Personal Expenses From the Business Account: Draw or Deduction?

Can I use my business account for personal expenses and deduct them?

No. A personal bill paid from the business account is still a personal expense, and personal, living and family expenses are not deductible unless a specific provision of the Code allows them. Only ordinary and necessary expenses of carrying on a trade or business are business deductions. The account the money leaves from does not change what it paid for, and the Schedule C instructions say not to include personal, living and family expenses in the Other expenses list.

The tax problem starts when the payment is deducted; in a multi-member LLC, a distribution above the member's basis can also be taxable. In the books, a personal payment is an owner's draw: money you took out of the business, not a cost of running it. Publication 334 says a sole proprietor cannot deduct personal withdrawals from the business. Mixing personal and business money this way is called commingling.

This page is for sole proprietors and for LLCs taxed as a sole proprietorship or a partnership. If your LLC elected S corporation or C corporation treatment, see an S corporation paying personal expenses or a C corporation paying owner expenses instead.

Your case is not simple if any of these is true:

• The personal payments run across several months or years.
• Any of them was already deducted on a filed return.
• More than one member used the same account.
• The IRS has written about the return, or a lender, buyer or investor is about to review the books.

Gather before you sort: statements for every account and card the business used, the receipts or invoices behind any payment you are unsure about, how the business is taxed (sole proprietor, one-member LLC, multi-member LLC or corporation), the operating agreement if there is more than one member, and the returns that may have taken these costs.

What makes an expense deductible, and what counts as personal, living or family?

An expense is deductible when it is both ordinary and necessary for the business. Publication 334 defines an ordinary expense as one that is common and accepted in your field, and a necessary expense as one that is helpful and appropriate for your business. A personal, living or family expense fails the test whoever pays it and whatever account it comes from.

The regulation under section 262 gives most examples of personal costs:

A sole proprietor's own retirement plan contributions and half of self-employment tax also have their own deduction on the owner's return, not on Schedule C (Publication 334). Book each payment as a draw, then claim the deduction there if you qualify. See self-employed health insurance in the books.

Does forming an LLC or buying something in the business name make it deductible?

No. A cost is deductible because of what it is for, not because of whose name is on the card, invoice or title.

For income tax, a one-member LLC is disregarded as separate from its owner unless it elects to be taxed as a corporation. Its activity goes on the owner's return, generally on Schedule C for an individual who runs a business. Forming the LLC does not make a personal cost deductible.

A domestic LLC with two or more members is a partnership for federal income tax unless it elects to be taxed as a corporation (IRS). If a husband and wife are the only owners and hold the LLC as community property under state law, the IRS accepts either treatment, disregarded or partnership, so check which one your returns have used (IRS). A partnership's deductions on lines 9 through 21 of Form 1065 are trade or business deductions only (instructions), so a member's personal bill does not belong there.

The status can change mid-year: by default, a second member makes a one-member LLC a partnership, and losing all but one member makes a partnership disregarded; a Form 8832 election can take effect up to 75 days before filing (instructions). Check the status on each payment's date.

An item bought in the business name is deductible only for its business use, such as the business miles of a car.

This page covers federal income tax. Whether mixed money affects an LLC's liability protection is not answered here; see fixing commingled funds.

How do I book a personal payment made from the business account?

Book it as an owner's draw in an equity account, not as an expense. Publication 334 describes a drawing account as a separate account for recording business income you withdraw to pay personal and family expenses.

1. Find each personal payment on the account statements.
2. Change its category from an expense to the owner's draw account.
3. Add a note of what it paid for.
4. Reconcile the account to its statement.

A draw is not a deduction, so it does not lower profit. A personal payment coded as an expense by mistake understated profit, so moving it to the draw account raises profit by that amount. A draw is not extra income either: a sole proprietor's income from the business is its net profit, business income less business expenses (Publication 334). For where a draw sits on the profit and loss statement and the balance sheet, see recording owner's draws.

What if the LLC has more than one member: whose capital account takes the payment?

The member who benefited. When a multi-member LLC pays one member's personal bill, treat it as a withdrawal by that member, booked against that member's capital account and not as an expense of the LLC, unless it is a loan or pay for services. Other members' accounts do not change.

A partner's capital account falls by withdrawals and distributions (Form 1065 instructions). A distribution is not taken into account in figuring the partner's share of income or loss, so it does not change that share (Publication 541).

Three traps:

• It can be a loan instead. If the members agreed the member would repay the LLC, it is a loan to the member, which a partnership reports on Schedule L (instructions). Which one applies depends on the operating agreement and what the members actually did.
• A payment for services is different. A payment the partnership makes to a partner for services, determined without regard to partnership income, can be a guaranteed payment (section 707(c); Publication 541). A personal bill is not one by itself, but paying it to settle an amount the partnership owes that partner for services can be, whatever the books call it. Health insurance the partnership pays for a partner is treated as a guaranteed payment, deductible by the partnership and income to the partner. If the partnership instead books it as a reduction in distributions, the partnership cannot deduct it (Publication 541). See guaranteed payments versus partner draws.
• A large distribution can be taxable. A partner generally recognizes gain on a cash distribution only to the extent it exceeds the adjusted basis of the partner's interest (Publication 541); see partner capital accounts.

What about costs that are part business and part personal, such as a car, phone or home?

Only the business part is deductible. Publication 334 says to separate the personal part of a partly personal expense from the business part, and that the personal part is generally not deductible.

For a car, keep an account book, diary or log, which Publication 463 lists as the kind of record that supports the business use. The percentage and the car's depreciation limits are in mixed-use expenses and the business percentage; the home-office tests are in the home office deduction.

I already deducted personal items on a return: what do I fix, and what penalty can apply?

A filed return that deducted a personal cost as a business expense understated profit for that year, so each affected year may need correcting.

• Sole proprietor or single-member LLC: file a separate Form 1040-X for each year. Income tax and self-employment tax can both change, and a state return may need changing too. On a joint return both spouses sign and are generally responsible for the added tax, interest and penalties, though innocent spouse relief may apply (instructions).
• Partnership or multi-member LLC: file an amended Form 1065 with amended Schedules K-1 for the partners. A partnership under the centralized audit rules (the default unless it elected out on a timely filed return) files an administrative adjustment request instead, generally within 3 years after the later of the filing date and the due date (section 6227(c); instructions). Each partner's own return can change.

Two things set the penalty exposure: why the deduction was taken, and whether you correct it before the IRS first makes contact about an examination.

Rates and tests are from the IRS accuracy-related penalty page. The IRS also charges interest on tax not paid by its due date and on these penalties (Form 1040-X instructions). The accuracy-related penalty does not apply to a part of an underpayment when you show reasonable cause for it and that you acted in good faith (26 U.S.C. 6664(c)).

Timing matters. An amended return, or a timely administrative adjustment request, filed after the due date, including extensions, and before the earliest cutoff in the regulation, such as the IRS first contacting you about examining that return, is a qualified amended return: its additional tax counts as shown on the return when the accuracy-related penalty is figured, except any part tied to a fraudulent position (26 CFR 1.6664-2). For a partnership item, the cutoff also includes the IRS first contacting the partnership about examining its return. Whether to amend depends on the facts. See amending a return for business expense mistakes.

What records show which payments were business and which were personal?

A bank statement shows that money left the account, not what it paid for. Publication 583 says supporting documents for an expense should show the amount paid and that it was for a business expense. It also says proof of payment alone does not establish a deduction, so keep the invoice or receipt that shows the cost was incurred.

Keep the records behind each deducted item until the period of limitations for the return runs out, generally 3 years after the return was filed, or after its due date if it was filed early. The period is 6 years if more than 25% of gross income was left off the return, and unlimited for a return never filed or a fraudulent one (IRS). For lost receipts, see lost receipts for business expenses.

How do I stop commingling personal and business money from now on?

Use one account for the business only, and take money out by transfer. Publication 583 says to keep the business account separate from your personal checking account, use it for business only, and write checks payable to yourself only for personal withdrawals. Steps 2, 3 and 5 below are habits that help, not IRS rules.

1. Pay business costs only from the business account, or from a card used only for the business.
2. Pay yourself by transfer to your own account, labeled as an owner's draw. Many owners use a regular amount on set dates so an unusual payment stands out.
3. Pay personal bills from your personal account. If you slip, book the payment as a draw when you find it.
4. Reconcile the business account to its statement every month.
5. In a multi-member LLC, keep one draw account per member.

For opening the account, see a business bank account for an LLC or sole proprietor. For ways to pay yourself, see paying yourself from an LLC.

Example

These examples are illustrative; all figures are in US dollars.

A sole proprietor pays a family trip and groceries

A sole proprietor's business earns a profit of $60,000 before these items. She pays a $1,200 family trip and a $300 grocery bill from the business account.

• Both are personal, so she books $1,500 as owner's draws. Schedule C profit stays $60,000.
• If she had coded them as expenses, profit would show $58,500, which understates it by $1,500.

A car bought in a single-member LLC's name

An owner buys a $40,000 SUV in his new single-member LLC's name after a friend says it is then fully deductible. The LLC is ignored for income tax, so only business use counts. A mileage log shows 70% of the miles are business. Generally only that share is deductible: business miles at the standard mileage rate, or about 70% of actual costs and allowed depreciation. The other 30% is personal. Vehicles have special depreciation and recordkeeping rules (Publication 334), so the share applies to what those rules allow.

A two-member LLC pays a member's family tuition

A two-member LLC pays $2,000 of one member's child's tuition from the LLC account. Unless the members agreed it was a loan or pay for services, it is booked as a withdrawal by that member: it reduces that member's capital account by $2,000 and is reported as a distribution, not as a partnership expense. The distribution is taxable only to the extent it exceeds that member's basis, which this example assumes it does not. The other member's capital account and the LLC's profit do not change.

Different for you?

• The mixed payments run across months or years, or you cannot tell which were business: sorting each payment, booking each personal one as a draw and reconciling every account is the work in fixing commingled funds. Rebuilding books that will not reconcile is a job for bookkeeping help.
• Personal costs were already deducted on a filed return: whether to amend, which years and what penalty risk remains depend on the facts and the timing. Start with amending a return for business expense mistakes, and consider bookkeeping help to rebuild the affected months from the statements.
• The IRS has written to you: the date and type of the letter change what you can still do on your own. See an IRS notice to your business and an IRS audit of a small business.
• Several members used the account, or members disagree on what was personal: see partner capital accounts and guaranteed payments versus partner draws. Sorting which member each payment belongs to, and booking each to that member's capital account, is work for bookkeeping help.
• Your LLC elected S corporation or C corporation treatment: see an S corporation paying personal expenses or a C corporation paying owner expenses.
• You paid business costs from a personal card instead: see business expenses on a personal credit card.
• You are unsure how your LLC is taxed: see how LLCs are taxed.