Surveys show that about 25 percent of small-business owners mingle personal and business funds. A study found that about 26 percent of business owners reported that they did not own a separate account for their business, and in a separate survey, other owners indicated that 23 percent used their company card for personal purchases. While this is a widespread trend, it may not appear alarming; however, this behavior places business owners at risk for three areas that can absolutely destroy their businesses.
Those three reasons are legal liability from corporate veil piercing, increased tax audit risk with large penalties, and a lack of quality business decision-making due to astoundingly poor financial records.
And you’re still not thinking about the bigger risk. As you probably know, the courts will regularly look at commingling to determine if and when an owner can be held personally liable for the debts of their entity. The IRS performs a similar exercise and uses mixed accounts as audit triggers. This is also likely to cause you problems with disallowed business deductions and large penalties.
And here’s something that a lot of people don’t think about: advisers and accountants can’t give potentially useful advice if the clients write up their transactions without separating their personal transactions from business transactions. Literally, you can get stuck making bad strategic decisions based on bad data, which is really dumb.
Knowing and controlling commingling and/or intermingling? It’s no longer optional. It’s critical risk management for any type of business entity (large or small).
What Is Commingling? Clear Definition and Bookkeeping Indicators
Let’s start at the beginning. Commingling occurs when personal and business finances become intertwined, generating a spaghetti mess of transaction patterns that completely obscure the separate legal and economic identity of your business entity.
From a bookkeeping perspective, you will typically see commingling in several ways: using business accounts for personal expenses (guilty as charged, right?), depositing business revenue into personal accounts, paying personal bills directly and indirectly from business checking, using business credit cards for personal purchases, and – this is a biggie – not maintaining documentation that separates business purposes from personal use.
For starters, the accounting implications of commingling are much larger than simple classification errors. If you have commingled accounts, generating an accurate profit and loss becomes virtually impossible. Your cash flow analysis is muddied, tax filing becomes a beast, and you cannot even achieve meaningful financial performance metrics. Also, if there is no documentation to support the business purpose of the transactions, bookkeepers will have to make an educated guess as to proper expense classification. Thus, some costs might be abundant while others could be understated, resulting in unreliable financial reporting.
Even though all these types will recognize commingling, their entity structure can matter in determining the definition of commingling and the consequences attached to that definition. The sole proprietor has a distinction in that the duality identity mistake of the owner is different than just tax treatment, which can lead to different proof of commingling; but a sole proprietorship has some validity in obtaining separate accounts for tax reporting and trend accounting for business success.
If you have a separate legal entity, this is where commingling gets tricky. Why? Because it blurs the distinction between the business entity and the owners. Corporations and LLCs depend on separation to keep limited liability intact. When financial boundaries disappear, legal boundaries may also disappear, and that places the owners at personal risk for the business obligations.
The IRS is pretty clear about this. Regardless of the entity type, they want you to maintain separate books and records for business activities to substantiate business expense tax deductions and permanently establish a bona fide business purpose. So, there really is no way around this.
Legal Consequences: Piercing the Corporate Veil and Related Liability Risks
So, when we talk about the “Corporate veil piercing,” we are talking about one of the most serious legal consequences you can face from repeated commingling. When this doctrine applies, it allows courts to disregard the legal identity of corporations and limited liability companies as her own and hold you personally liable for debts and obligations of the business. Courts do look at factors before they pierce the veil, but commingling usually is mentioned as part of the court’s analysis.
Here’s how courts view this, they look at commingling as evidence that the business owners did not maintain respect for the separate legal identity of the entity. If you mix personal and business expenses enough, the judge can conclude that the entity merely serves as an owner’s separate ego and not an actual separate business. The ruling that establishes the entity as the separate ego of the owner exposes the owners to unlimited liability for all business debts; everything that the business owes, contracts, loans, judgments, regulatory fines, etc.
The legal standard does differ, depending on the jurisdiction. Most courts do use similar analytical frameworks, however. They tend to look for patterns that imply that the entity is not separate. Indications of inadequate capitalization, not adhering to corporate formalities, commingling assets, using the entity for personal affairs, and treating entity assets as their own property. Commingling often serves as the clearest indication of those problematic patterns, because financial records provide permanent records of boundary violations.
An alarming element is that recent legal analyses note that the courts rarely make veil-piercing decisions based solely on commingling, but mixed funds can significantly bolster creditors’ claims in favor of personal liability. In essence, when owners commingle funds, they are giving a record of the transgressions that would be applied in any veil-piercing claim. Not something you want to be doing!
And even the liability exposure doesn’t stop there. Personal injury lawsuits (e.g., slip and fall), employment disputes (e.g., wrongful termination), regulatory enforcement actions (e.g., environmental violations), and even breach of contract claims can also trigger veil-piercing considerations when businesses choose to commingle their finances. This is why professional advisors emphasizing limited liability still represent a privilege that needs to be actively upheld through appropriate financial separation, and is not some absolute shield that can never be pierced through owner conduct.
Tax, Audit, and Regulatory Risks
Let’s talk about a topic where so many business owners can relate: tax compliance risks. Commingling has a lot of significant problems that go way beyond simple errors in categorization. It puts you at risk of tax avoidance in the eyes of the IRS, all of which often leads to heightened examination procedures and an increase in the likelihood of being audited. Once business transactions and personal transactions are intertwined, taxpayers often cannot substantiate legitimate business deductions. This, of course, creates problems that lead to adjustments, penalties, and interest charges.
Everything we deduct as a business has to have clear documentation of business purpose and proper substantiation. Yeah, that makes sense right? But proper substantiation is almost impossible with commingled accounts, because the auditor is unable to delineate between legitimate business expenses and a personal purchase. The IRS denies deductions from mixed accounts all the time, and the burden is on the taxpayer to prove the business purpose of the transaction that is questioned. If you’re reviewing multiple years of commingled transactions and trying to provide documentation and an explanation for each travel expense, that burden can be beyond paralyzing.
Now’s where things really get sticky: audit efforts usually increase pretty dramatically when examiners spot commingling. Routine document requests might grow to include not just the regular tax-related documents, but personal banking statements, credit card statements, and explanations of many transactions. Auditors might be examining more than one tax year at the same time to find patterns of claimed improper deductions or unreported income. When financial lines are blurred, the audit process takes longer, costs more, and, very importantly, becomes much more adversarial.
When this happens, penalty exposure goes up dramatically. There’s a chance the IRS imposes accuracy-related penalties when taxpayers can’t substantiate the deductions they claimed. Taxpayers also can be slapped with negligence penalties when they did not create sufficient records to support the tax position they took. There is a way worse penalty scenario when unreported income from business activity is concerned: the IRS might impose fraud penalties, which can lead to a criminal referral. That’s a place you REALLY don’t want to be!
State tax authorities will, at times, coordinate with federal examinations as well. This multiplies compliance costs and penalty risks in multiple jurisdictions. Sales tax, payroll tax, and business license compliance become more complicated when the patterns of transactions do not sufficiently separate between business expenses and personal spending. It’s one headache after another!
Bookkeeping Controls and Daily Practices to Prevent Commingling
Preventing commingling of funds is really a matter of having solid accounting controls and maintaining daily processes that will create a clear delineation between personal and business financial transactions. It all starts with the proper banking relationship, and we mean as dedicated as possible, including separate business checking accounts, business savings accounts, and business credit cards. Then you will need to practice strict discipline that recognizes those accounts and cards as only for business and never, and that’s never practice for personal transactions, even with ill-conceived ideas of it being a temporary convenience or appropriate in an emergency.
Establishing formal payroll systems or structured owner compensation helps maintain the important boundaries that should be created between business funds (income) and personal funds. Business owners should establish regular salaries or draws that follow a schedule vs. just paying themselves irregular amounts whenever there is a need for cash, which is actually not uncommon. This utilitarian method maintains demarcation of the owner’s compensation, and limits any appearance of treating business funds as your personal checking account. Formal written employment agreements or draw schedules help document the business purpose of owner payments, which is especially important during examinations.
You’re going to want to establish clear reimbursement policies with adequate evidence – receipts, denoting business purpose, and processing quickly so as not to have anyone confused about what happened hours or weeks later. Clear and formal reimbursement procedures helps limit the slow death to distinct pockets of money that ultimately turns into behaviourally unacceptable and forgotten systematic commingling.
Transaction classification rules provide business owners a steady source of directional reference on how to deal with situations when business transactions don’t quite fit cleanly into either the business transaction or personal transaction box. Well-written policies will need to chart the relevant gray areas that baffle people, such as – home office allocations, vehicular usage, entertainment, travel expenses, and possibly depreciable equipment purchases for items with mixed business and personal use. Written policies denote direction for bookkeepers and business owners, to help them ensure that consistent treatment of similar transactions will occur.
Monthly bank reconciliation procedures can flag potential commingling patterns before they materialize as systemic issues. Bank reconciliation procedures should flag all personal transactions in business accounts and all business transactions in personal accounts so the business can amend each account appropriately. Your reconciliation process should have review steps on purpose to identify boundary limits clearly.
Documenting standards requires clearly stating the business purpose for every business transaction. Receipt retention policies, expense report protocols, and transaction codes help keep the proper documentation to enable tax compliance and audit protection. More contemporary documentation is worth way more than reconstructed documentation prepared during an audit—You’ll have to trust us on that one.
Random independent review by external accountants or bookkeepers offers an independent opinion about the border maintenance. The process should determine the trending transactions for the signs of commingling and recommend improvements to the boundary maintenance. Independent perspectives will often reveal a police process that is gradually eroding the border or commingling, which the business owners fail to recognize.
Conclusion
Separating business and personal financial transactions are basic risk management requirements for any business. When these transactions are mixed, business owners will expose themselves to harmful legal liability, hefty tax penalties, and flawed business decisions that can completely undermine years of business development.
It’s not worth the risk.
Having systematic controls in place, proper documentation, and obtaining professional advice as problems develop can protect against these risks. The expense of proper bookkeeping practices has significant returns with less exposure to audits, better liability protection, and better decisions being made for the business.
Businesses looking for an easy way for accounting services can utilize MagicBooks’ automated tools on how to streamline accounting and maintain proper financial boundaries and audit-ready reports. Find out more comprehensive bookkeeping solutions at Magicbook.
