “investment” in the partnership (called partner’s adjusted basis in the partnership), these distributions do not have any further tax consequences to the partner but reduce his or her basis in the partnership down to zero. Once partner’s basis in the partnership has been fully exhausted, further distributions are taxable to him or her, usually as long-term capital gains.
In a corporate setting (Form 1120 reporting) payments for personal expenses are recharacterized as taxable dividends (to the extent the company has enough previously taxed earnings, called earnings and profits of a C corporation). Any further distributions in cash (or payments for personal expenses) are treated as a return of capital to the shareholder (not taxable to him or her until their investment in corporate stock is fully depleted, i.e. reaches zero). Further distributions are treated as taxable (usually long-term) capital gains. Note: corporate dividend distributions must be properly declared and paid. Therefore, the corporation may need the help of an attorney to document these dividend distributions.
In an S corporation setting (Form 1120S reporting)—payments for personal expenses of owner-shareholders are treated similarly to those in the partnership setting. They are not immediately taxable to the shareholder as long as he or she has enough basis in the corporation’s stock (although a few wrinkles may complicate things such as E&P from the entity’s previous C corporation years, and in some other instances). Once the shareholders’ basis in the S corporation stock reaches zero, further distributions are treated as a taxable (usually long-term) capital gains.

To summarize, 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 business’s taxable income, and

– are generally recharacterized as distributions to the owners who incurred them.

If you have any further questions about this topic, please let us know. We will be more than happy to discuss it further with you or your business associates.