Not separating personal and business finances is a common mistake among small business owners. In some respect, it may sound more straightforward to have all your money in one place. On the other hand, for all its lack of agency, cash tends to “disappear” if you don’t keep a close eye.
You may overspend or use the money you’d set aside for something else. Clumping your funds in one place can also be a nightmare at tax time, as we’ll discuss in the next section. After which, we’ll explore ways you can keep your personal and business finances separate.
I | Why You Should Separate Personal and Business Finances
It grants legitimacy.
It’s incredible how simple things like business cards and a professionally designed website make you look legit. Untangling your personal and business affairs sends the same message. It makes you look like an actual business owner to your clients, vendors, and of course, the IRS. Legitimizing your business is an asset when tax season rolls around.
It protects your assets and credit.
The IRS distinguishes between hobby and business when it comes to your taxes. The passing of the Tax Cuts and Jobs Act (TCJA) in 2018 implemented stricter guidelines to classify the two.
Without a clear line between your personal and business expenses, the IRS may audit your company and deny business deductions and company losses. This will affect your credit score if you take out loans in your name instead of your company’s.
If your commercial venture fails in the end, you’ll feel the consequences for a long time. This lowered score could affect your purchasing insurance or taking out loans to buy a car or a home. Separating your personal assets and those set for business purposes removes you from the gray area.
It helps track your company’s growth.
A part of monitoring your company’s growth is tracking your profit gains. The most straightforward method is to pool your business income into one account. It takes the guesswork out of determining if you’re making money or spending more than you’re earning. Avoid cash flow problems by separating your funds for easy tracking.
It grants legal protections.
By co-mingling your finances, you eliminate the personal liability protection granted by creating a corporation or a limited liability company. With the court’s backing, creditors can lay claims to your personal assets to satisfy compensation claims if you tangle up your finances.
By observing the conditions and formalities of establishing a separate business entity, you protect yourself from major legal disputes and resulting losses.
II | Simple Steps for Keeping Personal and Business Funds Separate
So bearing in mind the reasons for marking a clear line between personal and company funds, the general principles of the steps below are:
- You can’t spend by mistake what you have no access to;
- And developing financial discipline will protect your cash flow.
You can’t be lazy about your money, nor should you take shortcuts. The little extra time you spend splitting the two now saves you time and costly blunders later.
Let’s explore the steps and get you on track to safeguarding your finances.
1. Apply for an Employer Identification Number (EIN)
Applying for an employer identification number (EIN) is critical in setting up your business. You’ll use this unique nine-digit number assigned to your company by the IRS when:
- Filing your company’s income tax return;
- Filing for payroll tax return;
- Establishing your business entity;
- Opening a business bank account,
- Applying for a business credit card;
- Applying for business loans, etc.
Applying for an EIN is free. Download the application form from the IRS website, fill it out, and submit it electronically. Once the information you provided is validated, you’ll receive an EIN.
Your EIN acts as the business version of your social security number. It marks the first line in establishing a separate business credit since you’ll no longer use your SSN for company matters.
Note: Sole proprietors don’t require an EIN. But as you’ll learn when reviewing the structures available, being a sole proprietor makes you liable for debts incurred by your company.
2. Establish a commercial entity
With your EIN, you can now fully put your plans of becoming an entrepreneur into action and establish a legal entity for your company. Most freelancers set up LLC (Limited Liability Company), but there are other options like C Corp and S Corp.
In all three mentioned setups, the owner assumes no personal liability if something goes wrong with their products or services.
Your liability is limited to the amount of investment in the LLC.
Therefore, you’re not personally liable for the debts of the LLC.
Without any personal liability, there’s a layer of protection between your personal assets and creditors.
If you’re uncertain about which structure to choose, check the Small Business Administration. They offer expert tips on each format, how they work, and who’d benefit the most from each structure.
Your corporate system will determine how you register your company. Each structure comes with different legal implications. Seek advice from a legal expert to be on the safe side.
3. Create a separate business bank account
Widen the division of your personal matters from company interests by separating your money. Open a business checking account strictly for company use:
- Paying bills;
- Collect customer payments;
- Pay commercial vendors;
- Lease for office space;
- Paying employees;
- Buy work equipment.
Having a business bank account simplifies tracking your financial records and preparing bank statements when tax time comes.
4. Apply for a business credit card
Same as with your bank account, apply for a business credit card. More than 50% of small business owners in the US finance their operations with credit cards. (Source) It helps with consistent financing and increased financial flexibility.
A business card has other advantages besides keeping your company and personal finances separate.
- It builds your business credit score, which comes in handy in the same way your personal credit score does. It proves your responsibility as a business owner to manage your debt. If you see your business expanding or plan on getting a higher line of credit, your business credit score is an essential asset.
- It helps you access better terms like higher spending limits and extended interest-free repayment.
- It gives you access to company-specific rewards with more travel miles, higher cash-back percentages, and sign-up bonuses.
Don’t use your company card or account for personal expenses. Be strict and diligent about keeping the two areas of your life in their designated boxes.
5. Separate business and personal receipts
Always be prepared for an IRS audit. Keep receipts from business transactions like meals and travel expenses. You don’t want to miss any tax deductions while filing.
The payments you make with your business debit or credit card are easy to track by downloading a statement from your account. Tracking cash purchases require you to store your receipts. You might be in trouble if you can’t present separate receipts for business purchases. Create an organizational system for all of your business documents.
Take splitting up your receipts further by creating a business accounting system. Money management tools and apps geared toward small business owners often come with a feature to store digital copies of your receipts.
6. Pay yourself a monthly salary
After all of your hard work, it’s time to get paid. Give yourself a regular paycheck. Transfer your income into your savings account from your business checking account. Putting this into practice marks a clear line between your personal funds and money belonging to the company. Act as if you’re getting paid by someone else.
Practicing financial discipline will protect your company’s cash flow.
Conclusion
Not setting a clear distinction in your finances makes it harder for you to claim business expenses as deductions. Take the extra steps in establishing the difference.
- Apply for an Employer Identification Number (EIN). It’s free and affords you the advantages of legitimizing your business and filing your business tax returns. It’s the first line in establishing your corporate identity and shouldn’t be overlooked.
- Establish a commercial entity. Registering your business will unlock tax advantages and wrap a layer of protection around your personal credit history and finances.
- Create a separate business bank account. Use this account for business expenses. Downloading your financial statements for tax filing will be a breeze with your business expenditures in one place.
- Apply for a business credit card. It will help you separate expenses and build your business credit for future growth. They also unlock additional advantages for financing and saving money with no interest payments and higher cash-back percentages than personal credit cards.
- Separate business and personal receipts. When tax time comes, or if the IRS audits your business, you must give accurate earnings records.
- Pay yourself a monthly salary. Transfer your paycheck into your savings account on a scheduled basis. Practice this as if a third party is paying you. Be diligent with your bookkeeping.
All these steps separate hobbyists from entrepreneurs and bolster your professional image. All while maintaining a financial balance between your work and personal life.
