Interconnection of personal and business finances for small business owners: Part 2
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 addressed reasons why small business owners should separate personal and business finances. Part 2 of this blog series addresses how understanding the interconnection of personal and business finances helps position small business owners for long-term financial success.
Understanding the interconnection of personal and business finances
As mentioned in Part 1 of this blog series, separating personal and business finances is advisable, but recognizing the ultimate interconnection between the two is the key to effectively managing overall financial well-being for small business owners. Personal financial decisions impact business financial health and business success (or failure) impact personal financial health. Understanding how the two intertwine leads to more informed financial decisions that can benefit both the personal and business finances of small business owners and set them up for long-term financial success. I list three ways that personal and business finances interconnect in the financial life of small business owners: Taxation, Personal investment in business, and Financial goals.
Taxation
There are many small business owners that report business income on their personal tax returns, which means that business profitability (or loss) directly impacts their personal financial planning. Some small business owners are required to file a Schedule C on their tax return and there are other small business owners who are required to file a Schedule E on their tax return. Information from these Schedules flows to Schedule 1 (Part 1: Additional Income), which ultimately is reported on Form 1040 (U.S. Individual Income Tax Return) subjecting these small business owners to individual tax rates. Note that income tax brackets and ranges differ because they depend on filing status (single, married filing jointly or qualifying surviving spouse, married filing separately, head of household).
Personal investment in business
Many small business owners make the choice to use their personal savings and assets to start their business, which establishes an immediate link between personal and business finances. With personal assets being invested directly in the business, personal finances are now impacted by the extent of their business success or loss. Business success increases income and creates investment opportunities for small business owners, whereas business loss can lead to financial strain (e.g., using more personal assets to cover the shortfalls of the business). I illustrate with the following hypothetical example below.
Brett has successfully operated his marketing consulting business for 11 years. Prior to becoming a small business owner 11 years ago, he had a career working in the marketing department of a larger corporation for 7 years. Brett always had the desire to be a small business owner so while working for the larger corporation, he made sure to save up enough cash that would provide him financial flexibility when the time came to start his own business. Having this cash reserve gave him the flexibility and opportunity to invest heavily in his business (marketing efforts, outsourcing certain tasks) during the early years of his business even when he did not have many clients.
Financial goals
Personal and business financial goals for small business owners are interconnected. Periodic savings towards personal financial goals (e.g., retirement, college savings for children, down payment on home) can dictate how much money is available to be reinvested in the business. It can also be the other way around as business investments can dictate how much money is available for savings towards personal financial goals. With this interconnection, it is important that small business owners establish clear personal and business financial goals, which will help them maintain financial discipline in the areas where they are spending, saving, and investing. For overall financial well-being over the long-term, small business owners must balance investing in business growth with maintaining personal financial stability. I illustrate with a hypothetical example below.
Mary has successfully operated her sales consulting business for 14 years. Throughout these years, she has regularly contributed to her retirement plan (SEP-IRA), which was a recommendation by her financial planner. Although saving for retirement is a priority, the amounts of contribution varied throughout these years because there were years that were highly profitable for her business and years where profitability was not strong. On the other hand, she has made many business investments (better technology to serve clients, hiring an employee, training her employee to improve as a sales consultant) to further business growth, but there was one year that these business investments were limited because she used her free cash flow to help (bolstered her down payment amount to 20%, which was a benefit to her when negotiating terms) with the purchasing of a new home.