Business Expenses Paid out of Pocket by Shareholder(s) of S Corporation

Shareholder(s) and the corporation are two separate entities. The IRS recommends opening business-only banking accounts for any business. It is preferable to have the entity pay for all of its business expenses form the entity’s account and to have one credit card that is used solely for business expenses.

However, even when you do maintain separate business and personal banking accounts, you may occasionally pay for business expenses out of your own pocket. Examples of this include costs incurred while traveling to a client or purchases of business supplies. When this happens, you need to know:

  • how can the business owner receive the money owed to him or her in favor of taxpayer, and
  • what is the proper method of recording these transactions?

Every business costs and expenses paid by the shareholder-employee are deductible. A common practice is to reimburse such expenses to employee (shareholder). If the company has an “accountable” plan, such expenses do not have to be included in an employee’s wages.

What is an Accountable Employee Business Expense Reimbursement Plan?

The stockholders hereby authorize the president to establish, implement and modify a written accountable plan for payment or reimbursement of actual and necessary business expenses that are incurred or paid by an employee, officer, director or shareholder, subject to substantiation, pursuant to Internal Revenue Code Section 62(a)(2)(A) and Reg. Section 1.62-2.
According to IRS Publication 15, in order to be an accountable plan, an expense reimbursement plan or advance payment program must meet the following conditions:

  • Business connection – The expense must have been incurred in the performance of services as an employee of the employer.
  • Substantiation – The employee must substantiate his business expenses by providing the employer with evidence of the amount, time, place, and business purpose of the expenses within a reasonable period of time after they are paid or incurred.
  • Returning excess amounts – Amounts paid by the employer that exceed amounts spent by the employee must be returned to the employer within a reasonable period of time.

There are two methods of determining the reasonable period of time for substantiation and returning excess amounts:

  • Fixed-date method – The expense must be substantiated by the employee within 60 days of being paid or incurred, and the excess amount of any advance must be returned to the employer within 120 days of when the expense was paid or incurred.
  • Periodic statement method – The employer can issue a periodic statement to the employee detailing amounts that have been paid and not substantiated and require the employee to either substantiate the excess amount or return it to the employer within 120 days of receiving the statement.

What Kind of Valid Business Expenses May Be Incurred by Employees?

Expenses incurred by an employee are defined as valid business expenses only if they are considered to be necessary for the operation of the business and they are properly documented. Out-of-pocket expenses are business expenses that are incurred by an employee but are not directly paid for by the business. This would include expenses that have been paid for with cash, personal check, or an employee’s personal credit card.
In addition to the direct expenses described above, some employee-incurred expenses may be indirect expenses. For instance, when an employee uses his personal vehicle for company business, his employer may choose to not reimburse him for direct expenses, such as gasoline, oil, insurance, depreciation and maintenance. Instead, he would be reimbursed at a set rate, such as a certain number of cents per mile driven on business.

How to Comply with the IRS’ Rules for Expense Reimbursements?

Expenses incurred by employees in the course of business should be costs incurred by the employer, not by its employees. If the employer establishes an accountable plan, and the employees submit properly documented expenses under that plan, then the reimbursements are not taxable income. The key to maintaining any accountable plan is to properly substantiate expenses. You must keep copies of any receipts paid out-of-pocket to deduct them. Attach the receipts to a copy of the reimbursement check, and keep them in your files as proof of the business purpose for the check. By accountable reimbursement, the burden of proof is shifted from the employee to the corporation.
All tax deductible business expenses that are paid directly by your business immediately become tax deductions for your business. However any tax deductible business expenditures that you personally pay on behalf of your business, can only be considered tax deductions for your business at the point in time that your business reimburses you for these expenditures. This is generally accomplished by having your business write a reimbursement check made out in your name.

Strategy – Pay all your business expenses directly out of business funds, or have your business reimburse you immediately for any and all business expenditures you pay (out-of-pocket) on behalf of your business.
For example, let’s say you spent $40 on office supplies. Write a check payable to yourself for $40, and then categorize the expense to the appropriate expense account.

If reimbursement is not required immediately, or if funds are not available, the expense should still be recorded. Record the expense in the appropriate account and the amount owed to the shareholder to a shareholder’s credit account. Let’s say you made an out-of-pocket purchase totaling $150 for office supplies, but does not require immediate reimbursement. You have, in effect, lend money to your company. You can track these purchases in QuickBooks with an Other Current Liability account.

In your Chart of Accounts, create a “shareholder credit” account using the type Other Current Liability. You’ll use this account to track all the money you spend in your business. In QuickBooks, click on the “chart of accounts” icon. Find the “Shareholder credit” Account on the chart list. Enter the transaction details including: the date of purchase, the name of the business where the supplies were purchased from, and the amount. The amount of the credit account is increased showing what is due to the owner for later payment.
It’s a good idea to zero out your “shareholder credit” account at the end of the year, since this liability is not relevant to your business’s financial health as a liability to a bank or credit card company would be. You can do that in either of these two ways.

  •  Write a business check for the money owed to yourself.
  • Reinvest the money in your company by moving it to an equity account.

Avoid using shareholder Loans for Due To or Due From shareholder transactions. Shareholder Loans should only be used for real loans that have a note instrument, an interest rate assigned, and regular payments made.

How Can Business Expenses Become Taxable Wages?

If an employer does not have an accountable plan in place, then IRS Publication 15 states: “Payments to your employee for travel and other necessary expenses of your business under a nonaccountable plan are wages and are treated as supplemental wages and subject to the withholding and payment of income, social security, Medicare, and FUTA taxes.” So even if the business expenses are valid and necessary, if the employer does not have an accountable plan, then any reimbursements are taxable income.
On the other hand, if the employer has an accountable plan, but the employee fails to properly substantiate the expenses within a reasonable time, or the employee fails to return excess advance payments, then any reimbursements could become taxable income. In addition, if any indirect expenses are paid in excess of IRS limitations, then the excess is taxable income. For instance, in 2012 the federal rate for business travel is 55 cents per mile. If the employer pays 60 cents per mile, then the additional 5 cents per mile is taxable income.

Unreimbursed Business Expenses of Employees

Never pay business expenses personally without reimbursing yourself, or any other owner(s) – immediately. If you fail to have your business reimburse you for these business expenses, the only way you can take them as a tax deduction is to show them on your personal income tax return (Form 1040) as “Non-reimbursed Employee Business Expenses” as long as the shareholder was paid salaries as an employee.
Expenses must be ordinary and necessary. they include unreimbursed office supplies, reference materials, meals and entertainment, and travel, etc. But payment of business liability insurance, rent or mortgage do not qualify. There are four hurdles to deduct the Unreimbursed Business Expenses of Employees

  • If a reimbursement policy exists, you must seek reimbursement. Taxpayers should request a statement from their employer for expenses the employer is not reimbursing. You may not deduct reimbursable expenses. IRS auditors may request this documentation for unreimbursed expenses on Form 2106.
  • After reporting the unreimbursed expenses on Form 2106, the net amount of business expenses are carried forward to Form Schedule A, ‘Itemized Deductions’ where these amounts would be categorized as “Miscellaneous Itemized Deductions”.
  • These non-reimbursed business expenses must first exceed 2% of your “Adjusted Gross Income”. It’s only those in excess of the 2% figure that can be taken as a tax deduction on your personal tax return.
  • Deductible business expenses can be further reduced or completely phased out should a taxpayer be subject to Alternative Minimum Tax (AMT). When a taxpayer is in AMT, unreimbursed business expenses and other miscellaneous itemized deductions are added back to income thus increasing taxable income and potentially increasing the tax liability.

Unreimbursed Business Expenses by Nonemployee Shareholder(s)

Unreimbursed expenses incurred by non-employee S-corporation shareholders are generally not deductible (TC Memo 1989-207 and TC Memo 1997-446). A shareholder is not entitled to a business deduction for the payment of expenses of a corporation that he or she controls. Rev. Rul. 71-36, 1971-1 C.B. 51 which says pretty clearly: “…the sums advanced by him were expenses incurred in carrying on the business of the corporation, the business to which these expenses pertained was not the taxpayer’s business, but that of the corporation. Accordingly, the advances made by the taxpayer are not deductible in the years paid as ordinary and necessary business expenses under section 26 USC 162 of the Code.”

A work-around: If the corporation had simply reimbursed the shareholders for the expenses, the corporation would be entitled to the deductions, and the expenses would pass through to the shareholders.

In another way, the amount of the payment is treated as a loan by the shareholder to the corporation if the parties intended the payment to be treated as a loan and there is an obligation on the part of the corporation to make repayment. Such loans should be carefully documented and bear a fair market interest rate to avoid an IRS argument that they do not represent valid indebtedness. The unreimbursed expenses can be treated as contribution of capital. In either way, the shareholder has made the economic outlay and should, be entitled to increase stock basis for the expenditures made on behalf of the business.


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