Tax Implications of Commingling Expenses from Different Businesses

For U.S. taxpayers who own multiple businesses, they must be wary of commingling expenses between the businesses. If one company is used to pay the other’s expenses, the tax consequences could be severe. This point is demonstrated by the recent IRS case of Key Carpets v. Commissioner.

A Brief Look at Key Carpets v. Commissioner

Ray Johnson operated two businesses through closely held C corporations, Key Carpets and Clean Hands. Johnson and his wife were the sole shareholders for Key Carpets, while only Johnson owned shares in Clean Hands.

Johnson hired a computer technician as an employee of Clean Hands. The computer tech ended up doing some work for Key Carpets. Clean Hands paid the computer tech’s salary, but it also billed Key Carpets for much of his work. Key Carpets was effectively the primary source of the funds used to pay the salary of the Clean Hands employee. Key Carpets then claimed these funds as business expenses in its tax filings.

The Tax Court found that most of the funds paid by Key Carpets to Clean Hands were not tax-deductible. The court held most of these funds were not related to Key Carpets’ business. Accordingly, they were not deductible as ordinary and necessary business expenses, and Key Carpets owed a substantial understatement penalty.

In addition, the Tax Court found the payments by Key Carpets to Clean Hands were effectively constructive payments to Johnson himself. This caused Johnson to personally owe a sizable tax understatement penalty.

Consequences of One Company Paying for Other Company’s Expenses

The Key Carpets case illustrates several tax consequences of using one business to pay expenses for another business:

• The company that pays the expense cannot deduct the payment as a business expense.
• The company receiving the payment cannot claim a business expense deduction, since it did not pay the expense.
• The owner has to pay taxes on a constructive dividend. The IRS treats the situation as if the first company disbursed funds to the owner, and the owner then used the funds to pay the expenses of the second company.

How to Avoid Commingling Between Different Businesses

The primary lesson is to completely avoid using one company to pay the expenses of the other company. However, the owner may face a situation where one of his or her companies is short of funds and cannot pay expenses. The following are the best methods of dealing with this issue.

Loan Between the Companies: One company can make a documented loan to the other company. The loan should be documented with a promissory note and be made at a commercial rate of interest. The company receiving the loan should repay the loan according to the terms of the promissory note.

Distribution to Owner: One company can distribute the funds to the owner as a dividend, bonus or salary. The owner can then make a loan to the other company. Again, the loan must be fully documented and at a commercial interest rate.

Third Party Lending: The company in need can seek a loan from a commercial lending institution.

Contact a Virginia Tax Attorney at Thorn Law Group About Your Business Tax Needs

If you have tax-related legal issues arising from operating one or more businesses, contact the Thorn Law Group to consult with a Virginia tax attorney who can meet your tax needs. Contact Kevin E. Thorn, Managing Partner, at 703-752-3752 or ket@thornlawgroup.com to schedule a consultation.