Keep It Separate: Business and Personal Income
It's been said that it's best not to mix business with pleasure - and this is especially true when it comes to Uncle Sam. According to the Internal Revenue Service, business and personal income should always remain apart.
By Mark Battersby
3/1/1997
Because the IRS will make sure that you've
separated your incomes - and because a discrepancy may not be
resolved even when the IRS says it's resolved - keeping track
of transactions that fall between the cracks is essential to protect
yourself from possible tax penalties.
Case in Point
One couple, owners of a body shop, recently
had an encounter of the unpleasant kind when the courts permitted
the IRS to change its mind after reaching an agreement about the
couple's separation of business and personal income.
The fact that the IRS was legally allowed
to do this after reaching agreements concerning both the couple
and their body shop provides an excellent illustration of just
how difficult it has become to mix business income, personal income
and expenses - and how few body shop operators bother separating
them at all.
Two IRS auditors conducted separate audits
of the couple's personal income-tax returns and the corporate
return of their body shop - with the auditors reaching inconsistent
conclusions about the proper tax treatment of the couple's affairs.
Ultimately, most issues were resolved in favor of the shop.
In the course of resolving the tax disputes,
however, the corporation was allowed to treat a $24,000 payment
to the couple as a business expense. Unfortunately, the couple
had failed to report that transfer on their personal tax returns,
and rather than let the matter slip between the cracks, a court
case resulted.
A jury agreed with the couple that the postaudit
examination of their tax returns created a binding contract between
them and the IRS, closing the examined years to all further dispute.
The couple asserted that "the fact that [they] had failed
to inform the examiner about the $24,000 payment is just a tough
break for the [IRS]."
Turned out to be a tough break for the couple.
Citing our basic tax law, the Internal Revenue
Code, regarding closing agreements, the IRS argued that its examiner
didn't have the authority to make a government-binding promise
- meaning the IRS didn't have a binding contract with the couple
and that the examined years should still be open for examination.
The U.S. Court of Appeals for the 7th Circuit
ended up with the case and, ultimately, agreed with the IRS. "An
examiner just can't compromise a tax claim or close a tax year
to further examination," the appeals court concluded, pointing
out that the federal government is bound only in three circumstances:
the signing of a closing agreement by an authorized agent, the
expiration of the statute of limitations or the disposition of
litigation.
"Apparent authority," the court
said, "is not enough to bind the federal government to a
contract; unless the IRS agent had actual authority, any argument
is ineffectual."
In other words, agreements reached with low-level
IRS auditors or examiners are apparently not worth the paper they're
written on.
Although our couple's $24,000 payment from
their incorporated body shop wasn't allowed to slip away into
limbo, this court case illustrates how many transactions between
owners and their incorporated shops are often ignored, mislabeled
or out of line.
Corporate Considerations
Many owners today operate their body shops
as corporations. A corporation, like any business, is formed by
business associates to conduct a business venture and to divide
profits among investors. A completely separate, tax-paying entity
is created when a corporation is formed.
The following items are considered to be characteristics
of a corporation:
- limited liability for corporate debts (i.e., shareholders
are liable for corporate debts only up to the amount of their
investment in a corporation);
- free transferability of corporate ownership interests (i.e.,
shareholders may easily sell their shareholdings to others);
- centralized management (i.e., day-to-day business operations
are run by a centralized hierarchy of executors who may not always
be owners of the corporation); and
- continuity of life (i.e., a corporation does not dissolve
when a shareholder dies or sells his or her holding).
The two separate tax entities, the owner and the incorporated
body shop, are still "related" under our tax rules.
That means that unlike a body shop owner doing business as a sole
proprietor, the incorporated body shop owner must make every effort
to keep personal income, business income and expenses separate.
All transactions usually will be scrutinized, and they may be
changed - or recategorized - by the IRS.
Deductions & Depreciation
With some body shop owners using their homes as a base for their
businesses, it's only natural that some combining of business
and personal funds might occur - though the two should be separate.
Having the incorporated body shop rent a portion of the principal
shareholder's home for its offices may be quite legal, but the
body shop owner/ homeowner will still be denied a deduction for
home-office expenses in this "related-party" transaction.
In fact, the IRS is often permitted to restructure many of these
related-party transactions to more accurately reflect economic
reality.
Our tax rules also limit the amount of depreciation that may be
claimed for so-called "listed property," such as entertainment,
recreational and amusement property; computers and peripheral
equipment; cellular telephones and similar telecommunications
equipment; and automobiles and other forms of transportation -
all business assets that lend themselves to personal use.
Unless used predominantly for business (i.e., used more than 50
percent for business), special limited depreciation rules may
apply. What's more, not only is the depreciation deduction limited
for those "listed" items used for both business and
personal purposes, so, too, is the unique first-year write-off
under Section 179. Quite simply, if the cost of any purchased
"listed" property fails the more-than-50-percent-business-use
test, that property will not qualify for the first-year expensing
provision.
The IRS has also lobbied mightily to close loopholes in our tax
laws that have, in the past, allowed many body shop owners to
operate as one with their businesses. A good example is a recently
closed loophole that formerly permitted a number of operators
to benefit from using tax years that were different from those
of their body shops.
Today, when a different accounting method is used by "related
taxpayers," such as an incorporated body shop and its principal
shareholder, accrued interest and other expenses owed to the related
party cannot be deducted until a corresponding amount is includible
in the gross income of the cash-basis payee. The deduction is
deferred until the cash-basis payee takes the item into income,
thereby eliminating the possibility of finagling payments and
income between different tax years.
Compensation vs. Dividends
The couple mentioned earlier discovered the importance of keeping
track of payments made by the incorporated business to its principal/shareholder.
Most of the time, these payments take the form of loans, compensation
or bonuses because of the threat of double taxation on dividends.
Dividends paid by an incorporated business are paid from income
on which taxes have already been paid. Those payments from already-taxed
corporate income are not allowed as a tax deduction by the shop,
but when those dividends are received by a shareholder, they become
taxable income once again. Thus, the favored form of compensation:
salaries or bonuses.
Business owners are entitled to deduct a reasonable allowance
for salaries or other compensation for personal services. Only
publicly held corporations are prevented from deducting compensation
in excess of $1 million per year to certain employees.
A bonus, of course, is tax deductible if it's paid for services
actually performed and if, when it's added to other salaries,
does not exceed what the IRS feels is "reasonable" compensation.
Even compensation paid to a relative is deductible if the relative
performs needed services that would otherwise be performed by
an unrelated party. Naturally, the deduction is limited to the
amount that would have been paid to a third party.
Separate is Safer
Thinking and acting as if your body shop is a separate business
entity - and backing it up with proper records - will go a long
way toward avoiding the potential problem of income and expense
reallocations. Although the funds of many owners running small
shops are often "commingled," the IRS has the legal
authority to allocate those funds. What's more, it can allocate
them in a manner that will produce the highest possible taxes.
When it comes to fighting the IRS, it might be wise to remember
that income, expenses and even related-party transactions do occasionally
fall between the cracks. But the IRS has a long memory - and a
signed agreement that an audit is concluded doesn't really mean
that much when the IRS eventually discovers its - and your - errors.
Check It Out
Unlike a body shop operator doing business as a sole proprietor,
the incorporated body shop operator has must make every effort
to keep personal and business income and expenses separate because:
- A completely separate, tax-paying entity is created when a
- corporation is formed.
- Our tax rules limit the amount of depreciation that may be
claimed for so-called "listed property" - all business
assets that lend themselves to personal use.
- The IRS is often permitted to restructure many "related-party
transactions," where owners and their businesses didn't keep
personal and business affairs separate.
- The IRS has lobbied mightily to close loopholes in our tax
laws that have, in the past, allowed many body shop owners to
operate as one with their body shop businesses.
- Business owners are entitled to deduct a reasonable allowance
for salaries or other compensation for personal services. Only
publicly held corporations are prevented from deducting compensation
in excess of $1 million per year to certain employees.
- Although the funds of many individuals operating small businesses
are often "commingled," the IRS not only has the legal
authority to allocate those commingled funds, but to allocate
them in a manner that will produce the highest possible taxes.