It’s easy for entrepreneurs hatching startups to fudge the line between personal and business expenses. Is that laptop really used for your company, or for your kids? Are you discussing business at lunch, or gossiping with a friend? Beyond the typical admonitions about tax audits, running personal expenses through your business can backfire with employees, investors, partners, and buyers. I spoke to Ben Straughan, an attorney and partner in the emerging-companies practice at Seattle-based Perkins Coie. Edited excerpts of our conversation follow.
You work with a lot of startups. How common is this temptation to blur personal and business expenses?
It’s very common, particularly early on when entrepreneurs feel tempted to run “sort of” personal expenses through their corporations on the theory that they have no other owners to harm.
What kinds of misclassified expenditures have you seen?
They can be something related to a residence, furniture, fixtures, supplies, clothing for family members. Cars, structures, travel—anything that’s a personal-use item treated as a business asset.
What are the risks of claiming a personal expense as a business deduction?
Well, there are certainly tax implications. Nobody wants to be the subject of an audit or have a deduction challenged that can give rise not only to back taxes but also interest and penalties. That’s where a good accountant and careful bookkeeping come into play. But it also presents an appearance issue for potential investors and other persons who want to evaluate the profitability of your business. If your company’s bottom line reflects nonbusiness expenditures, investors must erase those expenses from your company’s financial information to get an accurate picture.
What happens when investors or potential partners uncover that kind of activity?
It’s disconcerting, but it’s not uncommon for investors to see things like this, or to see substantial salaries above market rates when they look at books. And investors are sophisticated; they understand the numbers. So when they have to start unwinding structures or payment streams to get to the bottom line, they wonder: How are my funds going to be used? The company’s true financial performance is called into question.
What about companies that aren’t seeking outside investment?
Investors in your company are not just cash investors. They’re purchasers, employees, partners, contractors—anyone who’s doing business with you. Even if these people aren’t looking at your books, entrepreneurs who aren’t focused on their businesses, who blur the line and use the business as more of a lifestyle operation, run the risk of getting a negative reputation that has long-lasting repercussions. If I’m an employee investing my time and work in someone’s business, I want to know that the owner is doing everything she or he can to maximize that business’s growth. If I feel like it’s being used as the owner’s personal checking account, that doesn’t send the right message.
Do you see a difference between entrepreneurs who resist this temptation and those who don’t?
I think companies that are successful, their founders have gotten this message. They’re the ones that grow successfully, get acquired and get investment, whether they are sole proprietors or incorporated. In my experience, these founders benefit in the long run because as much as people invest in a company, they also invest in the founder.
Are there some general expenditure guidelines you give your clients?
Trust your instincts. Think about being focused on the business and how your expenditures and resources contribute to that. Ask yourself how people who are betting on your business—your employees, your partners, your investors—would react to your taking this expenditure, if they knew about it.
What do you think about hiring family members?
Good employees are good employees, whether they’re related to you or not. But business owners should understand that investors will scrutinize those relationships very closely when they consider making an investment in your company. There’s a heightened risk that somebody might not be doing their job because there are other reasons to have them on your payroll. The bottom line is to make good decisions about hiring, whether it’s family members or otherwise.