Business Tax Preparation · Advising the business taxpayer

Comingling (e.g., personal usage of business accounts, separation of business and personal accounts)

Commingling is not itself a Code provision, and there is no penalty for it. Its cost is indirect and much larger than the direct one: it converts every deduction on the return from a documented fact into a contested allocation, and it supplies the evidence for a set of arguments the taxpayer would otherwise never face.

The rule

The bar it runs into. except as the chapter expressly provides otherwise, no deduction is allowed for personal, living or family expenses^TY2026 (IRC § 262(a)). Nothing in IRC § 162 rescues an expense that IRC § 262 has already denied.

Where separation becomes evidence. carrying the activity on in a businesslike manner and maintaining complete and accurate books and records may indicate a profit motive — the first of the nine factors, and the one a taxpayer controls entirely^TY2026 (Reg. § 1.183-2(b)(1)). This is why mixed accounts matter beyond the individual items — they are the first factor in the profit motive enquiry, and the taxpayer controls it completely.

And the enquiry is not arithmetic. all facts and circumstances are taken into account, no one factor is determinative, the listed factors are not exhaustive, and the determination is not made by counting factors on each side^TY2026 (Reg. § 1.183-2(b)).

The consequence if the activity loses. where an activity is not engaged in for profit, no deduction attributable to it is allowed except as IRC § 183(b) provides — the deductions allowable without regard to profit motive, and then others only to the extent gross income from the activity exceeds those^TY2026 (IRC § 183(a) and (b)), with the statutory safe harbour: where gross income exceeds the attributable deductions in 3 or more of the 5 consecutive taxable years ending with the year in question, the activity is presumed engaged in for profit unless the Secretary establishes otherwise — 2 of 7 years for an activity consisting in major part of breeding, training, showing or racing horses^TY2026 (IRC § 183(d)).

The dwelling unit rule. {fig:com.280A} (IRC § 280A(a)).

And where a corporation is involved. A personal expense paid by a C corporation for its shareholder is not a deduction and does not stay neutral: an amount a C corporation pays a shareholder that is not deductible compensation, rent or interest is a distribution — a dividend to the extent of earnings and profits, then a reduction of stock basis, then gain from the sale of the stock^TY2026 (IRC § 301(c)). In an S corporation it is a distribution reducing basis, or wages if it is really compensation.

What an examiner does. IRM 4.10.3.9 sets out a bank record reconciliation in five steps — reviewing the taxpayer’s own reconciliation, reviewing monthly statements, analysing deposits, reconciling deposits to gross receipts, and analysing cheques and electronic transfers. the examiner reconciles income reported on the return to the taxpayer’s books and records by asking how income was computed and duplicating the taxpayer’s steps; where the two cannot be reconciled the taxpayer is asked to explain how the book accounts were accumulated for the return^TY2026 (IRM 4.10.4.2.3.5).

Current figures

How it works in practice

The real cost is evidential, not arithmetic. A business with a dedicated account produces a bank statement that is a list of business transactions; an examiner reconciling deposits to gross receipts has a clean starting point and the burden of raising an issue. A business with one account produces a statement in which every line is a question, and the reconciliation the IRM directs becomes an item-by-item negotiation the taxpayer must win repeatedly.

Separate accounts are the cheapest evidence of profit motive there is. Reg. § 1.183-2(b)(1) puts the manner in which the activity is carried on first among the factors, and specifically mentions maintaining complete and accurate books and records. A taxpayer whose loss-making activity runs through a personal chequing account has conceded the one factor entirely within their control before the argument starts.

Do not rely on the IRC § 183(d) presumption as a plan. It is a presumption, not a rule: three profitable years in five shifts the burden, and the Secretary may still establish the contrary. It also arrives late — a taxpayer whose activity is being examined in year three cannot invoke a five-year record that does not yet exist.

Personal spending from a corporate account has three possible characters, none of them good. It is a constructive distribution, taxable under IRC § 301(c) to the extent of earnings and profits; or it is disguised compensation, deductible but subject to employment tax and reporting; or it is a loan, which then needs a note, a rate, a maturity and repayments to survive scrutiny. What it never is, without more, is a deductible business expense.

Allocate deliberately and record the basis at the time. Where an item genuinely has both characters — a vehicle, a phone, a room in a house — the answer is a contemporaneous allocation method, not a percentage chosen at year end. For the vehicle and the phone the substantiation rules apply; for the room, IRC § 280A applies and the exclusive use requirement is unforgiving.

Advise on process, not on individual items. The remedy is structural: a separate account, a separate card, an owner’s draw or salary run at a fixed interval, and personal spending done from personal money. Every item-level fix leaves the underlying evidential problem in place.

Scenarios

Traps

How this has changed

IRC § 262 and IRC § 183 have been substantively stable for decades, and the nine factors in Reg. § 1.183-2(b) have not been amended since they were promulgated. What has changed is the evidence available on both sides. Electronic banking, card-level transaction data and accounting platforms that classify at the point of entry make genuine separation cheaper than it has ever been, and make its absence harder to explain as an administrative accident.

The consequence of losing an IRC § 183 argument became materially worse in 2018. Before then a not-for-profit activity’s deductions under § 183(b)(2) were allowable as miscellaneous itemized deductions subject to the two percent floor, so a taxpayer with gross income from the activity recovered some of the costs. With those deductions suspended — permanently, since Pub. L. 119-21 § 70110(a), which also moved the suspension from IRC § 67(g) to § 67(h) — the § 183(b)(2) category now yields nothing at all. A hobby loss determination today means the income is fully taxable and the expenses are not deductible in any amount beyond those allowable anyway.

The IRM’s examination technique has moved toward electronic records. IRM 4.10.3.9 now contemplates electronic funds transfer analysis alongside cheque analysis, which makes a mixed account easier to dissect rather than harder.

Exam focus

Know that the disallowance is IRC § 262(a) and that it operates before IRC § 162 is reached, so an otherwise ordinary and necessary characterisation does not save a personal expense.

For IRC § 183, know the consequence in § 183(a) and (b), the presumption in § 183(d) with both the general and the horse variants, and that Reg. § 1.183-2(b) forbids deciding by counting factors.

Know the first factor by name and content — the manner in which the activity is carried on, including complete and accurate books and records — because it is the factor commingling directly defeats.

For a corporation, always give the second consequence: disallowance plus constructive distribution under IRC § 301(c), or wages.

Finally, remember that the practical damage is evidential. Questions framed around an examination usually turn on the taxpayer being unable to substantiate rather than on any single item being non-deductible.

Check yourself

1. A sole proprietor pays business and personal expenses from one account but keeps every receipt and can identify each payment. Has commingling cost anything?

Answer: Less than usual, but not nothing. The IRC § 262(a) analysis is item by item and complete receipts answer it, so the direct exposure is small. Two indirect costs remain. Reg. § 1.183-2(b)(1) weighs the manner in which the activity is carried on, and a single mixed account is weaker evidence of businesslike conduct than a dedicated one. And on the income side the reconciliation of deposits to gross receipts under IRM 4.10.3.9 becomes an exercise in explaining every non-business deposit, which receipts for expenses do nothing to help.

2. An activity produced net income in years 1, 2 and 4 and losses in years 3 and 5. May the taxpayer invoke IRC § 183(d) for year 5?

Answer: Yes. The presumption applies where gross income exceeds the attributable deductions in 3 or more of the 5 consecutive taxable years ending with the taxable year in question, and years 1, 2 and 4 give three profitable years in the five ending with year 5. The activity is therefore presumed engaged in for profit for year 5 — but only presumed: IRC § 183(d) preserves the Secretary’s ability to establish the contrary, so the presumption shifts the burden rather than settling the question.

3. An S corporation pays its shareholder’s personal utilities of $9,000 and deducts them. What are the consequences?

Answer: The deduction is denied by IRC § 262(a), and the $9,000 is a distribution to the shareholder — reducing stock basis under IRC § 1367(a)(2)(A), and producing gain to the extent it exceeds basis under IRC § 1368. If in substance it is remuneration for services it is wages instead, with employment tax, withholding and Form W-2 reporting. The one thing it is not is neutral: an S corporation cannot pay a shareholder’s personal costs without the payment being characterised as something.

4. Why does Reg. § 1.183-2(b)(1) matter more to a preparer than the other eight factors?

Answer: Because it is the only factor entirely within the taxpayer’s control and it can be fixed prospectively at almost no cost. Expertise, time and effort, the history of income and losses, the taxpayer’s other income and the elements of personal pleasure are all facts about the taxpayer’s circumstances. The manner in which the activity is carried on — a separate account, complete and accurate books, a written plan, a change of method when something is not working — is a set of decisions. Advising on it is the highest-value thing a preparer can do before an IRC § 183 argument arises.

5. Why is losing an IRC § 183 argument worse now than it was before 2018?

Answer: Because the deductions IRC § 183(b)(2) allows up to the activity’s gross income were miscellaneous itemized deductions subject to the two percent floor, and those are suspended. Before 2018 a taxpayer found to be pursuing a hobby still recovered some costs against the activity’s income; now the § 183(b)(2) category yields nothing, so the gross income is fully taxable and only the deductions allowable without regard to profit motive under § 183(b)(1) survive. Pub. L. 119-21 § 70110(a) made the suspension permanent and § 70110(b)(2) moved it to IRC § 67(h).