Expenses Paid by the Business

April 13, 2006

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Legitimate deductible expenses permitted for travel, meals, entertaining clients, automobile expenses and the like, if properly claimed and documented, give an owner many advantages not enjoyed by regular employees. Considerable benefit can be gained through the use of deductions for company cars and expense accounts, as long as they are supported by extensive documentation that substantiates their legitimate business purpose.

But often the business owner is tempted to go too far. Here is where many small businesses get into difficulty. The founder, failing to differentiate between himself and his business, plunders the business assets at will. After all, it's his business, so it's his money and he can spend it on himself if he likes, right? He's worked hard to build the business up and now he's going to reap the tax-free rewards. Forget compensation on which taxes must be paid, he thinks. He'll just pay his expenses directly out of the company. Or, if he's in a cash heavy business, skim some off the top and not run it through the books.

But an owner who uses his business to finance his hobbies or extravagant indulgences (boating, horse racing, luxury home improvement, world cruises, and private aviation come to mind) can expect frequent and costly visits from Uncle Sam's minions at the IRS.

Warning

IRS agents can look at many sources of information, not just the books of the company, for proof of a business owner's spending habits.

The newest wrinkle in audits is called a "lifestyle audit." The type of car you drive, the value of your residence, your travel patterns and general spending habits are all grist for the IRS mill. If your "official" salary and other distributions from your business would not appear to support your lifestyle, you're a sitting duck for severe penalties. As of 1998, the IRS cannot conduct lifestyle audits to detect the existence of unreported unless the IRS has some indication that there is a likelihood of unreported income. Nevertheless, triggering audits is not a recommended way to build your personal wealth.