If you are running a small business, working as a freelancer, or act as a sole proprietor, it is often tempting to simply have your business income come into your personal account, and then use that account for all of your expenses. This might seem to be simple, but it’s actually a bad idea for many reasons. No matter how new or small your business, you should create separate accounts to handle income and expenses so your business expenses don’t come out of your personal account or vice versa. You also need a separate business credit card.
Why is it so important to keep them separate?
The Risks of Combining Your Accounts
There are a number of risks involved in not keeping separate accounts:
- You are more likely to mess up your bookkeeping. Even with two accounts, mistakes happen and expenses can go out of the wrong account. Maybe you hit the wrong button in PayPal or didn’t realize something was automatically set to the business card.
- Major confusion can happen when you spend business expenses from your personal account or credit card. If you forget to write something down, you might look at your credit card statement and try to work out whether XXXXREDTREE is a deductible business expense or a gift to your spouse.
- The IRS doesn’t like it. This is a big one. The IRS can be picky about proving your business is a business and may rule you are a “hobby business.” This seriously increases your risk of being audited.
- If you are audited and don’t have a separate business account, it will not look good for you. Having separate accounts shows that you are serious. If you are incorporated, a business account is required.
- It makes things much harder to deal with if you get audited. It’s easier to prove that something you deducted is a business expense if it comes out of the business account.
What Are the Advantages of Keeping Separate Accounts?
In converse, there are a number of advantages. Even if you are a sole proprietor and don’t technically need a second account, it can give you some significant advantages.
- Bookkeeping becomes much easier. You can check your separate statements and see what is listed.
- You look much more professional, especially if you have a DBA or a business name. It can cause confusion for vendors and customers alike. If you don’t have a separate business name, it still looks better if you have a business account.
- It can be easier to get a receipt from a vendor who doesn’t normally provide them if you are showing a business credit card.
- You can build business credit. This can make a significant difference. Credit limits on business cards, for example, often start off low but can rise substantially and end up quite a lot higher than on a personal one.
- Easier revenue and overhead tracking. If you toss everything into a personal account it can be easy to lose track of how much you have spent on the business and thus your profit. With a business account, you can simply look at statements and record your money in and out before you withdraw any profit you are using for personal expenses.
- It is easier to get financing. If you end up needing a loan for your business, the lender will want to see all of the ins and outs of your business, and this is much easier with a separate account.
- It helps you be disciplined. If you are keeping a certain amount of money as operating capital and that money is in your personal account, it is very likely to end up being spent. Having a separate account can really help, and if the account has a minimum balance it can highly motivate you not to spend money that is supposed to be for business emergencies.
- You can transfer a specific amount over to cover either specific expenses or a certain amount of money a month (note that you should not call this a salary, it’s a “draw on the profits,” which is a slightly different thing).
- It helps work/life balance. For solopreneurs, work/life balance can be a nightmare. You end up answering emails from clients at midnight. Keeping separate accounts helps with that mental separation between work and life that can easily be blurred when your office is a corner of the bedroom.
The only expenses that should go through the household account are those where you are splitting the expense. For example, internet access might be paid part by the business and part by income from other sources, such as a part-time job or working spouse. In this case, however, you can record the outgoing transaction from the business to personal account as an expense, essentially treating yourself as the vendor.
How Does This Help With Taxes?
When tax time comes around, having a business makes everything more complicated. In fact, most business owners should not be trying to do their own books, but should at least have a tax preparer if not an accountant.
When it comes time to file taxes, separate accounts help streamline the entire process. Your tax preparer will not have to keep coming back to you to ask what is a business expense, but can simply look at what went out of the business account; you’ll only need to mark any errors. If you also record expenses using the categories used by the IRS, your tax filing will be a lot faster and, thus, a lot cheaper. Going through every transaction on your account to double-check what kind of expense it was can take hours and hours.
You also need to keep receipts on business expenses but not personal ones. Keeping unnecessary receipts will confuse you or your tax preparer when tax time comes around.
On top of that, if you don’t record your business expenses accurately, you won’t deduct them accurately, and will end up paying more in taxes. You don’t want to miss any deductions you are entitled to.
It is smart and, indeed, essential to keep separate checking accounts and credit cards for your business and your personal needs. When tax time comes around, you will be very glad you did. Contact us to learn more.