One of the most popular questions I get is “how should I handle business expenses that I pay for personally?” This is such an important detail to get right because it applies from the time you start thinking about starting a business all the way through the end of your business. Usually the question first comes up when someone is starting a business and is starting to incur expenses – like the expense to form the entity.
One of the great benefits of having an entity for your business is that it is separate from you. This allows for great tax and asset protection benefits. One of the key rules of keeping your entity separate from you is to not commingle funds. This means the entity pays for its expenses with its own funds.
The catch-22 is the entity cannot set up a bank account to pay for its own expenses until after it is formed and the formation fees must be paid before the entity can be set up. In this situation, personal funds must be used to pay the formation fees, and other expenses, until the entity’s bank account can be set up. There are a few things to keep in mind when you use personal funds for business expenses:
1. Capture It in Your Personal Bookkeeping
Your personal bookkeeping is the starting point since personal funds will be used. There are a few ways the personal funds can be coded in your personal bookkeeping.
For example, the funds could be considered a capital contribution or a loan to your entity. Let’s assume that they will be considered a loan.
When you code the expense(s) in your personal bookkeeping, code it to a current asset account that is used only for tracking expenses for your business. In my bookkeeping, I use the account name “Reimbursements Due from Entity XYZ.”
The key is making sure that this reimbursement account is an asset account. This will ensure that if you have not been reimbursed by your entity for these expenses you paid for personally, there will be a balance in this asset account. If your entity has reimbursed you in full, then the balance will be zero.
2. Capture It in Your Entity’s Bookkeeping
Next, you need to have your entity reimburse you. The amount your entity owes you is the balance in the asset account in your personal bookkeeping from above.
To complete this step, have your entity make a payment to you for the amount of the reimbursement due. When your entity makes this payment, it will code the payment in its bookkeeping to the appropriate account.
This is a key step because the reimbursement is how your entity records the expense on its books. It’s important to make sure the reimbursement gets done before the end of the year so your entity can capture the expense in the appropriate tax year.
If your entity doesn’t have the funds to reimburse you, then you should consider charging interest or categorizing the expenses paid personally as a contribution to your entity rather than a loan.
When your entity reimburses you, be sure to code it to the asset account you use to track your reimbursements in your personal bookkeeping. This is the “Reimbursements Due” account described above.
3. Use this Method for all Personal Funds Used for Business Expenses
While the most common instance of using personal funds for business expenses is during the formation phase, there are other times when you must use personal funds for business expenses.
When you run into this, use this same method. Capture the expenses in your personal bookkeeping when you pay the expense and then have your entity reimburse you. A quick way to check if your entity has properly reimbursed you is the reimbursement account on your personal books should be zero.
– Tom Wheelwright
Rich Dad Advisor