Blurring the lines between business and leisure is never a good idea. The need for separating business and personal finances is imperative when starting a business. It will play a significant role in how your business operates and how the corporate world perceives it. Differentiating between personal and business finances can provide an array of benefits, including tax advantages and the abiltity to shield your personal assets. However, if left undone, it can also leave you high and dry when things go awry.
Types of Business Finances
Business finances include how your business acquires money and how it spends it. How you acquire money includes two categories: debt funding and equity funding. Debt funding refers to any loans you take out to fund your business that you repay with interest. Equity funding refers to any money raised through funders. Typically, this money does not need to be prepared if the business fails, but more than likely, you will be required to grant your funders a seat at the decision-making table. Debt funding typically comes with more risk, but equity funding requires less control over the decision-making process of your business operations.
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Separating Personal and Business Finances
As a first-time business owner, it’s crucial to remember that your company is an independent entity; it’s free-standing from you and your personal finances. Although it may seem apparent, there are many reasons why business owners need to separate their personal and business finances. The following breaks down the most important reasons why you should consider doing so yourself:
Leverage
One of the biggest differences between business and personal finance is how leverage can, and should, be used. In the finance world, leverage essentially refers to using borrowed funds to invest — hoping that the financial payoff will be larger than the potential interest. Using leverage in personal finance can be risky, as you often put your funds and assets on the line. In business, however, leverage is used relatively frequently as a way to increase profits. Using leverage, you can make a smaller investment in your business while still setting yourself up for future profits. It is a good idea to make clear separations between your business and personal finances if you want to work with leverage.
Your Professional Image
The importance of separating your personal and business finances also comes down to your professional image. Your business is more than a hobby; therefore, your finances should be treated as such. Having two separate accounts rather than using the same for both business and private purposes makes you look more serious, including establishing your business identity. Investors should apply for credit cards and checks in their business name, which will help draw a clear line between personal and business expenses. At the end of the day, you want people to take you and your business seriously. Having them write a check to you personally, rather than the business, will come off as amateur.
Tax Reasons
One of the major reasons to separate your personal and business finances is for tax purposes. The ability to take advantage of tax deductions, including writing off business expenses, is a huge reason many business owners choose to split their personal and business finances. Keeping accurate records of personal and business expenses is vital when running a business, as this will help save time and a significant amount of stress.
“Entrepreneurs that don’t keep their finances separate often have troubles with taxes,” says Jim Pendergast, SVP of altLINE. “Write-offs are a large part of business, and if you don’t keep your finances from your business and personal accounts separate, you can run into a nasty audit. The IRS often looks for people who have started small businesses just to see if they’re running their businesses correctly,” says Pendergast.
Keeping good books of expenditures can also assist in the event of an IRS audit. If your finances are merged, this will more than likely result in the IRS auditing both your business and your personal records.
Business Credit
Another important reason to detach your personal and business finances is business credit. Obtaining working capital for your business is vital to growing it, and business credit will be mandatory to secure larger business loans. Having your personal and business income blended makes it more difficult to provide your business income to banking agencies, making it more difficult to establish your business credit.
Generally speaking, a business owner’s personal credit will be assessed to determine whether or not to extend credit. Those with a strong credit score will ultimately have more borrowing power, but bad credit isn’t a deal-breaker. In most cases, the borrower will be required to sign a guarantee in their name to secure the loan. But this also means you are personally responsible for any debt incurred by the business if it defaults.
Save Time And Money
The importance of separating personal and business finances comes down to saving time. Hiring an accountant will come with a cost, but having a complete separation of finances equates to fewer billable hours, helping to save you a large amount of cash in the process. Purchasing business accounting software is another option, as this will provide investors with options and guidance in maintaining their financial records.
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Tips For Keeping Your Personal & Business Finances Apart
Now that we understand the importance of dividing between personal and business finances, it’s time to go ahead and get started.
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Hire a certified personal accountant: Anyone looking to separate their personal finances from their business finances should consider working with a certified personal accountant (CPA). Personal finances can get complicated quickly, and the ramifications of poor bookkeeping within a business can be crippling. Therefore, investors should cover all of their corners and align their services with a CPA to ensure the two individual finances stay separated. According to Kimberly Gordon, a brand strategist, and marketing consultant, “it is imperative personal finances are not run through the business to maintain the business entity’s legal protections.” Consequently, “when money is distributed through one of these methods from your business to you personally, it maintains the integrity and corporate veil for the entity,” says Gordon.
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Maintain Separate Accounts: The ability to distinguish between personal and business finances is critically important. Creating an individual account for your business will help tell the difference between personal and business expenses and assist your case if the IRS ever questions the legitimacy of your business. Having separate accounts also doesn’t hurt the credibility of your business identity.
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Open a Business Credit Card: Once you open a business bank account, you should also open a business credit card. Like opening an account, a business credit card will allow you to make purchases on a separate business card. This will help you avoid the temptation of making business purchases with your personal card. Another benefit of using your business credit card is that it will help you build credit for your business. You can track how much you are spending on your business every month, make your monthly payments, and watch your business’ credit score grow.
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Keep Your Receipts Separate: To further distinguish between your personal and business finances, keep your business receipts in a separate place from your personal receipts. When it comes time to file taxes, you will have an organized system that will allow you to easily access documents from both your personal and your business finances without confusing the two.
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Determine How To Structure Your Business: Establishing a legal structure for your business is far and away the most important step you can take in separating your finances. Whether sole proprietor, corporation, or forming a real estate LLC, the legal structure of your business will basically dictate everything from your risk and liability to how the IRS will retrieve your business taxes. To make the best decision, take the time to discuss your options with an attorney, CPA, and financial planner. Depending on the corporate setup of your business, you can be held personally responsible for company debts, including seizing assets to satisfy creditors. The best way to disentangle yourself from personal and business debts is to form a limited liability company (LLC). This hybrid type of business structure provides legal protection, enhanced creditability, and pass-through taxes.
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Pay Yourself A Salary: Another tip for keeping personal and business finances separated is by paying yourself. Dishing out a salary can help business owners isolate the line between business and personal profits instead of haphazardly pulling money from their business. Providing yourself with a regular paycheck will not only better the chances of your business succeeding, but keeping you on your personal budget.
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Track Shared Expenses: The best way to steer clear from being audited is to track shared expenses. Separating receipts for your business expenses is vitally important when running a business, as co-mingling has the potential for dire tax consequences — which no one wants. The most efficient way to track expenses is to use separate credit cards. Use your business credit card for business expenditures, while personal expenses should be taken care of through your personal finances.
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Get an EIN: EIN stands for employment identification number. It is essentially a social security number for your business. You can use your EIN instead of your personal social security number when filing business tax documents, opening business bank accounts and credit cards, and many more business activities. Your assigned EIN will help to separate your personal and business activities further to help clearly draw the line between the two.
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Get Everyone on the Same Page: You may have decided to take the necessary steps to separate your business and personal finances. Still, you should also be sure to educate the rest of the members of your company as well. Ensure that you clearly communicate the practices you put into place to keep everyone on the same page and create efficiency across the business. Creating a boundary between your personal and business expenses will become much easier if everyone else is aware of the divide.
What Kinds Of Businesses Need Separate Business And Personal Finances?
All LLCs and corporations are required to have separate business and personal finances; however, sole proprietorships are not required to do so. An easy way to think of it is whether or not your business is a legally established entity. If yes, business and personal finances need to be kept separate. If no, you are not required to separate the two.
Sole proprietors are single-person businesses, and all profits or losses are directly tied to the owner. For example, a sole proprietorship could be anything from a lemonade stand to a photography business. However, just because sole proprietors are not required to separate personal and business income does not mean they shouldn’t. These business owners can still get audited by the IRS, and if finances are a mess it can be difficult to successfully navigate the process.
Summary
Starting a business is no easy feat, especially if you are navigating business finance and taxes for the first time. The task of separating business and personal finances can seem overwhelming and even impossible, but it is necessary for the long run. By doing so, you are setting your business up for tax advantages and even higher profit margins — all while reducing potential risk to your personal assets. Once you go through this process, you are one step closer to making your dreams of owning a successful business a reality.
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