Personal vs. Business Expenses: Does Keeping Them Separate Really Matter?

“Small business” is a vague term. The Small Business Administration (SBA) defines a small business as 500 or less employees. Various other associations use a total transaction value of $5M or less to define small business transactions. Whatever the definition, ownership of a small business is typically closely held. 

This means the owner(s) of a small business exercise a great degree of influence over the profitability, cash flow and value of that business — for better or for worse. Personal spending habits become a factor in business profitability, and even in business valuation.

But part of the benefit of being a business owner is having a business pay for some certain life expenses, right? Does it really matter if the business pays for personal expenses? The short answer is: Yes, it matters.

You Gotta Keep ‘Em Separated…

To quote The Offspring, you “gotta keep ‘em separated.” It is cleaner and easier to not mix personal and business expenses. The risks are too great. 

You risk losing cash flow, which takes away from the value of your business. Once lost, you cannot get it back. 

Even worse, you could trigger an Internal Revenue Service (IRS) audit and end up owing thousands, tens of thousands, or even hundreds of thousands of dollars. You could even go to prison. Your cost-benefit analysis of that situation should lead you to conclude: It’s simply not worth it.

Losing Cash Flow and Business Valuation

It is important to define the term “cash flow.” Analysts, brokers, lenders, buyers, and sellers all use cash flow as a basis for valuation. It is an important number! The higher the cash flow of the business, the higher the value of the business. 

In the arena of small business sales and mergers and acquisitions, cash flow comes in two forms: EBITDA and SDE. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. SDE stands for Seller’s Discretionary Earnings. 

SDE considers Owner’s Benefit, whereas EBITDA does not. Owner’s Benefit may be in the form of a   W-2 Owner Salary, fuel and vehicle expenses, life insurance policies, retirement policies, and perhaps even some other personal expenses. These are the fringe benefits and perks a business produces for the business owner. SDE is what’s typically used to value small businesses and what’s used in this article for cash flow.

What Counts as Cash Flow (SDE)?

Cash flow starts with the Net Income (Net). Net Income equals all expenses subtracted from all revenues. It’s the bottom line. Sometimes it’s a positive number; sometimes it’s a negative number. Net is another word for Taxable Income. Some business owners seek to intentionally minimize taxable income. This is why Net IS NOT cash flow. 

Cash flow takes the Net Income and builds on it by adding back certain expenses — things like depreciation, amortization, and interest. These three are always part of the cash flow, as they reflect the amount of debt the business is paying.

Other expenses are reviewed. A big expense is payroll — and if the owner is taking a salary that is run through payroll, then that salary is added back. Distributions ARE NOT considered cash flow items. 

Another similar expense includes retirement plans. If the owner has a retirement plan paid by the business, then the business must, by law, offer that same benefit to all employees. Thus, it becomes a regular business expense as part of the employee compensation package. 

These types of expenses count as cash flow items. They are both debt components of the business as well as owner benefit in the form of compensation. While they detract from the Net, they are added back as discretionary items not necessary for the operation of the business. A new owner does not necessarily have to continue them.

However, some take this to another level. 

Death by a Million Cents…

A while back we had a liquor store on the market for $450,000. It did around $900,000 in revenues. However, the company was not profitable. The net income was negative. The seller had two other restaurants they ran, so did not take any money from the business, nor were they really involved in the operations. We added back a manager salary to get the cash flow up to $50,000, which is a VERY low SDE to market.

We could not find “hidden” money. There appeared to be no discretionary expenses. But the cost of goods sold (COGS) was higher than normal, so we focused there. 

The liquor store could also sell grocery products. Groceries fell under COGS. This accounted for the higher-than-normal costs. It turned out the seller had been buying personal groceries and groceries for their other businesses through the liquor store business.

These were small transactions individually yet totaled close to $45,000 in personal grocery expenses. That’s a lot of groceries by any standard. Death by 4,500,000 cents. The point is, that amount was not related to the operations of the liquor store. It is a discretionary expense. 

Now, set aside the liquor store. Consider this tanning salon.  

The business was a cash cow. The business owner owned other businesses as well. The tanning salon had financed a home remodel for the owner, serviced the debt for all the owner’s other businesses via a single SBA note, and serviced other items outside of its normal business operations to the tune of $124,000 of non-business-related, potentially discretionary expenses. 

Both the liquor store and the tanning salon were used for personal expenses, which for all intents and purposes can be considered anything unrelated to that business, INCLUDING expenses for other business ventures. However, only one of the businesses was able to capture and use those expenses as part of its cash flow. 

Why?

Proof.

Anytime there are personal expenses being run through the business there must be a paper trail showing payment from the business. There must be documentation to even consider the expense as a discretionary add back. In the case of the tanning salon there was a paper trail for all of it. Aside from the questionable legality of such practices, in order to prove the cash, one has to show the cash. 

When it came time for financing on the tanning salon, we had the receipts. Literally. Whether right or wrong, we could prove the cash came from the business. There was a lot of paperwork the seller had to provide, however. Underwriting was not an easy process.

In the case of the liquor store, all those smaller transactions were lost in the bulk of the COGS account. They could not identify and pull out the personal expenses. The cash flow resulting from those expenses was simply lost. It vanished. That cash flow, and subsequent value, was lost. 

The $40,000 to $50,000 taken from the business was the difference between a below-average cash flow, and one approaching $100,000. An SDE of $100k on a $450,000 asking price is a doable deal. It is nearly impossible to make any deal on a cash flow of less than $50k. The liquor store never sold.

Taxes That Ain’t Business…

I recall doing a financial recast on a company that manufactured a novelty food item. Their product was in a major nationwide retailer. The company had good numbers. On the Statement of Other Deductions I noticed an unusual line item.

MISCELLANEOUS (Ask my accountant): 40,000

That’s a big miscellaneous item. I asked the seller what it was. 

“My daughter’s tuition.”

Well, that’s not a business expense — that’s tax fraud. I do not recommend tax fraud, for the record.

Mixing personal and business expenses together is a slippery slope, the gravest consequence of which is being found guilty of tax fraud. I don’t know the penalties involved, but I am certain they are unpleasant.

Take this article from The Hill on the IRS cracking down on wealthy taxpayers:

In one case, an individual was ordered to pay more than $15 million for falsifying personal expenses — including the construction of a 51,000-square-foot mansion, luxury cars, artwork, country club memberships and homes for his children — as deductible business expenses.

Last I checked, the IRS was hiring. With greater labor force, they won’t stop with auditing the wealthy but will soon end up on Main Street. Mixing personal and business expenses can lead to serious consequences. Maybe not initially, maybe not for a while, but if it ever catches up then the consequences can be devastating.

Ninety-five percent of my past interactions have been with clean businesses. But stick around long enough and one encounters it all. That novelty food business, while not pursued by the IRS, did eventually discover a key employee embezzled hundreds of thousands of USD. The owner was paying for a lot more than his daughter’s tuition. 

Here’s One More Reason…

Skewing valuation, creating accounting headaches, and exposing yourself to tax problems are just some of the reasons to not mix personal and business expenses. And if you need another, here’s one more — it’s called piercing the veil. When you create a separate entity for your business (such as a corporation), you create a shield, a buffer protecting your personal assets from the liabilities or debts of the corporation. If you then proceed to ignore that separation and begin commingling personal and business expenses, a court could pierce that corporate veil and treat all of your assets (business and personal) as fair game. Ask yourself: If you’re not going to treat your business and personal life separately, then why should a court? If that veil is pierced, a lawsuit against your business could put your personal assets at risk.