Separating Business and Personal Finances for Small Business Owners
The reasons to start a small business and be your own boss are too numerous to mention. Profits go directly to the business owner, providing a sense of enjoyment and pride. There are risky challenges, but great rewards as well.
Small business owners take all of the actions necessary to design a business that will provide maximum benefits to themselves. However, with hard work and success comes the importance of separating business and personal finance.
It's easy for small business owners to rely on mixing their personal and business funds, but it's always best to separate your business from your personal finances.
It doesn't matter whether you're starting a new business or strengthening an existing one, if you really want to boost your chances of success, then you should adopt the principle of financial separation.
Business Entity Accounting Concept
If you have a background in accounting, you will be familiar with an accounting concept known as the business entity concept. The business entity concept states that the business is treated as a separate entity from its owners.
Here's an illustration of the business entity concept:
Think about a name; let's say John. John owns a bakery called "John's Cakes." According to the business entity concept, John's Cakes is treated as a separate entity from John, the owner.
This means that John has his own personal bank account, where he deposits his salary, pays his personal bills, and manages his household expenses. John's Cakes has its own bank account. This account is used for business-related transactions like buying ingredients, paying employees, and collecting payments from customers.
If John takes $1,000 from his personal savings and invests it in John's Cakes, this transaction is recorded in the business's books as a liability (or equity) owed to John.
The business entity concept ensures that John's personal financial activities are not mixed with the business activities of John's Cakes. Through this concept, John's Cake can get a clearer view of the financial health of his cake business.
I used the illustration above to explain the meaning of separating business and personal finances, so you don't start wondering what it means. Are you a business owner? Do you separate your personal and business finances?
If you aren't doing so, you will definitely have problems during tax filing. Either you will be paying more taxes or you will pay less. Whichever way, you might get into trouble with the IRS.
How to Separate Business and Personal Finances
Separating business and personal finances is crucial for financial clarity and tax purposes. Here are key steps to achieve this:
- Open separate bank accounts for each entity.
- Get a business credit card for business expenses.
- Create a clear and detailed budget plan.
- Pay yourself a salary from business earnings.
- Use accounting software to track expenses accurately.
- Maintain organized records for all financial transactions.
- Hire a professional accountant for financial advice.
- Reimburse personal expenses used for business purposes.
- Avoid mixing personal and business assets.
- Ensure distinct invoicing for personal and business activities.
- Register your business as a separate legal entity.
- Set up a formal business structure, like an LLC.
- Establish a clear paper trail for all expenses.
- Keep detailed receipts for all business purchases.
- Regularly review and reconcile business bank statements.
The Importance of Separating Business and Personal Finances
Naturally, there are a lot of benefits to separating business and personal finances; otherwise, most business experts wouldn't advise business owners to do so.
Here are three fundamental benefits of separating business and personal finances:
1. Legal and Tax Implications
Legal and tax issues could arise if a business does not separate business and personal accounts and something occurs where the business lacks the resources to fulfill its responsibilities. Creditors are often willing to look toward the owner's personal accounts for satisfaction.
What most business owners and other individuals fail to realize is that once a business is formed, it too has a credit report and can be declared bankrupt.
Additionally, separate bank accounts offer proof of business records, which can be used to back up data from accounting software when the IRS or credit agencies investigate a business.
Maintaining business finances is also a great step in helping protect businesses from accusations of fraudulent activity and getting the tax deductions that you qualify for.
2. Professionalism and Credibility
Some potential clients may consider a small business owner who fails to separate business and personal finances as unprofessional or lacking in adequate financial management skills.
If a client assumes that the owner handles business matters carelessly, he may not want to trust the quality of his project to that business owner or make a major purchase.
The business owner will want to put the client's mind at ease that his business is managed well and that the business entity has sufficient financial stability to complete the project in a satisfactory manner.
Proper separation of business and personal finances addresses the professional business image.
3. Financial Clarity
When you are first starting your business, your accounting system may be something as simple as a handwritten journal. That doesn't provide much in the way of financial reports.
As your business grows, so will your need for more financial clarity. You will need clear, up-to-date financial information to identify potential business opportunities or personal financial risks and to respond to other opportunities and risks.
You may also need specific financial reports, such as a personal financial statement, to support your financing requests. Furthermore, you will need to measure your business and your personal financial health separately and communicate this information between your business and your personal finances.
This means that you will need to maintain your personal finances separately from your business's finances. Remember, any financial statements that include your personal finances should be communicated separately.
Best Practices for Maintaining Separate Finances
With the risks of combining business and personal finances established, it should be at the top of your list to separate the two right away.
You should have separate bank accounts as well as consider getting a business credit card in the name of your business and not in your own personal name. You should also develop a budget and stick with it.
These best practices are discussed in more detail below.
1. Opening separate bank accounts
The first step in separating your business and personal finances and establishing your business's separate credit profile is to open a business checking account.
Your business is a separate entity from yourself and should have its own separate bank account to keep clear records. A business bank account is a necessity as it simplifies filing taxes and also reduces the risk of personal versus corporate expense disputes.
You can use the business bank account to deposit any funds the business earns, and by not mixing it with your personal money, you can reduce any confusion about what the company has earned and what money is still available to be distributed elsewhere.
Even if you are a sole proprietor and your business is unincorporated, it's a good idea to open a separate business bank account from your personal account because it's easier to track business expenses and you'll have a record of the transactions that you can use when preparing your taxes.
Business bank accounts also provide legal protection, reduce personal liability, and increase the credibility of your business. You'll be asked to provide certain information on the application documents and may be requested to provide additional documentation.
2. Using separate credit cards
Once you have a business checking account open, you should apply for a business credit card. There are several choices to consider when deciding on the credit card that is right for you. Some cards offer reward points that can be redeemed for travel, cash back, and merchandise, while other business cards keep business and personal spending separate.
However, choosing the business credit card that best meets the needs of the business and takes advantage of rewards points can help build the business’s credit history. Some cards are specifically designed to help business owners establish and build their business credit.
No matter what card you choose, remember to use your business credit card responsibly. Promptly pay your bills when they are due. It doesn’t matter what type of business you have. As long as you act as the owner of your business, your business credit card will be a part of your business credit profile.
Keep business transactions in their rightful categories. Small business retailers should keep business sales separate from personal expenses. Online retailers and other service-oriented businesses should do the same. It’s always a good idea to have department numbers on file to keep business and private transactions separate.
3. Maintaining detailed records
A third step in this effort is to be sure to obtain and maintain documentary support for all transactions, to show who and what (to the extent possible) and when. This might mean scanning and retaining copies of checks used for payment, as well as receipts or invoices for sums received as the result of sales or payments of loans or settlements of disputes.
Amounts paid or received in cash are particularly problematic, and prior to paying in cash, one should obtain a receipt as documentation.
The next thing to do is classify who and what. This requires using some form of account number system. The account number should be used in a chart of accounts. The system can be organized into responsibility areas (e.g., revenue, cost of goods sold (COGS), office supply expenditures, etc.).
Retention of expenditure and revenue classification detail over time generally reduces the time and effort expended in the preparation of the business return, potentially involving not only the individual owner's return but also payroll, sales, real estate, or other tax returns.
As a small business owner who is in charge of handling almost every aspect of your business, including bookkeeping and accounting, the best way to go is to buy the best bookkeeping software to help you with income and expense tracking, handle bank reconciliation, generate financial statements, and many more services.
4. Develop a budget and stick to it
A budget is an estimate of revenue and expenses over a specified future period of time. The purpose of setting up a budget is to have an estimate of where revenues will come from and how much will be spent in order to reach the objectives set for the business.
A signed budget is a corporation's internal financial plan for the forthcoming period. Budget estimates form the basis for business planning, and its associated performance targets, as well as overall corporate management actions. Ask your bookkeeper/accountant, financial advisor, or bank if you need help preparing a budget.
To set up a budget, you simply estimate income and expenses. Income is the money that comes into your business for the goods or services that you provide. Expenses are continual costs (power, rent, insurance, salaries) and occasional costs (advertising, printing, phone, etc.).
A simple way to draw up a budget is to use the "buckets'' budgeting approach. Use separate bank accounts if possible to separate your various revenue and expense sources.
A "buckets'' system separates your main income source (i.e., direct deposits) from other income sources and automatically co-mingled income.
5. Pay yourself a salary
Paying yourself is a critical part of separating business and personal finances. If you are not paying yourself a salary, you will often find yourself taking the business funds to solve personal problems without returning them to the business because you lack proper record keeping.
Therefore, if you start paying yourself salary, then you will have enough money of your own to spend on personal problems, include of withdrawing for personal use.
If you're self-employed and have no employees, the difference between the roles you and your business play is a bit fuzzier when it comes to tax time, but your income and expenses should still be recorded meticulously as separate items in your bookkeeping software.
When tracking your income, separate any sales taxes that should be paid to the government from the sales you plan to pay yourself – keeping these sums separate, in your business bank account, will make it much easier to set aside enough to stay on the right side of tax law.
Common Mistakes When Mixing Business and Personal Finances
In the process of separating your business and personal finances, there are some costly mistakes that you must avoid. They include the following:
- Using personal accounts for business expenses
- Failing to set up a business bank account
- Not maintaining clear records of transactions
- Mixing personal and business credit card use
- Ignoring the need for proper financial documentation
- Not paying yourself a formal business salary
- Overlooking the tax implications of mixed finances
Conclusion: Separating Business and Personal Finances
The process of separating business and personal finances does not end with the opening of separate bank accounts. In order to remain separate, it is important to avoid intertwining such finances in their entirety.
At a minimum, a small business owner should refrain from using business checks and credit cards for personal expenses and should avoid making business or personal payments out of the wrong accounts. A small business owner accessing business funds should either draw a proper wage or use long-term loans.
If a small business owner desires a return on their investment in addition to compensation for their labor, the funds drawn in repayment of equity are not wages to the owner and should not be entered as expenses (paid in general). The assets of the owners and the business are separate entities.
Failing to differentiate between the funds of a small business and those of the small business owner can result in confusion about the true performance and worth of the business.
