A common issue with single-owner and other closely held corporations is the intermingling of funds. This happens when a corporate shareholder uses their personal checking account for payment of corporate expenses or corporate deposits.
Separation of funds can be essential in preserving the liability protection of the corporate veil. Courts can pierce the corporate veil by finding that the corporation is an “alter ego” of the shareholder. This means that the corporation is not separate and distinct from the individual, which is demonstrated by the intermingling of finances.
In addition, a shareholder that deposits personal funds or pays personal expenses from the corporate checking account is intermingling funds. Courts can cite this as evidence that the corporation is not a separate and distinct entity from the individual.
Tax Problems Caused by Intermingling Funds
Tax consequences can be an unintended result when personal and corporate funds are intermingled. Depending on the circumstances, there are several different types of tax treatment that may apply when a shareholder provides funds to or on behalf of a corporation. For example, when a shareholder provides funds to a corporation, it can be classified as one of the following transactions:
Capital contribution
Loan to the corporation
Repayment of a loan from the corporation
Expense reimbursement
Purchase
When a shareholder uses their own personal funds to purchase an item for the corporation, that shareholder is considered to have provided funds, or made a contribution, to the corporation. Classification is determined by how the transaction is structured and the circumstances surrounding the transaction. Unintended tax consequences can be a result of providing funds to corporations without careful planning.
If an individual takes funds from a corporation checking account, the transaction can be classified as:
Taxable dividend
Nontaxable distribution
Nontaxable expense reimbursement
Wages
Loan to the shareholder
Repayment of a loan from the shareholder
Nontaxable transactions can become taxable as a result of failure to carefully structure transactions when taking disbursements from a corporation. This can also open the corporation up for a court to pierce the corporate veil.
Example: Lucy owns a home and garden store. She recently incorporated in order to shield herself from the liabilities of the business. Lucy meant to open a corporation checking account, but she never got around to it. Since she had been doing business with her suppliers for many years as a sole proprietor, she continued to use her personal checking account to purchase supplies and inventory on the account and pay the invoices. Unfortunately, Lucy had a particularly bad year, and she was successfully sued for $1 million by a customer who was injured by a Venus Flytrap that was purchased at her store. She also fell under audit by the IRS.
Due to Lucy’s equity in the store only being $1,000, the plaintiff’s attorney asked the court to pierce the corporate veil. The court agreed, stating as evidenced by the intermingling of funds, the corporation did not operate as a separate legal entity and was a mere alter ego for Lucy. Lucy was personally liable for the damages caused by the Venus Flytrap.
When Lucy made purchases for her business from her personal funds, she had been writing off those amounts as expenses on her corporation tax return. It was determined by the IRS that the amounts paid represented capital contributions rather than paid expenses, which adjusted her taxable income upward for the year that she was under investigation. Lucy’s accountant tried to cheer her up by stating how in some cases, expenses paid by a shareholder have been disallowed altogether and the deductions permanently lost.
Court Case:
A taxpayer operated a tax preparation business as a sole proprietor. Later, the taxpayer incorporated but continued to have clients make checks out to him personally and treated funds received from the business as his own. There was no evidence of an employment agreement between the taxpayer and his corruption. The court ruled that the taxpayer operated his business as a sole proprietor, so the income earned should be treated as earned by the individual rather than the corporation, so he was subject to self-employment tax. (Reginald Jarritt, et al, T.C. Summary 2008-94)
Personal Use of Corporate Assets (H3)
A similar situation with intermingling funds occurs when personal assets are used by the corporation, and vice versa. The IRS can reclassify expenses reported on the corporation tax return as expenses attributable to the shareholder rather than the corporation in cases where corporate assets are used for personal purposes. On the other hand, if a corporation uses personal assets owned by the shareholder, this could indicate lack of separation of the shareholder and corporation, which opens the possibility of having the corporate veil pierced.
Court Case:
The taxpayer was engaged in several business activities, some of which included real estate, entertainment services, and interior design. She incorporated her business in New York under the name Real Services, Inc. She often used the corporation checking account to intermingle funds, as her books were not well-kept. Business deposits were made into the account, however, checks were written for items like birthday presents for family members, tuition costs for the daughter of a friend, and contact lenses for her friend. The taxpayer was audited by the IRS and taxes were assessed on unreported income.
The taxpayer argued that she was not individually liable for the taxes. Instead, her corporation, Real Services, Inc., should be liable because the corporation received the funds in question. The court decision determined the corporation was a sham and stated that the corporation had the characteristics of an alter ego, including:
“The intermingling of corporate and personal funds, undercapitalization of the corporation, failure to observe corporate formalities, such as the maintenance of separate books and records, failure to pay dividends, insolvency at the time of a transaction, siphoning off funds by the dominant shareholder, and in the inactivity of other officers and directors.” (Pappas, T.C. Memo. 2002-127)
BrightBooks is here to help. Contact us for bookkeeping assistance and/or assistance with structuring your business to ensure you do not intermingle funds.