When a business starts out, cash flow is always tight. Paying for things needed for the office or business expenses sometimes come out of our own pockets, and sometimes that is the only option we have available to us in that moment.
You’ll be pleased to know that it is possible (and legal) to pay personally for business expenses and how to account for business expenses paid personally.
The two most common business structure types are Sole Proprietors and Limited Liability Companies (LLC), and these differ greatly in the ways in which paying personally for business expenses must be repaid and in which manner they are reflected in accounting.
It is important to understand these structures and the tax and legal intricacies of each for your business’ future growth.
Common Business Structures
1. Sole Proprietor
Also commonly referred to as a Sole Trader is an individual entrepreneurship or business entity that is run and owned by a single person.
In this business structure, there is no legal division between the owner and the business. The owner is personally responsible for all legal and tax aspects of this business.
2. Limited Liability Company
Limited Liability Company or commonly known as LLC is a business structure in which the owners aren’t personally responsible for the company’s legal and tax liabilities.
To simplify it, an LLC can best be considered as a “legal person” with the same abilities and liabilities for accounts and legal obligations as an individual.
These business types are combinations of different business structure types with the characteristics and traits of Corporations (in that they act as an entity separate from its owners and which carry the rights and responsibilities of individuals) and can carry the same organizational structures as Partnerships (where parties agree to cooperate to advance their mutual interests) or the same responsibilities as a Sole Proprietorship.
Why do we need to account for business expenses paid personally?
To answer the questions you might be asking yourself of why do you need to account for business expenses paid personally and why can’t a business simply reimburse a person for those expenses, we need to take a look at the types of expenses and the tax implications of such repayments.
The type of costs that can be repaid to a person in full Sole Proprietorships and LLCs much the same, but differ in the taxation of those repayments.
The types of expenses that would cause you headaches with the IRS are:
- Travel
- Meals
- Groceries
- Personal loan repayments for cars or home loans
- Rent
- Expenses for your home office
- Personal hygiene expenses, and
- Entertainment
No matter the expense and regardless of your business structure (LLC or Sole Proprietorship), keeping up-to-date records and journals of these expenses will save you countless headaches when it comes to filing for tax and will go a long way to avoid penalties from tax mistakes.
The most common mistake many businesses and business owners make is called “commingling your books”. Making this mistake can lead to costly penalties and fines for your business and your personal tax.
Commingling your books occurs when you don’t separate your business and personal finances, and the IRS can’t distinguish between expenses that are business-oriented or personal.
Personal expenses aren’t eligible business expenses that can be deducted against your business’ income – and thereby the expenses aren’t deductible from the taxable incomes for the IRS. To be clear, the IRS might consider reimbursements to business owners as fringe benefits and that has a large tax implication. A fringe benefit can be loosely defined as payments made to persons for the performance of services and when those payments are made it can be considered as a compensation for salary or wages.
Strictly defining your business expenses and personal expenses – and creating a separate business account – will help you to avoid incurring tax penalties. Developing strict bookkeeping habits are vital to avoid this commingling of your books.
This doesn’t mean you need to cease all business expenses paid personally. As a business owner, you can pay for whatever you want – just be aware of the tax implications. As a Sole Proprietor, you cannot use these business expenses (and repayments) to reduce the profit of your business – and thereby reduce the taxable income. As mentioned, that is when the IRS will audit you and you’ll be liable for penalties and fines.
As an LLC, it is a little different. When you’re reimbursed by your business, you will need to pay tax on that amount as the IRS will see that as a possible fringe benefit. Bear those two points in mind…
To alleviate commingling of your books, and to right the mistakes, you can simply record the business expenses paid personally as a shareholder’s loan – and those repayments can be accounted for as repayments of the loan. It must be noted that reallocating the business expenses in this way isn’t technically allowed, recording it as a shareholder’s loan won’t attract the same scrutiny from the IRS as other categories – but the repayments can’t affect the taxable income of the business.
Pro Tip: Seek out the advice of a tax specialist before going this route.
How do you account for business expenses paid personally?
As we have already established, there are two main ways in which you can reflect repayments or reimbursements from Sole Proprietorships and LLCs.
For a Sole Proprietorship, you can reflect this repayment as a Shareholder’s Loan (outlined above – and with advice to seek a tax specialist first). You can also record the business expense as a seed money from the person to the business, only to help you separate your personal and business finances in the future.
Another way to reflect this in your bookkeeping journals is by debiting those business expenses paid personally and then crediting them under the liability account as “Due to Owner.”
For an LLC, you can do the same in your journal and then show under your expenses account that repayment as “Owed to Owner.”
Taking a deep dive into each of these methods, we can walk you through the process to help you avoid commingling your books.
Bringing in Expenses with a Journal
- It is advisable to split the receipts of your personal payments into month-by-month categories and order accordingly. This makes it easier to arrange your reimbursements for your tax files.
- In your journal, create debit entries of the relevant expenses to the relevant expense accounts. Credit the “Owner’s Drawings” account (and, don’t forget as owner, you can withdraw as much money as you’d like through Drawings from your business, but taking money from your business isn’t viable for the company’s future growth and success – and without keeping track of those Withdrawals could incur the IRS’ attention). What this does is that it increases your business’ expenses and decreases the Drawings account and you of course need to show where that money entered your business and to which business expense accounts it is reflected.
- The last step is that you need to let this reflect in your journals just how the owner was repaid by showing the payments made to them and put those repayments into the Drawings Account (and thereby lower the drawings account’s amount).
Bringing in expenses through accounts payable
- As with the above method, enter those business expenses paid personally just as you would list regular business expenses.
- When recording them, create a credit note for each item. This will allow you to then Withdraw that credit via your Drawings account – but, don’t forget to record those Drawings accurately too.
As this is a time-consuming – and often stressful – matter, the best option for your next tax season is to better organize your business with stricter bookkeeping habits and creating separate bank accounts for your business.
