5 essential steps to separate personal and business finances
Keep your personal and business funds distinct
- Become a business entity
- Obtain an employer identification number (EIN)
- Open a business bank account
- Start building business credit
- Keep track of expenses
Starting — and sustaining — a small business is a deeply personal venture. After all, it’s your brainchild, passion, time and money on the line. Nonetheless, it is imperative that business owners keep their personal and business finances clearly delineated, no matter how small the company.
Distinguishing between personal and business expenses makes for better accounting and cash flow awareness. Not only is this important when dealing with stakeholders, clients and lenders, it enables you to maximize tax deductions while shielding you from issues that could arise should you be audited by the IRS. Depending on the legal structure of your business, having distinct finances also puts you in a better position to protect your personal assets should your business get sued or go bankrupt.
Take these five essential steps to separate personal and business financial lives.
1. Become a business entity
How you structure your small business impacts your company operations, tax obligations, insurance coverage and liability protection. Discuss what structure is best for your business with your lawyer, accountant and insurance company.
Limited liability companies (LLCs) and corporations are considered distinct legal entities from the business owner and protects the owner’s personal assets from business liability. Personal and business finances must be separated under these structures and they may require specialized insurance coverage.
Sole proprietors and independent contractors are not considered legal entities independent from their owner and must operate under the owner’s name. Filing a Doing Business As (DBA) designation allows sole proprietors the right to operate under the name of their small business and open a bank account in the company’s name, but does not offer any protections of an LLC or corporation. As such, it’s critical for sole proprietors to keep detailed records of personal and business finances in the event of an IRS audit.
2. Obtain an employer identification number (EIN)
Once your small business is an established entity, you can apply for an EIN through the IRS. Also known as a federal tax identification number, an EIN is effectively a social security number for your business. You will use the EIN to file your business tax returns separately from your personal taxes.
Sole proprietors without employees are not required by the IRS to have an EIN, but may choose to get one for business purposes such as opening a company bank account.
3. Open a business bank account
Create a business bank account in your company’s name to handle all company-related income and expenses. This should include your own salary disbursements, either through payroll or personal draws depending on your business structure.
Even if you have a fledgling business, a separate account helps establish a paper trail of business expenses. Should your business end up in court and you cannot demonstrate a clear difference between your personal and business funds, you may be held personally responsible for any business debt or liability.
Set a hard budget and avoid dipping between personal and business accounts to cover any unforeseen expenses. Communicate the importance of this financial designation to anyone else who has access to your personal and business accounts, such as a spouse or business partner.
4. Start building business credit.
When starting a new business, it is all but impossible to completely separate your personal and business credit. Business credit is calculated distinctly from personal credit, but often factors in the owner’s personal score as a partial indicator of the company’s creditworthiness. Start building a credit history for your company to set yourself up for wider financing opportunities in the future.
Check the accuracy of your business information with each of the three business credit bureaus: Dun & Bradstreet, Equifax and Experian. Unlike personal credit, you must pay to access these reports and they often require you to establish an account to receive a specific business credit score. For example, Dun & Bradstreet requires businesses to set up a Data Universal Numbering System (DUNS) number to have a credit file eligible for Paydex scoring.
Transfer any credit lines that you use for your business into your company’s name. This can include trade lines with suppliers, office drinking water and stationary deliveries. If you have a distinct physical office, put utilities in your business’ name as well. Ensure that all of your payments are made on time or early.
Taking out a business credit card is another way to build company credit. Credit cards are relatively easy to obtain for new businesses, although interest rates will be high and most require a personal guarantee. While you should try to avoid carrying a balance on the card, business credit card interest may be tax deductible.
5. Keep track of expenses
With a business bank account and credit card, you should be able to keep most company expenses clearly separated from personal finances. There are grey areas, however, particularly when it comes to personal assets used for business that are eligible for tax deduction.
You may deduct the cost of personal vehicles and personal electronics used for business purposes; business travel; healthcare premiums for you and your family; and a home office used solely for business purposes — that is, not your dining room table or a converted guest room.
It is particularly important to maintain detailed receipts and records for such shared expenses to avoid problems if you are ever audited by the IRS.
Always check with your tax advisor on deductions and tax breaks.