As a small business owner, every purchase you make is an opportunity to mix your personal and business finances. Some owners would rather not do this, but feel as though they have to. Others might not give it much thought, or not know why it could be important to keep things separate.
You gain several short and long-term benefits when you organize your business finances and your personal books separately, and it’s worth understanding those benefits. Let’s take a look.
1. Business entity requirements
Some business entities require you to keep everything separate. For example, if you have a small business corporation, you have to stay on top of the business accounting and avoid mixing it up with your personal finance habits. You don’t have the same requirement as a sole proprietorship, but you can still choose to follow the same rules. This approach is particularly useful if you plan on changing your business entity in the future after a growth period or a similar change in circumstances.
2. Audit defense
You have a lot of deductions and tax credits you can leverage as a small business owner, but it’s possible to attract unwanted attention from the IRS in the form of an audit. One of the most common red flags for small business owners is claiming home office deductions. If you claim these deductions, the IRS may take a closer look at your tax records and perform an audit.
When you have a well-documented division between your personal and business activities and finances, you can rest easier, knowing that you’re protecting yourself from potential penalties. If you are relatively new to filing taxes for your small business, get assistance from a CPA or another tax professional, so you avoid errors.
3. Greater ease of accounting
Trying to sort out receipts, income, expenses and assets after they get mixed up takes a lot of time. You have to worry about this every quarter when it’s time to pay business taxes, as well as when you want to get an idea of your revenue and expenses.
You or your accountant has a much easier time when you maintain a strong separation from the start. If you need to look up information on your company income for a particular month, you have access to this information within a few minutes. The tax filing process is streamlined and you get better visibility into the cash flow.
4. Credit score impact
Your personal and business credit can have major impacts on each other. Some small business owners leverage their strong personal FICO score as a way of financing operations or covering expenses. Using your personal credit is one way to open lines of credit without having any commercial accounts established, but you would be personally responsible for any debt.
If you take out a lot of personal credit cards and loans for your small business and you run into financial trouble, you may have to deal with the consequences to your credit score. For example, with every additional loan, you’ll have another “hard pull” on your credit, and those add up. Your FICO score takes a hit, which can affect your housing situation, insurance rates and ability to get more credit in the future.
A common approach some business owners take is to use a personal guarantee on the first few business lines of credit. Once you have established your creditworthiness as a business, you can focus solely on building up your financing options through your company.
Separating your personal and business finances
Now that you know how important it is to keep your personal and business money matters divided, it’s time to put systems in place to make it easy. Here are five things you can do to improve your accounting practices.
Get a business bank account.
When you have company funds flowing through a dedicated bank account, you limit the chances that you end up mixing things up. Your financial institution may also have business credit products available as well.
Stick to the plan.
Be vigilant about using business funds solely for business expenses, and vice versa. You can look at statements to discover where your money goes without playing guessing games about whether it’s a personal or business expense. Receipt tracking software and similar applications can scan your receipts as you make purchases and categorize them for you.
Understand what you’re signing up for.
Many business credit accounts require personal guarantees. Make sure you know what your personal liabilities will be and make an informed decision about the amount of risk you’re willing to bear. The status of your personal credit or financial situation will be an important factor here.
Establish a salary.
You don’t run the risk of dipping into company funds to cover personal expenses if you have a regular salary coming to you from the business.
Keep detailed records.
Document the business use of your personal assets. You may have assets that you need to use for personal and business purposes, such as a vehicle. Write down exactly how much you’re using it and when so you have these records for accounting.
In the past, SMBs have largely been at the mercy of big banks when it came to funding, and were rated on a single metric: their personal FICO score. Many business owners were bootstrapped and may have leveraged their personal credit to achieve their goals. FICO is a powerful tool, but it’s not always reflective of your total business health. Traditional lenders’ reliance on it can put you in a position of mixing business and personal expenses, even if you’d rather not.
Thankfully, new fintech firms are starting to treat small business owners less like individuals, and more like businesses. One way they’re doing this is by looking at more data points beyond just FICO scores (like bank, invoice and transaction histories, for example). This allows them to make more holistic lending and credit decisions. For business owners looking to grow, online fintech firms offer a way out of this, allowing you greater control of your business data and your financial future.
Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.