Keep Your business and personal money separate.
That is a fundamental piece of advice.
Almost all experts will advise this:
- Business Coaches
- Financial Planners
It is relatively uncommon for certain things to be almost universally agreed upon.
This happens to be one such rare instance.
And, it is very sound advice.
One reason is the cost savings.
We’ll cover more reasons to separate the personal & business funds in a little bit.
Perhaps more importantly, if you commingle or misappropriate business funds, you run the risk of running into trouble with the IRS.
How can mixing business and personal expenses lead to IRS issues?
The answer is because, just like anything else, there is a right way and a wrong way to get money out of the business to take care of personal expenses.
The Problem With Taking Money From A Business
The money that comes into a business is meant to be used strictly for business purposes.
That means it can only be used for paying for supplies, business rents or utilities, payroll, and anything directly related to the operation of the business.
That money is not to be used to pay your mortgage, groceries, anything for your kids, personal vacations, or anything else that has nothing to do with the business.
If you work from home, you can take a reasonable portion of certain household expenses such as phone, power, internet, or auto-related outlays.
Sometimes, however, it is necessary to take money out of the business in order to cover some personal expenses…
The Wrong Way To Take Money Out
Lots of people who own small businesses don’t know how to properly handle the task of taking money out of the business.
They simply make payments for their personal expenses out of the business checking account or use the business credit card for those personal expenses.
Some even head over to the ATM machine and take cash out of the business for no other reason than to have some pocket cash.
None of those methods are even close to proper.
The Correct Way(s) To Get Your Money
If you need to access money for personal reasons, there are three acceptable methods for doing so:
- Putting yourself on salary (if an S-Corp)
- Writing a check to yourself in the form of a distribution (again, if an S-Corp)
- Schedule regular draws (if you’re a sole prop or Single-Member LLC) instead of random withdrawals
You should always create some sort of separation between business and personal expenses, and taking either of these steps does so without drawing any unnecessary attention to the transactions.
Setting yourself up with regular payments, even if they aren’t actual “salary” checks helps not only keep the business looking legit, but it also helps people budget better because it simulates a regular salary like before they took on the entrepreneurial venture.
It also creates a paper trail which keeps you in a good position if/when it comes to…
What trouble can follow
So what’s the worst thing that can happen if you don’t keep your business and personal money and expenses separate?
If you continue to treat your business as your personal piggy bank?
Bottom line is that if you are ever looked at for any reason by the IRS, a whole lot actually.
The first that that would happen is that you would have to undergo an audit, during which the burden would lie on your shoulders to establish the expenses in question as valid business expenses.
It is your responsibility to show proof in the form of receipts or invoices that can support your claims.
If you cannot, then the fun really begins.
If you happen to be a C-Corporation, then the tax return would be recalculated with all of the expenses added back.
What makes this particularly troublesome is that C-Corps are taxed at higher rates than individuals.
Not only that, but you will be assessed interest and penalties on the unpaid portion of the newly calculated tax liability.
If the business is a partnership or an S-Corporation, the expenses will still be added back to the tax return, but it gets a little more dicey from there.
Since those business formats flow through to the personal 1040 income tax return, you not only have to have your individual return recalculated, but the additional income may in fact cause you to be phased out from deductions and/or credits that were originally claimed.
From there, your new income tax liability will be computed and you will again be charged penalties and interest on the unpaid portion of this new figure.
Additionally, you will now be on the IRS’s radar and the chance for future review and audits will increase.
On top of that, if you needed to raid the business accounts to support your personal lifestyle, then you will be in even greater trouble once the interest and penalties start piling on.
5 More Reasons To Separate Your Money
You decided on a business.
You developed a website.
You set up your social media profiles.
You obtained your EIN.
Did you open up a business checking account yet?
If you didn’t form a business, why go through the hassle?
It’s true–you can run your business and your personal finances from a single account.
Assuming that it’s a sole proprietorship.
Some “experts” say that having another account means more work.
And then there are the fees associated with business checking accounts.
You still should be separating your business and personal money!
1. It Helps Psychologically
People love segregating their money for different needs and wants.
They open bank accounts for different purposes like vacations and holiday gifts.
They stuff money in envelopes labeled for specific purposes.
It’s a psychological technique that helps them reach specified financial goals by preventing the robbing Peter to give to Paul.
It makes sense that by having a bank account specifically designated for business purposes, you will use that money solely to operate your business.
It’s the exact same reasoning for having separate pots for personal goals.
Having a clearly defined business pot follows that same logic.
You will be less likely to raid the business to pay for personal expenses, keeping that money where it belongs.
Should you need money to cover personal expenses at some point, you will simply take a draw.
After all, that’s how you’re supposed to take money from a business.
And, from all of the blog posts on the subject it would seem that not only do people need to use psychological tactics to manage money, many find success in it.
So if psychology works to save for emergencies or specific purchases, what’s the big deal about employing such techniques to keep your business and personal funds independent of each other?
2. Separate Business and Personal Accounts IS Easier
But, if there are more accounts, how is it easier?
There are some people who say that there is no need, as having multiple accounts is too difficult to track.
Maybe for an old indie/hippie lady that’s true.
Well, for starters, everything is easier to keep track of.
People who are completely useless at keeping track of their finances have a built-in method of keeping business and personal money accounted for in each respective account.
All of your transactions will be organized.
You won’t have to sift through every single transaction to find a specific one when needed.
If you’re the type of person who is clueless about accounting systems (in which case you really should hire an accountant), you’ll at least have some distinction between your personal and business stuff.
If you want to see how your business is performing financially, there aren’t a bunch of non-business items to fudge the figures.
If you want to see how your household budget is faring, your business transactions won’t get in the way.
A place for everything and everything in its place, as the saying goes.
Technology makes it even easier to manage multiple accounts.
Most banks allow for simultaneous log-in, meaning you can have both your business account and personal accounts accessible without having to remember additional passwords.
Plus, taking a draw is only a few mouse clicks away and instantaneous as well!
3. You’ll Save On Accounting Costs
That’s assuming you actually have an accountant, because, you know it makes more sense to spend your time on revenue-driving activities.
The more work your accountant has to do, the more it will cost you.
It’s a simple equation.
If you’re all up in arms about paying the bank fee, imagine how you’ll feel knowing how much you have to spend just for your accountant to sort through all your personal stuff to find the business transactions.
The same holds true for those of you who employ freelance bookkeepers to come in and keep the books.
At $25 or more per hour, if you can cut their service by just one hour you can more than recoup the fee for a business bank account.
Who doesn’t like coming out ahead while still getting everything done?
Oh, wait, that’s right, there are still free business checking accounts being offered.
Guess that eliminates the talk of fees.
And that means you keep all of the savings in the business by reducing the amount of accounting work you pay others to do!
4. Your Private Spending Will Remain Private
You’re not forced to acquire an EIN for your sole proprietorship, but it makes sense to do so.
Because you won’t have to give out your social security number, which gives you an added layer of identity protection.
The same goes for having a separate business bank account.
By having a separate account, you are only giving your accountant access to that part of your life.
If you have to provide bank statements to a credit card company or get audited by the IRS, you only have to supply the business info (in most cases).
You don’t have to worry about anyone seeing or judging how you spend your personal money.
Who cares if you like to visit swinger clubs?
Want to crossdress at home, who cares?
Have a video game habit, pssht!
After all, it really isn’t any of their business to begin with.
5. It May Help You With The IRS
Not everyone gets audited…in fact only a fraction of the population does, but anyone can be the subject of an inquiry.
The IRS tends to examine sole proprietors who file Schedule C on their 1040 more closely.
The reason is simple–there’s no distinction between business and individual.
It leaves the door open for both honest mistakes and purposeful deceit.
Using a separate business bank account at least gives you a bit of insulation.
By limiting transactions to their respective accounts, you can show due diligence in case of an audit.
Making an effort like this can be the difference between an agent finding you guilty of fraudulently passing off personal expenses as non-deductible business expenses or making an honest mistake in using the wrong account.
Using separate bank accounts also makes life easier for the auditor.
In turn, it makes life easier for you as well.
Rather than having to through a year’s worth of transactions in a single account, the auditor’s job is made easier by limiting the info they have to dig through strictly to business transactions.
This speeds up the audit process.
And who knows, if you make things easy for them they make it easy for you and simply overlook inconsequential mistakes.
Look, everyone has to make up their own mind on the subject.
Are you required to have a separate account for a sole proprietorship?
Does that mean you shouldn’t have one?
Just because it’s not a requirement, doesn’t make it a bad choice.
After all, I just laid out 5 pretty good reasons to get one.
What’s your stance on the subject. I know there are people who separate all of their savings goals into different accounts, so those people should definitely not be opposed to having a separate biz checking account! Why do or don’t you set up your business in this way?