What’s the #1 rule for small business accounting and finance? Personal and business separation!
“Commingling funds” sounds like your money is having a party together, but in fact it’s one of the most common mistakes that small business owners make. Commingling is not keeping your business money and your private personal money separated. It’s a risky thing to do for a lot of reasons.
What does separation mean?
When you form a company, it becomes its own legal entity. The company then becomes responsible for all the actions of the company and its debts, rather than the company’s owners and officers. However, businesses that aren’t separately formed, and don’t maintain separation between owner finances and business finances can threaten that lack of legal responsibility. This then makes the owners and officers once again liable for the actions and debts of the company. It’s called “piercing the corporate veil.”
In order to keep that veil intact, make sure that the company is properly formed, separates its finances, keeps the purchase of assets and assumption of liabilities separated, and always does business with the business name rather than anyone’s personal name.
Why is business separation important?
The big reason is the very first one we’ve already covered: not creating a situation where owners and officers are liable for the company’s actions and liabilities.
The second most important reason is the IRS. Business expenses are deductible and personal expenses are not. You run the risk of being audited for deducting personal expenses (and having your expenses disallowed), or even for the IRS to classify your business as a hobby. The IRS particularly looks into several types of expenses specifically: travel, meals and entertainment, car expenses, personal rent and home office expenses, clohing and similar. Plus anything categorized as “miscellaneous” (my least favorite category). From the IRS website:
“It is important to separate business expenses from the following expenses:
1. The expenses used to figure the cost of goods sold,IRS website: Deducting Business Expenses
2. Capital Expenses, and
3. Personal Expenses”
The third reason for personal and business separation is that you can’t get a truly accurate picture of your profitability or cash flow if you’re commingling funds. It will likely always look as if you’re more or less profitable than you really are. It can be difficult to budget for or control business spending when you’re commingling funds. How can you tell how much business money you have if you’re constantly spending it on personal items? It’s also difficult to clearly show revenue and financial position if you’re always making “personal loans” to your business and repaying them from the same accounts.
Finally, another reason to avoid commingling is getting financing. Not having accurate records, or having records that show considerable personal withdrawals and personal spending can cause a lot of trouble when applying for loans or other funding. It isn’t good when your reports don’t make clear to the funder what state your company is really in. It may also suggest that your spending habits are not be in the best interests of your company. According the the Federal Reserve Bank of New York, more than half of all small business owners fail to obtain loans because of poor business credit and business habits.
7 Tips for keeping personal and business separate
1. Become an official business.
Establish yourself as an LLC, S-corporation, partnership or sole proprietorship. File corporation documents with your state secretary of state or corporation division. Get an official EIN with the IRS. Sites like LegalZoom and Rocket Lawyer can help you with the legal setup part.
2. Keep Separate Bank Accounts.
Maintaining separate bank accounts for personal funds and business funds is the most important thing that you can do to avoid commingling. Use the business bank account to pay yourself and purchase business expenses only. Use the income from your business and your personal bank account to pay for all your personal expenses.
3. Keep track of your business expenses.
Keep track of your business expenses using either spreadsheet software or bookkeeping software. Categorize the expenses using the standard IRS categories for deductible expenses. This helps you be aware of what you’re spending your money on. It also helps you be aware of accidentally spending your business funds on personal items. You should also keep receipts for your expenses to prove that you made them (credit card statements are not allowed as receipts).
4. Pay yourself a salary.
You can base your salary on your business’s profitability. It’s much easier to see that if you’re not using business funds for personal spending! Setting up a personal income, and keeping that personal income separate from your business income is an important step and key part of separating business and personal finances.
5. Always use the Business Name.
If you purchase assets for the business, do it under the business’s name, not your own. When you accept a business loan, do it under the business’s name. If you have a contract with someone, the contract should show the business name. For that matter, all of your business financial and legal transactions should only show the business name. That includes invoices, receipts and other business documents.
6. File taxes as a business.
Your CPA will likely thank you for keeping your personal and business income separated! You can also maximize your deductions this way if you’ve been keeping track of business expenses. It’s also a cost savings to be separated, as your bookkeeper and/or accountant doesn’t have to spend time separating them out, or tracking your personal spending.
7. Build business credit.
Open a business (not personal) credit card in your business’ name and use it for business expenses. Use one that reports to business credit bureaus rather than personal ones. Make sure to always pay it on time to build credit. You can often deduct the finance charges on your taxes as well. The other option, using personal credit cards to finance business operations, can potentially damage your personal credit in many ways and will pierce the corporate veil of personal accountability for business activities.