I accidentally paid my S Corp's expense with my personal credit card. What do I do now?

Things happen and sometimes we mistakenly pay our business expenses with our personal credit cards. Can we still deduct those expenses even though they were paid from personal funds? The answer is yes - but you need to know an accounting workaround.

Let’s break it down step by step so it’s easy to understand.

So, what is the issue?

Before 2018, you could deduct unreimbursed business expenses on Form 2106 of your personal return. It wasn’t a full deduction, since only the part of those expenses that were more than 2% of your adjusted gross income could be deducted and only if you itemized. Due to the Tax Cuts and Jobs Act, those deductions are currently suspended. That means you can’t deduct them at all on your personal return.

Also, you can’t put these on Schedule E of your 1040 either. Courts like in Russell v. C.I.R., T.C. Memo 1989-207, said that shareholders can’t deduct these expenses on their personal returns just because they paid them.

However, the IRS still agrees to take this deduction as long as it was entered on the S Corp tax return. But the main question is: how do you show this expense on the 1120 S return? This expense was not paid out of the business bank account and does not show on the S Corps financial statements.

Two Ways Your Out-of-Pocket Expense Can Be Treated by the IRS:

1. A loan to the corporation OR

2. A contribution to your corporation.

And the classification depends on your accounting entry

1. Loan From the Shareholder

Your journal entry would be:

Debit: Expense

Credit: Shareholder Loan

This journal entry increases shareholder debt basis. However, if you treat the money you spent as a loan to the S corporation, it must be documented that way. This means creating a repayment schedule and calculating (and making) actual payments on the loan. If you don’t properly record it as a loan, you can’t treat it like one.

2. Capital Contribution – An Easy Solution!

The IRS allows you to treat the out of pocket payment as putting more money into the business—as a capital contribution.

This workaround is the easiest one, since you can post a journal entry when preparing a tax return post-fact. Since it’s not a loan, and no repayment schedule or associated payments are required, there is no time-sensitive requirement to adjust your financials.

In my experience, this works very well for disorganized clients who try to scramble for tax deductions at tax time. I usually ask them to go over their personal bank statements and look for business-related expenses. After that, I just post a journal entry and voilà! The expense is on your books and on the tax return, passing the deduction to the shareholder’s personal return.

What’s the journal entry, you ask me? Here it is, my guy:

Debit: Expense

Credit: Capital Contribution

Capital contribution increases paid-in capital (APIC) on Schedule L of the 1120S. So yes, if you continuously make these types of journal entries from year to year, your APIC account will be growing.

Another Option: Create an Accountable Plan.

An accountable plan would be an even better solution, since the owner would be able to get cash out of the S Corp tax free during the year.

The journal entry for an accountable plan is:

Debit: Expense

Credit: Cash

And you do need to create legal paperwork for the accountable plan and also make timely reimbursements. Here is more information on the accountable plan.

IRS Audit Tax Pro Tip:

When the IRS risks 1120Ss, they specifically look if the shareholder’s Schedule E on their form 1040 shows a plug for personally paid S corporation expenses ( Similarly to UPE in partnerships). But while with partnerships, this technique is allowed, with S Corps this technique does not fly. If you want the IRS to accept the expense that was paid out of a personal account, you need to imploy one of the techniques that I mentioned above.

Final Thoughts:

The IRS doesn’t let shareholder-employees casually deduct expenses on their personal returns unless they flow through the shareholder K-1 form. (If they did, our CPA life would be so much easier!)

Knowing the difference between a loan, a capital contribution, and an accountable plan can help legally save on tax.

Feeling overwhelmed by it all? I don't blame you. We’re here to help - as our focus is only on S Corp business owners. Please feel free to check out our services here.

Key Sources & Citations:

- IRC § 67(g) – Miscellaneous itemized deduction suspension

- IRC § 162 – Business expense deductions

- Russell v. C.I.R., T.C. Memo 1989-207

- Cavalaris v. Comm’r, T.C. Memo 1996-308

- Grossman v. Comm’r, T.C. Memo 1974-269

- Rev. Rul. 57-502