Ed note: Financial management can be a pain when it comes to just your personal accounts. Now imagine mixing up your business expenses with your every day spending. It’s a recipe for a headache, especially at tax time. Here are some of the most important reasons you need to set up separate systems for success.
One of the most common mistakes many new business owners make is combining their personal and business finances. Combining your personal and business accounts can be a red flag that can lead to an IRS audit. It can also make it much more difficult to take deductions, or sell your business should you ever reach that point.
When do you need to separate your finances? Great question. If you have a hobby business – something you do for fun that also generates a little extra income, but isn’t designed as a business – then you probably don’t need to separate your finances (but you should always keep good records). For everything else, you should keep separate financial accounts and records.
Benefits of separate financial accounts. When you maintain separate accounts, you are showing the IRS that you are running a business, not a hobby. This opens the door to taking more tax deductions, because the IRS doesn’t allow as many expenses for hobbies as it does for businesses.
Maintaining separate accounts also makes it easier to track income and expenses, take legitimate deductions, create a profit and loss statement, obtain a business loan and file your taxes, since your paperwork should already be organized as personal and business. Keeping separate records will also help you defend an audit, should that ever happen.
How to Separate Your Personal and Business Expenses
Start as soon as you can. Ideally, you will start your business with separate accounts right away. If you have been mixing your finances all along, then I encourage you to stop ASAP.
Get a Business Tax ID. You can get an Employer Identification Number (EIN) from the IRS. This is a business tax ID number, similar to an individual’s Social Security Number. These are free and can be obtained online in just a few minutes. With an EIN, you can open a business checking or savings account at your local bank.* Another benefit of having an EIN is being able to give out your EIN instead of your SSN, reducing your chances of your SSN being misused.
*You can often open a business bank account as a Sole Proprietorship, but some banks may require a formal business entity such as an LLC, S-Corp, C-Corp, etc. Call your local bank to determine which documents are necessary to open a business account.
Open a credit card, PayPal or other business account. Once you get a business bank account, it can be a good idea to open other accounts you might use frequently, such as a business credit card and a PayPal account, both of which are almost essential for making or receiving payments online.
Use a dedicated method for tracking business finances. You also need to track your business income and expenses separately from your personal finances. You can do this with something as basic as a manual ledger or a spreadsheet (MS Excel, Open Office and Google Docs are all readily available options). You can also spring for a dedicated software program or even hire a bookkeeper. The key is making sure you have a dedicated system for tracking all business income and expenses. This is essential for filing your taxes each year and for proving to the IRS that your business records aren’t mingled with your personal records.
Get started now. Maintaining separate finances may seem daunting to new business owners. But it’s a best practice that will pay dividends in the long run. The best part is once you separate your funds, it’s easy to maintain the system.
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