While launching and growing your business, it’s likely that you’ve used funds from personal financial assets – such as personal savings, home equity funds, and personal credit cards – to start and keep your business running.
When you get used to this scenario you might think that the reverse is alright, too – that it’s okay to use business income for personal expenses. On the contrary, separating business and personal finances is essential.
In this overview, you’ll learn why you need to separate your business and personal finances, how to do this, and what to do if you’ve been co-mingling your finances. By following these steps, you can mitigate complications while better managing your business and protecting your personal assets.
What’s considered co-mingling of business and personal finances?
Co-mingling business and personal finances happens anytime you use funds from one of those to cover expenses from the other. Some examples might be buying office supplies using your personal debit card or using a business credit card to pay for your groceries.
Think of it this way: Business expenses should be paid using revenue from your business, while personal expenses should be paid using the salaries, hourly pay, or distributions that you receive from your business or any other sources of your income.
It’s important to note that, as a business owner, you can and should pay yourself, either through a salary or distributions from the business. However, this should be clearly reflected on your business’s balance sheet. Once your salary or distribution is taken, that money is yours to use in any way you wish (similar to receiving a paycheck from a job).
Why separating business and personal finances is important
Separating your business and personal finances ensures you have financial clarity and legal protection. It also simplifies your accounting, protects your personal assets, and improves your business credit.
In fact, the IRS requires that many business entities, including limited liability companies (LLCs) and corporations, maintain separate business and personal accounts. Even if your business is a sole proprietorship, keeping your finances separate makes it easier to do your taxes correctly, clarify anything if you’re audited, and can potentially provide a measure of personal protection, too. Here’s a closer look at the reasons to separate:
- Legal clarity and liability protection: Separating business and personal finances can help to protect your personal assets from business debts and liabilities. For example, when you form an LLC, the principals have personal-liability protection. This means that if the LLC defaults on debt or is sued, your personal assets aren’t at risk. Instead, liability is limited to what each owner invested into the business. However, if you co-mingle personal and business finances, what you invested –the amount that you’re responsible for – gets murky.
- Tax benefits: Separate accounts simplify the tax-filing process and ensures more accurate reporting of business income and expenses. Your risk of being audited can be higher when your finances are mixed.
- Improved financial management: Separate accounts help you better manage your business’s finances because they provide an accurate picture of what’s coming in from revenue generated, and what’s going out as business expenses.
- Professionalism and credibility with lenders: Banks and other lenders, as well as potential investors, typically require clear financial records. Consider this scenario: You’re applying for a business loan but, while reviewing your financials, your lender notices that your business financials show personal expenses. This makes it harder for a lender to accurately determine your business’s financial health, which may lead to denying your loan application.
Separating business and personal finances: Six essential steps
To ensure you’re complying with IRS and other requirements as well as protecting yourself (and your business partners), here are six steps you should take today:
1. Develop a relationship with a certified public accountant (CPA) or other accountant and adhere to their guidance.
Your CPA’s expertise will get your business financials set up correctly from the start. If your finances are co-mingled, they can detangle your current financial situation and resolve any potential issues.
If you don’t already have a CPA on your team, ask other business owners in your industry for recommendations. Then, have an initial meeting to discuss your situation and follow through on steps or recommendations that your CPA gives you. For some businesses, this may include changing your business entity, such as going from a sole proprietorship to an LLC to gain tax and other advantages.
In addition, when potential lenders see that you’re working with a CPA, it shows that you understand the responsibilities of financial management and compliance. While this isn’t necessarily a determining factor in loan approval, it will give your lender confidence in you and reflect favorably on you and your business.
2. Obtain an Employer Identification Number (EIN).
For most businesses, this is a requirement from the start. If you have a sole proprietorship with no employees, you’re not required to obtain one, but it’s still a good idea. It protects your personal information from identity theft (as opposed to using your Social Security number), helps your business establish a separate credit profile, and prepares you to add employees since you can’t hire one without an EIN.
Getting yours is free and it takes just a few minutes via the IRS, or your accountant can do it for you. Due to high rates of fraud, be sure that if you do this yourself, you only go through the IRS website, not any third-party websites.
3. Establish business accounts that are separate from your personal accounts.
If your business is in operation but you’re still co-mingling expenses, you should meet with your accountant to correct the situation. If you’re about to launch, as soon as you create your business entity, open a separate bank account for your business. This includes getting a business-only debit and/or credit card and, if needed, checks. In addition, if you’re using personal funds to launch your business, work with your accountant to ensure that your owner-equity infusion is properly tracked.
If you have multiple businesses – as many small business owners do – all of your business accounts must be maintained separately from your personal account and from each other. Although it’s common for owners of multiple businesses to “borrow” funds from one business to pay expenses of another, it’s out of compliance with the IRS and it’s a bad financial practice that could lead to tax problems and declined loan applications.
4. Apply for a business credit card or line of credit and only use it for business expenses.
Depending on which stage your business is in, you may have several credit card options, so select the one that’s best for your business needs and goals. This will help with separating business and personal finances, along with tracking expenses and establishing a positive business credit history.
In addition, be sure that any co-owners and employees who have access to credit cards or debit cards for your business also understand the importance of using them only for business.
5. Ensure that your business financials reflect best practices.
It’s important to know how your decisions and actions today could impact your business’s financial health in the long run. For example, many business owners use tax strategies to reduce their overall tax liabilities, but some strategies can work against them if financing is needed down the line.
When your accountant suggests tax strategies, be sure to ask about the potential impact on getting approved for a small business loan, since most businesses eventually will need one to grow. While you should take deductions, you also want to show some net profit, as this demonstrates your business’s ability to take on and repay new debt.
Another best practice is to conduct monthly or quarterly reviews of your financial activities to catch and correct any accidental co-mingling of personal and business finances. If that happens, work with your accountant to resolve the issues. You may also find other issues that need to be addressed – such as signatories on your accounts that need to be added or removed.
6. Keep receipts.
Although it can seem tedious, receipts provide valuable information at tax time, especially if your business is ever audited. Accurate financial records work in your favor, so do your best to establish them and keep them that way.
Best practices create business success
Establishing business best practices takes a bit of time up front, but it’s well worth the investment. These steps can save you from stress and potential expense down the road, should you ever have an audit or other challenge from the IRS, or need to apply for a business loan.
At Pursuit, we provide small businesses with financing and business resources that support your success. We have loans and a line of credit for businesses in New York, New Jersey, Connecticut, Pennsylvania, and Illinois – if your located in our service area, contact us to learn more about ways we can help.
