Commingling sounds like fun, but it can be pretty messy. When you’re mixing business and personal expenses, you’re putting yourself at risk, both financially and legally. Additionally, commingling can lead to serious tax problems. To ensure you don’t end up on the IRS naughty list, make sure you understand how to keep expenses separated and your tax filings compliant.
Business Expense vs. Personal Expense
According to IRS Publication 535, a business expense must be “both ordinary and necessary” to be deductible. An “ordinary” expense is one that is common and accepted in your industry. A “necessary” expense is one that is helpful and appropriate for your trade or business. Although it doesn’t have to be indispensable to be considered necessary.
Generally, you cannot deduct personal, living, or family expenses on your tax return. But what if you have an expense that is partly business and partly personal? You’ll need to determine which portion of the expense is used for each and deduct accordingly.
For example, if you run a cooking YouTube channel and purchase new cutlery that is used equally for business and personal use, you can deduct 50% of the cost as a business expense.
The Risks of Commingling Funds
When mixing business with personal expenses, your finances can quickly become a mess. Sometimes it seems innocent, like extending a business trip for a week to include a vacation, but commingling your expenses can have serious consequences, such as:
- Increased Legal Risk: If you’re an LLC and mix your business and personal expenses, you could compromise your liability protection. This could put your personal assets at risk if your business is audited or sued.
- Tax Audits: Claiming personal expenses as business expenses can also trigger red flags with the IRS. If audited, you could face penalties, interest fees, and even legal actions. Additionally, you’re likely to face a larger tax bill.
- Inaccurate Financial Reports: Mixing your financials can lead to inaccurate reporting. This not only misrepresents your company’s financial health but can also damage its reputation and creditworthiness.
Tips For Keeping Your Business And Personal Expenses Separate
There are several things you can do to avoid commingling your business and personal expenses.
- Keep separate bank accounts and credit cards: The easiest way to keep your finances separate is to set up different accounts and cards for your business. Only use these funds when making business purchases or paying business expenses.
- Use accounting software: Accounting solutions, such as FreshBooks, provide an easy way to track and identify your expenses if you run a small business.
- Hire an accountant: For larger businesses, hiring an accountant may make more sense. They will not only help with the day-to-day financials but can also assist during tax time.
- Digitally organize receipts and invoices: Forget about storing your paper receipts in folders or boxes. This antiquated method is too messy and doesn’t protect receipts from fading over time. Instead, invest in a receipt scanner and digitally store them on your computer. You can also use an app, such as WellyBox, to generate expense reports or forward the information to your accounting software.
- Track business use of personal items: If you purchase an item that is being used for both personal and business use, be sure to keep a log. You’ll want to track the exact date and time of business use to determine the percentage you can deduct at tax time. If the IRS questions your deduction, you’ll have documentation to support your claim.
- Review your business accounts regularly: Conduct regular audits (at least twice a year if not more) of your business accounts to identify any possible commingling issues. Correcting these issues early can save you from a major headache later on.
Although it’s not uncommon for small business owners to use their personal credit cards and bank accounts to pay business expenses, we strongly advise against it. The risks associated with commingling far outweigh the convenience of using one account. It can also be an expensive mistake if the IRS determines you overstated your business deductions. If you need help separating your personal and business expenses at tax time, consider working with a CPA or tax professional. They’ll help you get organized and keep your business compliant.