As you grow your portfolio and business, you will likely run into the issue of commingling personal and business funds. Whether you are new to the game or a real estate mogul, it will be beneficial to understand the ins and outs of commingling funds.
That's what we're going to explore today. I'll provide examples of commingling funds and aim to address how big or small the issue really is. I'll then discuss when you should consider getting separate bank accounts and what to do when you mess up.
Examples of Commingling Funds
Think of "commingling funds" as accidentally using your personal account for business income and expenses or your business bank account for personal income and expenses. If you only have one bank account for both your personal and business use, you are commingling funds. It may or may not be an issue depending on how you're structured.
Examples of commingling funds are:
- Depositing business checks into your personal bank account;
- Withdrawing from your business checking account to pay for personal expenses;
- Using the same bank account for business and personal use;
- Moving money between your business and personal accounts without documentation;
- Paying for a business meal with a personal card; and
- Grocery shop in and using your business card because you forgot your personal card.
All of the examples have one thing in common: using the wrong bank account for the income/expense item and not including documentation.
How big of an issue is Commingling Funds really?
In Classic CPA fashion: it depends.
There are several variables at play here. We need to know how you are structured and what your risk tolerance is. We also want to take a look at your accounting and documentation systems. If you're operating efficiently and effectively, we won't have a big issue.
The IRS does not require that you maintain separate bank accounts for your personal and business activities. But, they do encourage it.
Commingling funds will cause more of a legal problem than a tax problem. Your entity structure can expose you to more or less risk, as we'll discuss in a bit. Importantly, risk averse investors should avoid commingling funds at all costs.
Of course, we can retroactively adjust the the books and to correct commingling mistakes. This will be important for tax purposes as we will want the books of the business to reflect what we report on the tax return. We can also implement an accountable reimbursement plan. This will provide flexibility when using personal accounts for business expenses. More on that later.
Every single investor and business owner should have a separate business account.
In my opinion, every single investor and business owner should have a separate business account. It's a best practice and will greatly simplify your accounting. There are plenty of online banks out there today that have "no fee checking" accounts. A separate business bank account makes a ton of sense. And while commingling may not be a huge issue, why expose yourself to unnecessary risk?
Commingling Funds as a Sole Proprietor
If you are operating as a sole proprietor, commingling funds becomes less of an issue. This is mainly due to the fact that you won't have an entity's integrity to protect.
Creating separation between your personal and business transactions will, however, make your life much easier come tax time. Your business bank account can literally act as your accounting platform. As you grow, you'll want to look into more robust accounting platforms. But in the beginning, a business bank account can be your "books."
A great example comes from yours truly. At the time of this writing, I have one three-unit property in my investment portfolio. I check my transactions once a month to make sure my tenants pay rent. But I do all the bookkeeping at year end and it takes less than an hour. Why? Because I run all of my income and expenses through a completely separate account. Viola! Accounting made easy.
Operating without an entity makes everything very simple. And having a separate bank account makes it much easier to track your business transactions.
Commingling Funds as an LLC Member
Operating out of an entity brings the commingling issue front and center. Commingling funds should be 100% avoided when using an entity.
The good news is that LLC's have some flexibility in regards to commingling funds. If a mistake occurs, we can generally retroactively fix it. This is good news for new investors and business owners who are still figuring out how to effectively operate their businesses.
We'll talk about how to fix the issues in a minute, but just because we can fix issues doesn't mean you should take commingling funds less seriously.
Let's say you drive to view all of the rentals in your portfolio once every two weeks. The traveling is a business expense along with any gas, parking, tolls, and meal expenses you occur along the way. Many investors tend to use their personal credit cards to pay for these expenses because they receive more points. This makes sense and we can deal with the occasional purchase.
The problem arises when you consistently use your personal credit cards for business expenses. You are establishing a pattern of commingling funds. This hurts the integrity of your entity and exposes you to risk.
When I say "integrity" I mean the liability protection your entity offers. I'm not a lawyer and none of this should be construed as legal advice. But I'd be willing to bet that lawyers are nodding along here.
When you establish a pattern of bad business practices such as commingling personal and business funds, the integrity of the entity deteriorates. While we can certainly correct some of these mistakes, we can't do much where there is a deliberate pattern emerging. Attorneys will attempt to "pierce the corporate veil" and they will most certainly use your commingling patterns as reasoning to do so.
The good news is that the IRS doesn't care much about commingling funds when using an LLC. From their perspective, the LLC is an extension of the sole proprietor. The taxation is the same, the accounting is likely the same, so the treatment is the same. But, this benefit of simplicity shouldn't overshadow the liability risk that commingling funds causes.
Commingling Funds as a C or S Corporation Owner
C and S Corporation owners need to take commingling funds seriously. This is true from a tax, accounting, and legal perspective. If commingling exists and is not dealt with properly and promptly, the IRS could disallow many of the deductions.
It is imperative that a shareholder/employee of a corporation build good habits of separating out personal and business expenses. However, swiping the personal card for a business expense is still okay - provided an accountable reimbursement plan exists.
An accountable reimbursement plan resolves commingling issues for corporations. Basically, it allows the owner to use a personal card for business expenses and still receive a business write-off for the expense.
Without an accountable reimbursement plan, some business expenses will no longer be deductible by the business.
The accountable reimbursement plan outlines how employees of a corporation are reimbursed for expenses. Without an accountable reimbursement plan, some business expenses will no longer be deductible by the business. Rather, the employee will have to report the business expenses on Schedule A as an unreimbursed expense. Due to the rules surrounding Schedule A reporting, there is a good chance the employee will lose the ability to deduct those expenses.
For example, mileage for business trips are usually deductible by the business. With a corporation, this is only so if the business actually owns the car. Because many investors and business owners own the car in their personal name, they need a way to deduct the mileage expense as a business trip. The accountable reimbursement plan solves this issue for corporations.
You will need to record the miles driven and submit an expense report to the corporation. The corporation must then reimburse you within a reasonable timeframe. The corporation now has a deductible business expense. Without this process, you're stuck with reporting mileage on Schedule A as "unreimbursed employee expenses" and likely losing the deduction.
So to wrap up this section - corporations must have an accountable reimbursement plan in order to deduct what you would consider typical business expenses. Make sure you absolutely have this and abide by it.
Fixing the Mistakes
Fixing the mistakes can be easy or difficult and risky. For LLCs and sole prioprietorships, fixing commingling mistakes can be done using adjustable journal entries. A bit of accounting magic can reclassify the expense as either a contribution to or a distribution from the business, depending on the nature of the expense.
If you are operating a corporation though, it becomes much harder to fix mistakes. We can still reclassify expenses using adjusting journal entries, but there's a solid chance the IRS may come in and disallow the adjustments. When you are using a corporation, you really need to be vigilant when it comes to commingling funds on an ongoing basis.
Follow the Rules and It's Easy
As long as you are following the rules and working with both a CPA and an attorney, you won't have any major problems. IRS inquiries will be a breeze as commingling funds will largely not exist.
At the end of the day, you need to have business systems in place that allow you to separate your personal life from that of your business. Maintaining a separate business checking account is a great way to start.