Interconnection of personal and business finances for small business owners: Part 1
For the purposes of clarity, effective management, and legal protection, it is prudent for small business owners to separate their personal and business finances. However, personal and business finances are ultimately interconnected for small business owners in ways that significantly impact overall financial well-being. Part 1 of this blog series addresses reasons why small business owners should separate personal and business finances. Part 2 of this blog series will address how understanding the interconnection of personal and business finances helps position small business owners for long-term financial success.
Separating personal and business finances
It might seem convenient to mix personal and business finances, but it is essential to maintain financial boundaries between the two. Examples of practical ways for small business owners to create this separation include having a business bank account and personal bank account, using a business credit card and personal credit card, and setting up utility accounts (services used to operate the business) in the company’s name. I note three reasons why this separation of personal and business finances is so important to the financial success and sustainability of small business owners.
Accuracy of tax return preparation
Accurate reporting of business income and expenses is required by the Internal Revenue Service (IRS). The IRS website states, “Good records will help you monitor the progress of your business, prepare your financial statements, identify sources of income, keep track of deductible expenses, keep track of your basis in property, prepare your tax returns, and support items reported on your tax returns.” If personal and business finances are mixed, then small business owners and/or their tax preparers could potentially make more reporting errors and run the risk of the following items.
Overreporting income: paying more taxes than required
Underreporting income potential audit by IRS and penalties
Overreporting expenses: potential audit by IRS and penalties (by taking too many business expense deductions)
Underreporting expenses: paying more taxes than required (by not maximizing business expense deductions)
I illustrate a hypothetical example below of how mixing personal and business finances can lead to underreporting expenses and how it will negatively impact a small business owner.
Matthew owns a sales consulting company, and his business income has grown significantly over the past 12 years, but he still sometimes mixes personal and business finances. He has both a credit card for personal expenses and a credit card for business expenses, but there are times when he will use the credit card for personal expenses to pay for a business expense. As a result, he underreported his business expenses on Schedule C of his tax return because he used a summary of his business expenses (provided by credit card company) as his guide to report total business expenses. With not all his business expenses showing on his Schedule C, he did not maximize his business expense deductions resulting in him paying more taxes than required. The money used to pay taxes that were not required could have been cash flow used in a more efficient manner such as investing for retirement, saving for his child’s college education, and/or reinvesting in the growth of his business. Matthew has the tools in place (having both a personal credit card and a business credit card) to separate personal and business finances, but he must make more of a commitment to using them properly by only using the business credit card when paying a business expense.
Personal asset protection
Separating personal and business finances creates a clear distinction between the two, which means that personal assets can be protected from creditors in the event that the business faces legal and/or debt issues. For example, business structures such as limited liability companies (LLCs), partnerships, and corporations provide small business owners with varying levels of protection of personal assets from business liabilities and debt.
Financial clarity and professionalism
If personal and business finances are mixed, then small business owners could have a challenging time understanding the real profitability and sustainability of their business. Separating personal and business finances helps small business owners see a clearer picture of their business’s overall financial health, which leads to more informed decision making in areas such as business budgeting and growth.
Small business owners who separate personal and business finances show a level of professionalism and strong commitment to the business, which means that clients, potential clients, and vendors are more likely to view their business as reputable. With clients and potential clients viewing the business as committed and reputable, this can enhance trust and lead to long-term relationships that will help business growth going forward. Regarding vendors, this can provide better access to financing since lenders, as part of the loan approval process, will require small business owners to show a clear snapshot of their business’s financial strength. By having personal and business accounts separated, small business owners will show professionalism, which will make them a stronger candidate for financing.