Tax-Time Tip: Don't Mix Business and Personal Income and Expenses
Restaurants USA, March 1997

Experts advise operators to be vigilant in keeping business and personal income and expenses separate or else risk incurring the wrath of the IRS.
By Mark E. Battersby

Building a successful restaurant business often comes down to taking care of the details. Unfortunately, the most important details are not always updating the wine stock or installing an elaborate computerized inventory system, but determining whether any of the merlot was used for private consumption or whether the computer contains any personal files.

Keeping track of business and personal income and expenses may be one of the most important commitments a restaurateur can make to his or her business. While customers might not notice the difference, the Internal Revenue Service (IRS) probably will — and that can result in huge taxes and penalties if the business is ever subject to an audit.

And as Frank and Lisa Walsh (not their real names) recently learned, when it comes to taxes, it isn't over until the IRS says that it is over — and even then, the agency may not live up to its agreements. In fact, the IRS was legally allowed to change its mind after reaching agreements with both the Walshes and their restaurant, which illustrates how difficult — and dangerous — it has become to mix business and personal income and expenses.

Reversal of fortune

The Walshes' troubles began when two IRS auditors conducted separate audits of their personal income-tax returns and the corporate return of their restaurant business. The different auditors reached inconsistent conclusions about the proper tax treatment of the couple's affairs. Ultimately, most issues were resolved in favor of the restaurant corporation.

However, in the course of resolving the tax disputes, the corporation was allowed to treat a $24,000 payment to the Walshes as a business expense. Unfortunately, they had failed to report that transfer on their tax returns.

The IRS pursued the matter — and a court case resulted. A jury agreed with the Walshes that the postaudit examination of their tax returns created a binding contract, closing the examined years to all further dispute. The Walshes asserted that "the fact that [the couple] had failed to inform the examiner about the $24,000 payment is just a tough break for the [IRS]."

Citing an area of the Internal Revenue Code (our basic tax law) regarding closing agreements and offers in compromise, the IRS argued that their examiner did not have the authority to make a promise binding upon the government.

The U.S. Court of Appeals for the 7th Circuit in Chicago ended up with the case. "An examiner just can't compromise a tax claim or close a tax year to further examination," the appeals court concluded, pointing out that the federal government may be bound only in three circumstances: the signing of a closing agreement by an authorized agent, the expiration of the statute of limitations or the disposition of litigation.

"Apparent authority," the court said, "is not enough to bind the federal government to a contract; unless the IRS agent had actual authority, any argument is ineffectual." In other words, agreements reached with low-level IRS auditors or examiners may not be worth the paper they are written on.

Although the Walshes' $24,000 payment from their incorporated restaurant business was not allowed to slip away into limbo, their court case illustrates how transactions between any restaurateur and his or her incorporated business can often be ignored, mislabeled or simply wrong.

Status has its advantages

Many operators today operate their restaurants as corporations, because of the tax advantages. A corporation, like any enterprise, is formed by associates to conduct a business venture and divide profits among investors. In other words, a completely separate taxpaying entity is created that has many advantages over other forms of association, such as the following:

limited liability for corporate debts, whereby shareholders are liable only up to the amount of their investment in a corporation

free transferability of corporate ownership interests, meaning shareholders may easily sell their shareholdings to others

centralized management, in which day-to-day business operations are run by a centralized hierarchy of executors who may not always be owners of the corporation

continuity of life, which says a corporation does not dissolve when a shareholder dies or sells his or her holding.

The two separate tax entities, the owner and the incorporated restaurant operation, are still "related" under our tax rules. That means that although a restaurateur must make every effort to keep personal and business income and expenses separate, all transactions will usually be scrutinized to see whether they are conducted at arm's length — and designations for transactions may be changed by the IRS.

When property is acquired by a corporation from a shareholder, the book value, or basis, of that property to the corporation is the same as it was in the hands of the transferor. In other words, transferring money or property to a restaurant corporation is generally a tax-free transaction.

Blurred lines

However, problems can arise when lines between the two entities are blurred. With many restaurateurs using their homes as a base for their businesses, it is only natural that some commingling of business and personal funds might occur, although the two should be kept separate. Having the incorporated restaurant business rent a portion of the principal shareholder's home for its offices may be quite legal. However, that restaurateur/homeowner will be denied an expense for home-office expenses in the "related-party" transaction.

Tax rules also limit the amount of depreciation that may be claimed for so-called "listed property" such as entertainment, amusement and recreational gear; computers and peripheral equipment; cellular telephones and similar telecommunications devices; and of course, automobiles and other forms of transportation. Those are all business assets that lend themselves to personal use.

Unless used predominantly for the enterprise (more than 50 percent), special limited-depreciation rules may apply. What's more, not only is the depreciation deduction limited for "listed" items used for both business and personal purposes, so too is the unique first-year write-off under Section 179 limited.

Put simply, if the cost of any purchased "listed" property fails the more-than-50-percent business-use test, that property will not qualify for the special first-year expensing provision.

Lending a helping hand

Federal tax rules do keep restaurant business owners/shareholders and their financial affairs separate from those of their closely held businesses. In fact, the IRS is often permitted to restructure many of those "related-party transactions" in which owners and their concerns didn't conduct business at "arm's length" to more accurately reflect economic reality.

The IRS also has lobbied mightily to close loopholes in our tax laws that have, in the past, allowed many business owners to operate as one with their restaurants and related businesses. A good example is a recently closed loophole that formerly permitted a number of restaurateurs to benefit from using tax years that were different from those of their restaurant operations.

That loophole made it possible for some to finagle payments and income between different tax years when separate accounting methods were used by their personal and business interests. Now, for example, when an incorporated restaurant uses an accrual method of accounting and its principal shareholder uses a cash-basis method of accounting, accrued interest and other expenses owed to the related party cannot be deducted until a corresponding amount can be included in the gross income of the cash-basis payee. The deduction has to be deferred until the cash-basis payee takes the item into income.

This is one of the reasons it is so important to keep track of payments made by the incorporated business to its principal/shareholder, as the Walshes so painfully discovered.

Deducing deductions

Most of the time, those payments take the form of loans, compensation or bonuses to escape the threat of double taxation on dividends. And dividends distributed by any incorporated business are paid out of income from which taxes have already been collected. Those payments from already-taxed corporate income are not allowed as a tax deduction by the restaurant operation. However, when those dividends are received by a shareholder, they are taxable income once again. That is why dividends are not the form of compensation restaurateurs favor.

Trying to hang on to a fair portion of a restaurant's earnings may seem difficult, but anyone carrying on any trade or business is entitled to deduct a reasonable allowance for salaries or other compensation for personal services. Only publicly held corporations are prevented from deducting compensation in excess of $1 million per year to certain employees.

A bonus, of course, is tax-deductible if paid for services performed and if, when added to other salaries, it does not exceed reasonable compensation. Even compensation paid to a relative is deductible if the relative performs needed services that would otherwise be performed by an unrelated party. Naturally, the deduction is limited to the amount that would have been paid to a third party.

Dividing the spoils

Keeping track of every expense may appear overwhelming, but it is possible to separate the income and deductions of restaurateurs and their corporations — especially when the IRS threatens to do it for you. Although the funds of many operating small businesses are often "commingled," the IRS has the legal authority to allocate those commingled funds. What's more, the agency can allocate them in a manner that will produce the highest possible taxes.

Thinking — and acting — as if the restaurant operation were a separate business entity, backed up with proper records, will go a long way toward forestalling the potential problem of income and expense reallocations. Keeping all transactions at arm's length will also reduce the possibility that the IRS will second-guess the restaurant's owners and managers and assess higher taxes.

When it comes to dealing with the Internal Revenue Service, it might be wise to remember that although income, expenses and even related-party transactions do occasionally escape the IRS's eagle eye, the agency does have a long memory. Even signed agreements that an audit is concluded won't necessarily afford much protection when the IRS eventually discovers its — and your — errors.

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