One of the most common mistakes small business owners make is failing to separate their personal and small business finances. Many owners try to process their business transactions through their personal bank accounts, but whether they do it for convenience or to help reduce expenses and bank fees, the reasons to not do it are much more compelling — not least of which because it makes you a prime target for IRS audits.
It undermines your business professionalism
When you run a business, it pays off to appear professional, especially if you’re thinking about the long term. According to small business management expert and entrepreneur Dr. Jean Murray, mixing your personal and business finances undermines that professionalism. “If you are dealing with a vendor or customer and you pull out your personal checkbook or credit card to pay a business expense, you are giving the impression that you are not a real business owner,” she writes.
She adds that similarly, this same lack of separation “shouts ‘hobby’ to the IRS.” Consequently, if the IRS doesn’t view your business as a legitimate enterprise rather than a hobby, it will be more likely to deny your deductions and losses.
It makes auditing and taxes much simpler
Though the government doesn’t say you should have separate bank accounts for your personal and business expenses — nor does it, in fact, say anything about how you should go about tracking said expenses — “it does require that whatever method you use, all records are accurate, complete, permanent, and show a clear record of income and deductions,” says business writer Darrell Zahorsky.
The best way to do this is to avoid combining your personal and business expenses, else you find yourself facing a confusing mix of transactions on your account statement. Having a separate business statement not only provides a clear audit trail for the IRS, it also makes it a lot easier for you to declare income and expenses related to your business.
“Whether you prepare your own tax return or use an accountant, messy record keeping will cost you time, money, and possibly missed deductions,” Zahorsky warns.
How to keep personal and small business banking separate
At times, keeping your personal and small business expenses from overlapping may be more difficult than it seems, especially when it comes to transactions between you and the business. According to Murray, all such transactions “must be ‘arm’s length,’ that is, the transactions clearly separate you as a personal entity and the business as an entity.”
For example, if you put money in the business — such as with cash or property — Murray says you should clearly designate whether the money is to be considered as a loan or as an owner investment. “Make sure the paperwork is complete and that it is easy to see how the transaction is considered on the books of the business,” she adds. If you are using part of your home for business, you should create a rental agreement that includes all of the terms and conditions governing how you are renting space to your business.
Furthermore, if you are a sole proprietor or partner of the business, you can take a draw by writing a check to yourself from the business account; and if you are an employee, you should pay yourself just as you pay other employees in similar positions. Don’t simply transfer funds from your business account to your personal account.
Ultimately, you should always strive to separate your personal and small business finances, even when it’s inconvenient. Strong record keeping will make it a lot easier to manage your business and to take advantage of the deductibles you deserve. If it seems overwhelming, hire an accountant to help support you with the financial management of the business.