In the early stages of running a business, your personal and business finances will often be intimately interconnected. At first, there’s no such thing as an office—only your home, a place that you happen to work out of and stock with supplies. There’s no such thing as a company car—only the car you already own, a vehicle that you drive literally everywhere you go.
If your business is a sole proprietorship, as about 73 percent of all businesses currently are, the line between business and personal finances will be even more blurred. As long as you are paying taxes (likely with a 1040 form), you may be able to operate for years without creating a separate legal entity. However, in doing so, you are choosing to take on more risk than is necessary.
On your business’ balance sheet, you will have both assets and liabilities. Who has the right to “claim” the laptop you work with every day? You or your business? Who is the person who will be paying your monthly subscription fees? You or your business? As you quickly discover, drawing the line between you and your personal enterprise—even if you are the sole employee and the sole stakeholder—will not only provide you with some legal protections, but it will also make it much easier to keep things running smoothly.
In this article, we will answer a question that seemingly all entrepreneurs ask at some point in their careers: when is it the right time to separate my personal and business finances? We will also discuss the benefits of separating these finances and how you can go about doing so.
Recognizing (and Managing) Liabilities
Generally speaking, it is a good idea to separate your business and personal finances as soon as you begin “doing business.” Once you have either accrued one revenue or one expense, you will want to begin drawing the line between yourself and your enterprise. The sooner you are able (or willing) to do this, the sooner you will be able to give yourself financial protection and increase the legitimacy of your business.
Hiring a small business accountant can help your business ensure that you have the right systems in place in order to move forward. Creating a separate business entity is crucial for managing your liabilities. In the accounting world, a liability is considered to be any “obligation” or anything that is “owed.”
Liabilities can include loans, accounts payable, utility bills, taxes due, and any other obligation accrued by your business. By creating a distinct enterprise, you can ensure that it is your company—rather than you individually—that is on the hook for paying future bills.
Of course, separating these finances does not remove all of your exposure to risk, but it does protect you in the event that something goes wrong. For example, if your business goes bankrupt (where your liabilities are greater than your assets), the bank will not necessarily have the right to claim certain assets, such as issue a lien on your mortgage. So with every liability that you accrue and every asset that you own, be sure that you are properly designating the holding of risks and the right to future revenues. Making this transition might be messy, at times, but it will undeniably be worth the effort.
The Benefits of Separating your Business and Personal Finances
There is probably not a single accountant that would recommend keeping your business and personal finances intertwined for very long. While there are basically no drawbacks for deciding to make this change, there are certainly many benefits.
As suggested, these are a few of the reasons to keep these finances apart:
- Taxes: in order to reduce your tax obligations, you will need to reduce your taxable income. There are many business expenses recognized by the IRS, which may even include your utilities and car payments. Keeping business expenses separate will make it much easier to identify these deductions and, if needed, pass an IRS audit.
- Independent Credit: if you have a less than desirable personal credit score, the last thing you’d want is for this score to affect your credit. In many cases, lenders will look at your business credit, rather than your personal score. Keeping your finances apart will make it much easier to things such as open an account, apply for a loan, and—eventually—incorporate.
- Personal Liability: there are a lot of uncertainties when it comes to running a business, which is why you’ll want to give yourself as much protection as you can. Creating a distinct enterprise is one of the best ways—as the name “limited liability corporation” suggests—to literally limit your exposure to liabilities.
- Legitimacy: having a formal enterprise with distinct finances helps increase the legitimacy of your business. Depending on the nature of your business, you might want to avoid writing personal checks from your home address (this tends to look unprofessional). Committing to a distinct enterprise shows that you are invested in your business for the long run, which may, in turn, inspire people to become invested in you.
Clearly, making this change can be very beneficial. Now, let’s take a look at how you can functionally go about ensuring that these finances remain distinct.
How to Separate Business and Personal Finances
If you haven’t already, be sure to speak with a certified public accountant to learn about your business’ current financial structure and which changes might need to be made. In general, each of these actions can help you create a system that works for you.
- Register Your Business: while not always a legal requirement, registering your business helps create a distinct legal entity with notable advantages. Most new businesses are Limited Liability Corporations (LLC), but many are partnerships or, when larger, S Corporations.
- Begin Paying Quarterly Taxes: once you start your own business, you will likely need to pay quarterly taxes, rather than simply filing a return once per year. Your accountant should let you know when your taxes are due.
- Create a Business Bank Account: adding a new account will help you draw the line between your personal and business expenses even further. New business checking accounts also frequently have special perks, such as access to various loans.
- Create a Distinctive Set of Books: is your monthly Wi-Fi bill a personal or a business expense? Regardless of what you go with, you’ll want to be sure that your accounting and bookkeeping is consistent over time. If you do pay yourself out of your business accounts (as many business owners do), be sure to make a distinct bookkeeping entry. Failing to track these movements is the surest way your financials will become a mess.
Once you have taken the time to complete each of these actions, your business will be a distinct financial entity. From there, the sky is the limit.
While you might be reluctant to add anything else to your already full “to-do” list, separating business and personal finances is something that all aspiring entrepreneurs need to do. With tax benefits, legal protections, access to new capital, and increased legitimacy, you’ll be happy you made the change. Choose an ecommerce accounting firm today!