I have seen it all as a consultant. Accountant’s advise their clients to maintain separate business and personal accounts and ensure that all reasonable business expenses are accounted for in the business. These include things like a home office, cell phones, automobile expenses, client meals and entertainment, etc. The key is being able to meet the standards set by the government and being able to articulate the business reason for the expense. The goal is to not be charged with tax evasion for taking advantage of the system.
Seeing it all includes the occasional industry association convention where a small business owner may spend an extra day or two. Or the sports team season tickets you use as a marketing expense to keep your clients engaged. But sometimes it gets weird, like payments to individuals who are not present in the business, nor appear to be engaged in the productivity. Not bribes, but close. I have seen family businesses where this has occurred.
Let me explain. One time while working with a client, I noticed quarterly payments to two individuals being recorded in the “other expenses” account. This is normally where expenses that are not part of the regular business operation are recorded, so I pay particular attention to this category. In this case, the payments were substantial and totaled almost $100k per year for two years. Of course I asked about the payments and the owner immediately blushed and looked away. He said, “well, I’m kind of embarrassed about this. Two years ago, we made the decision to pay my wife’s brother and his wife, not to come to work.” He explained that as employees their presence was so disruptive that having them not come in was better for the business. He figured that it was all a wash in the end. They were just receiving their portion of any proceeds from a sale or inheritance in advance. Like I said, I’ve seen it all.
Here are a few guidelines to help you stay out of prison. BizFilings, by Wolters Kluwer has a fantastic resource for this information. The complete article can be found here. Here are a few takeaways from the article.
- Should you capitalize the expense? If the item you purchased is designed or intended to last longer than one year, you may consider capitalizing it and taking a depreciation expense instead. The example they used was capitalizing the purchase of a copier, but expensing the paper you use with it.
- Is this purchase really necessary? The IRS will look at the expense to see if it was truly appropriate and reasonable for the type of business you are in. It might not make sense for you to buy your aunt a Corvette, if she doesn’t work for you and you own a pet store.
- Mixing some business with pleasure. If your intention is to get a few extra days out of your Hawaii trade show conference as a mini vacation, be sure you allocate to business only the portion of your trip that was a business expense.
- If you don’t have a record of it – it didn’t happen. The only way to protect yourself during an IRS audit is to keep the most detailed and accurate records possible. It is the best way to answer any of the above questions about your purpose and intentions.
Bottom line is to take advantage of the business related expenses that you are truly entitled to. Besides saving you money personally during the purchase, there is an added benefit of saving you money in federal income taxes owed at the end of the year by reducing your taxable income. Plus, when you sell your business, you might get to add some of those expenses back into your earnings to increase your value. It’s a double bonus!