Having to keep track of finances is a fact of life that can't be avoided. It takes time and attention to detail. But doing it right by respecting the difference between business and personal finances can pay off handsomely.
What is the difference between business and personal finances?
Personal finances are the money management and financial decisions for your household. It includes the income from a paycheck, business earnings, and other sources as well as the money going out to pay your expenses. It also includes personal savings and other investments.
Business finances are essentially the money and credit limited to your business. It includes income earned by the business, including fee income for services or sales proceeds if you sell products. Expenses are outlays for the business, such as payroll services for employees and insurance premiums for a business policy. It also includes investments made by the business, such as capital equipment. And it covers the credit worthiness of the business and its borrowing activities.
Why is it important to separate personal and business finances?
It's important to separate personal and business finances because doing so allows you to operate your business successfully without needlessly creating problems. If you don't know how to separate business expenses from personal expenses, it can adversely affect your business's day-to-day operations because you may not have a good handle on cash flow. For example, you may be assuming there are funds available to meet accounts payable, but those funds may not be in the business, and you could fall short or default on payments for business expenses as they come due. Unless you can stay on top of expense management for your business, it can impede your ability to continue doing business with vendors and can also adversely affect your business's credit.
The benefits of having a business bank account are numerous. There are several good reasons for learning how to separate business expenses from personal expenses:
- It can develop a professional image for your business. Using personal checks, for example, can tarnish the business's professional image. You want to be viewed as professional and trustworthy, and that goal can be hindered if you're using a personal banking account for business. When it comes to business vs. personal checking accounts, the former is the clear choice if you want to be taken seriously.
- It simplifies your business taxes. You need financial records and receipts for preparing your tax returns. Separating personal and business finances facilitates the return preparation process. For example, if you maintain an accounting record for your business income and expenses, these numbers can easily be transferred to your business tax return without the need to parse out nondeductible personal expenses. Keeping your business account and personal account separate can save you a lot of time.
- Your personal and business credit scores can rise. Recognize that there are separate credit scores for a person and for a business. These are generated using different factors. By maintaining the distinction between your business and personal accounts, you can increase both your personal and business scores; one won't be a drag on the other.
- You can avoid negative legal implications. Creditors will respect the distinction between your personal and business finances only if you do. For example, if you set up a corporation but comingle business and personal funds, a business creditor can "pierce the corporate veil" and reach your personal assets, despite the personal liability protection afforded by corporations in general. The benefits of having a business bank account separate from your personal account are obvious in this case.
Best practices for keeping business and personal finances separate
It's not difficult separating personal and business finances. All you need is a mindset to note which finances belong in which category — personal or business — and some actions to help you follow through. Here are some best practices to separate business expenses from personal expenses, ensuring that your company's finances stand alone.
1. Create a separate entity for your business
A critical step in keeping business and personal finances separate is to formalize your business entity by incorporating or forming a limited liability company (LLC). The decision of which entity to use depends on several factors (e.g., co-owners, financing needs) and is something to discuss with your accountant or attorney when starting a business. Incorporating or forming an LLC requires you to take legal steps on the state level to establish your business entity (you can do this yourself through a website or use the services of an attorney).
But even if you're self-employed and don't take any legal steps, you can still formalize your business by registering it with your city or county (typically a simple form you can complete yourself). For example, if your business is a sole proprietorship that does website design under the business name Wonderful Websites, you can register it in your name but "doing business as" Wonderful Websites. This is called a DBA.
Taking these actions for your business entity enables you to set up a bank account and credit card under the business name.
2. Open a separate business bank account
The easiest action you can take is to set up dedicated bank accounts for your business, abiding by the difference between personal and business checking accounts. It is a myth to think that you can use a single bank account for business and personal purposes and still remember which payments are business expenses and which are personal expenses. Time goes by and you forget what the expense was all about. The only sure way to keep finances separate is to have a bank account and credit card devoted solely to the business. Your business account and personal account must be kept separate. When considering business vs. personal checking accounts, one thing is certain: Using a personal bank account for business is a recipe for disaster.
3. Maintain separate expense records
Individuals may choose to keep track of their income and expenses (and certainly should, to maintain a budget and have records at tax time). But businesses are required by federal tax law to maintain books and records; it's not optional. Keep the business's books separate from any personal record. Here are a few examples why:
- You take someone out to lunch. If it's a friend, this is a personal cost that's not deductible. If it's a customer, then you can take a business deduction (up to the 50 percent limit on meal expenses). The only way to remember that a charge at a restaurant was for business or pleasure is to keep separate records.
- You purchase a tablet for your salesperson to use in the field. Unless you can establish that the business bought it (and it wasn't for your personal use), the business won't be able to write off the cost.
Keeping your separate records is easy to do nowadays with personal and business finance software, cloud solutions, and apps for mobile devices. What's more, by figuring out how to separate business expenses from personal expenses and keeping good records, you may be able to find deductions and tax credits you hadn't even thought about.
4. Avoid personal guarantees for business loans
Your business may need to borrow money, but think twice before you give your personal guarantee on a business loan. If the business fails to make payments, you'll be personally responsible for them. It can strip you of your home, your savings, and other personal assets and put your personal credit score at risk. For example, say the business takes a five-year lease for office space, and you give your personal guarantee to the landlord. Something unforeseen happens that prematurely requires you to leave that location, such as a disaster or relocation because of a spouse's new job. If you're unable get out of the lease, you'll be stuck paying for it if the business can't.
Of course, there are situations where giving your personal guarantee can't be avoided. For example, if you obtain a Small Business Administration (SBA) loan, any owner with an interest in the business of at least 20 percent must give a personal guarantee; there's no option here. But if the company is buying a vehicle with a loan, don't automatically give your personal guarantee just because the dealer asks you to. It may be possible for the loan to stand on the business's credit without any personal guarantee.
5. Pay yourself as an employee
One of the cleanest ways of keeping business and personal finances separate is to become an employee of your corporation and receive a regular paycheck. Payments to you can easily be tracked by the business, and you get a steady stream of personal income.
Of course, doing this is not an option if you're a sole proprietor or a partner in a partnership. In those cases, you're a self-employed individual who doesn't receive a salary. If you own an LLC, the business can make a special tax election (referred to as a check-the-box election because it's done by checking a box on IRS Form 8832) that will enable it to make salary payments to you.
Learn more about solutions available to assist with setting up your business finances.