As you navigate the process of business financing, it can be tempting to use your personal finances to boost your business. However, that’s not always the best solution — especially for the long haul.
Ensure you’re keeping your personal and business expenses separate to maintain their identities. Here’s why it’s important and how to manage your finances.
Why It’s Important to Keep Business and Personal Expenses Separate
Mixing your personal and business finances is never a good idea. It’s crucial to separate them, especially when starting your own business. Doing so will play a large role in how your business operates, and it can provide you with many benefits – such as tax deductions and shielding your personal assets.
It’s important to remember that your business is a separate entity. It should be free-standing from your personal finances. The following reasons will show you why you need to consider keeping them separate.
1. Using Leverage
In financing, leverage refers to the use of borrowed money for investment. Essentially, you would hope the financial payoff will be larger than the interest paid.
In personal finance, leverage can be risky for your funds and assets. However, business finance can be a great way to increase your profits. When using leverage, you can make small investments in your business while getting your profits ready for the future.
If you decide to work with leverage, it’s essential to keep business and personal finances separate.
2. Pertains to Your Professional Image
Another reason for keeping your business and personal finances separate is to solidify your professional image.
For instance, having two separate accounts for your finances makes you look serious about your business. It’s also especially helpful in establishing your business identity.
Treat your business as more than a hobby by applying for credit cards in your business’s name. Doing so draws a clear line between your expenses. Plus, it will help you come off as a true, up-and-running business in the long run.
3. Tax Purposes
Another major reason to separate your finances is for taxes. This gives you the ability to keep everything organized for deductions and write off business expenses during tax time.
Keeping track of your expenditures is a great way to save time, as well. When you don’t separate your costs, you may find yourself having trouble with taxes – contributing to a significant amount of stress.
It can also place you in an audit situation since the IRS often looks for new small business owners to check and see if they’re running everything correctly.
Therefore, keeping a good record of your expenditures can assist you in the event of one. If you merge your finances, the IRS can audit both your personal and business documents.
4. Helps Secure Larger Business Loans
If you need to secure a business loan, detaching your business and personal finances gives you your working capital. If you blended the two, obtaining a loan would be more difficult while presenting your business income to lenders. Therefore, it makes it more difficult to establish business credit.
In general, a bank will assess your personal credit to determine whether to extend you a loan. If you possess a higher credit score, you have more borrowing power. However, you may be required to sign your name to secure a loan, meaning you’re personally liable for debt acquired by your business if it defaults.
Your goal should be to avoid personal guarantees whenever possible. If you can build strong business credit, you give lenders assurance that your business will repay its debts.
5. Saves You Money and Time
Keeping finances separate in business and leisure helps you save time. While hiring an accountant will cost you, the separation will lead to fewer billable hours. As a result, you save a large amount of money in the process.
Another option is to sign up for business accounting software, which will provide you with guidance in maintaining your financial records.
How to Keep Your Business and Personal Expenses Separate
Now that you have a good understanding of why keeping your business and personal finances separate is important, here’s what you can do to take action.
1. Establish a Budget
Setting a budget is one thing that can help you keep your finances in check. While it may not seem like budgeting for your business does much with keeping your finances separate, it does prepare you. Budgeting helps prevent you from digging into your personal finances due to poor planning.
Of course, budgeting doesn’t always work out as intended since emergencies can happen. However, a clear budget plan can reduce costs and the risk of turning to your personal finances for rescue.
For the best budget planning results, the 50/30/20 rule is a good framework to use to help you save money.
2. Obtain an Employer Identification Number
An EIN (employer identification number) is a nine-digit number the IRS assigns to your small business. You can use it when it comes time to file your tax return, establish a business entity type, open a business bank account, or apply for a business credit card.
You can think of it as a Social Security number for your business. Once you obtain an EIN, you won’t have to use your personal Social Security number for tax or business purposes. Therefore, you’re creating a line between your personal and business finances.
3. Establish Your Business Entity Type
Consider incorporating your business as an LLC (limited liability corporation) or corporation. Doing so will provide tax advantages but also protects your personal assets. Once you set it up correctly, you can keep your personal assets protected from business losses, debts, and lawsuits.
Think of establishing a business entity as your way of adding a layer of legal protection for your business. Plus, it allows you to file your tax returns separately from personal tax returns.
4. Open a Business Checking Account
Opening a business bank account is the best way to keep your business and personal finances separate. Consider starting with a business checking account as a fundamental way to keep your company’s financial records in check.
When you have a dedicated business checking account, you can deposit money, collect invoice payments, pay bills, and purchase equipment.
5. Apply for a Business Credit Card
You’re likely familiar with how a personal credit score works. It helps you get loans, mortgages, credit cards, and more. Applying for a business credit card works the same way.
As an entrepreneur, you can build a business credit score for your operation, which helps you enhance your borrowing power. Additionally, you can qualify for small business loans with lower interest rates.
Once you open a business credit card, you can also streamline your business finances, allowing you to keep your expenses distinct.
Establishing your business credit is essential, especially if you plan on expanding, opening other locations, increasing your line of credit, and more.
6. Keep Your Receipts Separate
Ensure your business and personal finances are distinguishable by keeping your receipts separate. If you store these together, you risk being audited by the IRS. Therefore, having an organized system will save you time and sanity when accessing your documents.
7. Keep Track of Personal Items Used for Business Purposes
Did you know you can legally write off personal items as a tax deduction for your business? For instance, the mileage you use to meet with a client or the cellphone you use regularly can help you save money at tax time.
Consider working with a tax advisor to help you learn more about what’s deductible and how to maintain your records.
8. Hire a Certified Public Accountant
If you’re looking to keep your personal and business finances separate, you may want to work with a CPA (certified public accountant).
A CPA is beneficial, especially if you struggle with bookkeeping for your business. They can cover all the corners of finances and ensure they remain separated. Hiring a CPA is also imperative for legally protecting your business. Therefore, it’s important you ensure their subject matter expertise aligns with your business needs.
9. Track Your Shared Expenses
One payoff to being a small business owner is deducting many business expenses. For instance, if you’re taking a prospective business partner to lunch or buying coffee for your employees, write it off. However, for best practices, ensure you avoid using your business card for personal purchases.
Or, you can consider using a business debit card that allows you to label your personal and business expenses. Keeping those expenses separate will save a headache for you and your accountant during tax time.
Plus, you also maintain a spotless financial record.
What Types of Entities Should Separate Personal and Business Finances?
If you’re an LLC or corporation, you must file your business and personal finances separately. However, sole proprietors don’t have to do this.
Think of whether your business is a legally established entity or not. If it is, then those business and personal finances need to be separate and vice versa.
Even though sole proprietors aren’t required to separate their finances, they should still consider keeping them separated. The IRS can still audit sole proprietors. Therefore, if the finances are messy, you could have difficulty navigating the process.
Make Owning a Successful Business a Reality
Starting your own business may be no easy feat. It can be challenging to navigate your business financing and taxes the first time around. However, this task of keeping your finances separate is a necessity, even though it can seem overwhelming.
Yet, you set your business up for tax advantages and higher profit margins. In addition, you reduce the risk to your personal assets. In the long run, you keep your dreams of being a successful entrepreneur a reality.