“Hey Fritz, I know our motto is "Every Deduction Legally Possible,´ but I´m not too sure about this charge from Felman´s Jewelry. How does a diamond pendant fit into the auto repair business?”
"Oh that "?¦ I stopped to get paper for the office printer, and the jewelry store was right next door, and all of a sudden I remembered it was my wife´s birthday, and all I had in my wallet was the company credit card "?¦ you just don´t know how upset my wife gets if I forget her birthday "?¦" Fritz screws up his face. "I guess you´re gonna give me one of those lectures "?¦" He rolls his eyes like a teenager who just got home from a party two hours late.
Well, yeah, I´ll give Fritz a lecture. Because I care. In legal terms, what Fritz did with the diamond pendant and the company credit card is known as commingling funds.
"But I own the company." Fritz seems genuinely wounded by my lack of understanding. "It´s my money, isn’t it? So what if I spend some of it on a present for my wife?"
Sometimes bad things happen to good people. While browsing through recent Tax Court opinions yesterday, I came across a case that reminded me of one of the reasons I keep hounding clients to use the proper procedures when passing money back and forth between company and shareholders.
The taxpayer in the Tax Court case, I´ll call him JR, owned two corporations that provided tax, accounting, and return preparation services, and his wife owned a third corporation. JR should have known better, but nevertheless he used money that belonged to his wife´s corporation to pay some of his personal expenses. One of the issues addressed in the case was whether JR could deduct home mortgage interest and real estate taxes on his personal income tax return. The Tax Court said no deduction, because the corporation paid the taxes and made the mortgage payments for him. To be entitled to the deduction for mortgage interest and real estate taxes on a residence, there are three requirements: 1. the taxpayer must own the house; 2. the house must be the taxpayer´s principal resident; and 3. the taxpayer must pay the interest and taxes.
Losing your home mortgage interest and tax deductions is just one of several possible unpleasant consequences of commingling funds. What many business owners forget (or perhaps don´t realize) is that a corporation is a legal person in its own right. Although Fritz is the sole owner of On The Fritz Auto Repair Incorporated, and therefore has control of the corporation´s money, it´s crucial to remember that the corporation´s money is not Fritz´s money, and vice versa.
Tomorrow, I´ll talk about a very quick and easy step JR could have taken to save his home mortgage interest and tax deductions. In case you´d like to read JR´s case for yourself, you can find the text of the opinion here: Rappaport v. Commissioner of Internal Revenue
Note: Unless otherwise indicated, whenever I write about things my clients have said or done, the names of businesses and individuals, and all identifying details will have been disguised in order to protect client confidentiality.