Why, then, is it so important not to fund your personal life from your business’s coffers?
As a business owner, there are many reasons to learn how to separately track business expenses and personal spending. And to stay motivated to do that, you have to know why it matters. Here, we’ll dig into both.
Why business finances must be separate from personal finances
Why do business owners mix personal and business expenses in the first place? The reasons vary.
Usually, business owners don’t know the risks (or rewards) of doing it correctly. Sometimes, they may be trying to avoid higher bank fees. Other times, entrepreneurs are so busy that they believe they don’t have time to fuss with using separate payment methods for commercial activities.
Whatever your temptation, it can and must be overridden. To do that, let’s look at why you should learn how to track business expenses separately.
When the two mingle, business suffers
The number one reason to separate your personal finances from business expenses is that, if you don’t, tax time can become a nightmare. The IRS disallows personal expenses to be claimed against your company’s taxable income as a deductible. So every quarter — and again every year — business owners who have paid for business needs with personal funds struggle to claim those personal account debits as deductions. It’s especially sad when this tedious, manual process causes you to miss deductions — or claim too many.
Claiming too many business expenses can come back to haunt you for years to come. If the government launches an inquiry (audit) three years from now, for example, they’ll comb previous years’ deductible expenditures as well. They’ll remove any that appear to be personal, and you’ll owe the difference, plus a penalty.
Unfortunately, there are even more tax implications when you mingle personal and business expenses. When the two are a mishmash, your business sends signals that it doesn’t make enough money to support itself. The IRS may declare it a hobby, requiring more in taxes and potential back taxes and fees for past expenditures.
Mingling expenses can hurt both you and your business
Another reason mixed personal and business expenses hurt your business is that untangling the two (a required task) takes too much of a business leader’s valuable time. New research out of Switzerland’s University of Zurich shows that business owners who mix their business and personal lives experience exhaustion and diminished well-being. That’s because they spend way too much time sorting out business from personal transactions every time they file taxes. The practice is unsustainable.
They also carry the foreboding weight of a potential audit. They bear the heavy feeling of being unprepared to show their financials under scrutiny. And that can wear on a person. Especially since, according to accounting experts at Ignite Spot, comingling personal and business finances puts small companies at an even higher risk of an IRS audit. If and when the government initiates an audit, you will need a list (and documentation) of all business and personal transactions — separated.
Conflating your personal and business spending is also risky. Take, for example, unpaid personal debt that’s used to fund a business: if the venture goes belly-up, that becomes household debt, making it more difficult (or, in many cases, impossible) to dig out or get future funding. Also, legally, using personal accounts to pay for business expenses opens you up to personal liability that formal business expenditures are covered by.
Finally, your mixed personal and business transactions send a message to customers, lenders, and vendors. People can view personal checks and card usage as unprofessional and unreliable, diminishing their trust in your establishment.
When you separate business and personal expenses, business benefits
In short, unsnarling your personal and business transactions one from the other addresses all these drawbacks.
Tax time will be a breeze when you’ve operated within compliance throughout the tax period. You’ll also be deducting the right amounts — no overages or insufficiencies. Years later, you’ll be able to quickly prove things were paid for correctly and in an organized manner. And you won’t need to take a day of line-by-line analysis to do so. You’ll shake the feeling of dread that comes with disorganized books and avoid the fees and penalties that come with back taxes when the IRS audits your business.
You’ll also attenuate the risks that come with the dicey practice of operating without knowing how to track business expenses separately. You won’t be held personally liable for a legal charge against your business. And your debts will remain your company’s debts, which saves your household credit the hit and hassle of more financial obligations.
Finally, distinguishing and splitting business expenses from personal spending helps you project the image of a legitimate, trustworthy business to your customers and community.
How to track business expenses so they don’t touch personal spending
Now that you’re intrinsically motivated to decouple your finances, here’s how to track business expenses separately.
Establish your company formally
Start by forming a legal entity. The U.S. Small Business Administration has a helpful, comprehensive, easy-to-follow guide that walks business owners through how to register their venture with federal, state, and local governments. Next, apply for and obtain an employer identification number (EIN) from the IRS, which many business customers and vendors will need to pay your business properly.
Why go through the trouble of establishing a registered business? Because you’ll need the structure and an accompanying EIN to open a business bank account. And a business account gives you the ultimate tools and tactics to keep business expenses separate from personal spending.
Open a business bank account
Your next step is to vet, choose, open, and use a bank account. Compare business bank accounts against one another to find one that suits your needs and preferences. Be wary of free accounts, because sometimes, spending a little each month for features like mobile deposit can save you valuable time and make it worth the fee.
Use your business checkbook, debit card, and credit card only for business spending, and use your personal account just for personal expenditures.
To ensure that your personal bank account is always capable of covering personal expenses, pay yourself a salary from your new business account. You’ll want to be able to assess this activity in the future, so make it a regular weekly or monthly transfer; and in your bookkeeping ledger, categorize the transaction as a distribution or owner’s withdrawal.
Deciding what to pay yourself depends heavily on your industry and business structure. An S-Corp, for example, is required to pay its owner what the market average compensation happens to be. Other entities have more freedom to choose, but analysts agree: you must pay the company’s founder something.
Don’t be afraid to infuse money into your business from personal accounts — especially during times of volatility, like the present. But do it the right way. Instead of paying business expenses from personal accounts, make documented transfers and categorize the transactions as owners’ equity.
Get a mobile bookkeeping app
Finally, get a tool to help you automate the collection and tracking of business expenses. You’ll be tracking your business expenses from day one, so don’t wait for a handful of transactions to upload.
Install a mobile app like Neat to snap or send expenditures straight to your mobile app for instantaneous data extraction, matching, and bank reconciliation. You’ll store all documents in the app, so you can confidently toss paper receipts, invoices, bills, and other paper clutter.
Knowing how to track business expenses is just the beginning
After you’ve taken these steps, you’ll need to learn how to file quarterly taxes.
However, with tidy books, doing so will be a breeze. In fact, the quarterly financial exercise is a chance for you to look into your financial statements. Many business owners feel that accurate, organized transactions can even make it enjoyable. See for yourself by downloading the Neat app today and giving it a try — for free!