It can be difficult to keep your personal and business finances separate when you own a small business. It is especially challenging to keep your accounts divided if your business is structured as a sole proprietorship. Since sole proprietorship is considered a nonentity, there is no legal separation between you and the business.
When you set up your business as a Limited Liability Company (LLC) or corporation, however, you must have separate business bank accounts. Keeping the two separate, no matter how your business is structured, will create challenges and even lead to legal troubles. But, the separation of personal and business expenses also simplifies your life immensely by saving you both time and money. And, it’s not as difficult as you may have assumed.
Defining Personal Vs. Business Expenses
It’s essential to understand how personal expenses and business expenses are defined before we can separate them. According to the IRS, businesses can claim tax deductions on business expenses. A business expense is defined as: “Both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.” Expenses incurred in maintaining and running your business are considered business expenses. Among them are:
- Equipment and supplies
- Insurance and taxes
- Office rent
- Wages and salaries
- Activities and resources related to professional development
- Business travel
If you’re familiar with most other accounting terms, there’s also a lot of a grey area here. For example, in the case of a business run that’s from home, a portion of your home expenses, such as your mortgage or utilities, can be deducted as a business expense.
In general, the distinction between business expenses and personal expenses is typically crystal clear. Next, let’s quickly explain why it’s absolutely necessary to keep your business and personal finances separate.
One of the most important reasons to separate your personal and business finances is to minimize your tax burden. Again, business-related expenses, such as office supplies and travel, are tax-deductible for business owners. However, you must have appropriate supporting documentation, like receipts, in order to claim these deductions. During an IRS audit, they’ll carefully examine every expense to ensure it relates to your business. If you have a dedicated business account, keeping detailed records of business expenses and how you paid for them will simplify this process.
Personal asset exposure.
Establishing your company’s structure is vital for legal protection. Whatever legal structure you choose for your business determines your risk, liability, and tax responsibilities. Protecting personal assets is one of the reasons business owners set up an LLC or corporation. Even if your business structure protects you legally, if you’re sued, and the court cannot clearly segregate your business and personal finances, you may still be held personally liable for business debts.
Your legal protections vanish if your business and personal finances are not separated, and a court may be able to “pierce the corporate veil,” which means your assets could be seized. In these situations, creditors may pursue your personal assets to collect unpaid business debts, such as your bank account, investments, home, or other possessions. Keeping a separate account for business expenses will help you avoid this situation. Likewise, never deposit company checks into your personal bank account. In short, you can safeguard your personal assets by keeping your business and personal accounts separate.
Building business credit history (and qualifying for financing).
Keeping your business and personal credit histories separate is also important. Lenders will examine your individual creditworthiness, as well as your business’s history of repaying its creditors. Why? To establish your business as a separate entity with a unique credit history and credit history that is different from yours as an individual, you’ll need to establish separate accounts in the business’s name.
Ease of record keeping.
Searching through your personal documents for business purchases or payments to track can be a time-consuming and stressful endeavor. The best way to save time, along with maintaining your sanity, is to keep things separated. Moreover, this can help you get a clearer picture of your cash flow. Also, this makes tracking expenses a breeze. And, it provides some much-needed peace of mind.
How to Keep your Business and Personal Finances Separate
Now that we’ve gone over why it’s essential to keep your business and personal finances separate, let’s discuss how you can put this into effect. In comparison to personal accounts, business accounts — whether checking, savings, or debit and credit cards — are set up very differently. Accounting integration, cash back for businesses, and bank account management are some of the features available for business accounts. Here are eight suggested steps to separate your business and personal finances:
Step 1: officially register your business. As you know, there are many types of business structures available. When you choose your business structure, you must be careful as it impacts your capacity to raise capital, the amount of taxes you pay, and your personal liability. By structuring your business as a corporation, a limited liability company, or an S corporation, you have a separate legal identity from all other shareholders in your company. Incorporation provides the most significant protection from liability for its owners, increases an organization’s credibility, and enhances capital access. However, this type of business structure is also more costly. The higher cost is because of additional administrative requirements, higher taxes, and more rigorous record keeping. Before registering your business, make sure to research your options. I’d recommend reviewing the guide on starting a business by the U.S. Small Business Administration if you’re stuck.
Step2: Obtain an Employee ID Number (EIN). Business EINs are like social security numbers. To separate your social security number from your business transactions and documentation, you must obtain an EIN. You will be assigned this unique nine-digit number by the IRS when you register your business with the agency. Business-related tax-related activities and establishing a bank account are possible with this number. It is a valuable way of separating your business assets from your personal assets, and it prevents identity theft. The process of applying for an EIN is entirely free of charge and takes just a few minutes through the IRS website.
Step 3: Open a business bank account. After you’ve determined what products and services you need for your business finances, you can ask a banking professional for further recommendations. Once you understand what your bank offers and how it can suit your business needs, you can open up a designated account. What if you’re a sole proprietor operating a business under an assumed name? To open a bank account in the name of your business, you need to register it with your state. Your Employer Identification Number (EIN) is then used by the bank for opening your business account.
Step 4: Consider a business credit card. Even though it is optional, a company credit card is another way to separate business and personal purchases and keep track of business expenses. Separating accounts can also be helpful when it comes to claiming tax deductions. Furthermore, you will be building separate business credit and personal credit by responsibly using your business credit card. First, choose a card that caters to your business needs. For instance, you can find cards without annual fees, or those that offer cash-back or travel rewards. Also, consider your payment habits, like if you’ll pay off the balance every month and if your employees can use the cards.
Step 5: Set up utility accounts in the company’s name. Your business should pay for utility services under its name. Services such as business phones, cell phones, internet, electricity should all be included. It’s important to manage these service accounts as they are the monthly expenses your business incurs.
Step 6: Track your expenses and receipts. In the absence of separating your personal and business finances, looking over your checking account statements may take hours. As such, that could lead to a serious investment in ibuprofen. Again, this is when having separate bank statements for business and personal accounts is beneficial. By reviewing your monthly and end-of-year statements, you can verify the financial records of your business, like how much you spent and what business expenses to reduce.
Step 7: Pay yourself a salary. Establishing a formal boundary between your business and personal finances is easier if you pay yourself a salary. Then, as if you were working for someone else, transfer money from your business account to your personal checking account once or twice a month. If you pay yourself a salary, you determine when and how you will withdraw funds from your business, instead of just using your business funds whenever you need them.
Step 8: Educate other members of the business. We will need to make sure all business stakeholders are on the same page before separating business and personal finances. In business, separating your personal and business finances won’t make any difference if other members aren’t on board. Everyone involved in the decisions needs to be with you in an all-hands-on-deck effort. Establish a system to help people separate business finances from personal finances and ensure everyone knows the difference between them.
Using a straightforward method for identifying your business income should not be underestimated. In fact, when you work with a bookkeeper or accountant, they will insist on keeping your finances separate from your personal finances. Besides, it just makes life easier.
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Copyright ©John Trenary 2021