Regardless of the type of business you run, you should separate your personal and business expenses. Not only can this make analyzing your financial situation easier and possibly save you money on taxes, it also ensures you stay on good terms with the IRS (who have specific guidelines to follow).
While some personal and business expenses tend to blend together, figuring out how to set boundaries between the two doesn’t have to get confusing. Here’s how you can go about separating your business and personal expenses effectively.
Why You Should Separate Personal & Business Expenses
Simply put, you want your business to avoid financial headaches and tax issues. To do that, you can’t get your business and personal expenses intertwined, even if you used a personal loan to start your business.
According to the National Federation of Independent Business, cash flow and money management are two of the most common reasons small businesses fail. If you’re not tracking and separating your business expenses from your personal ones, you run the risk of mismanaging your funds.
And if you accidentally deduct personal expenses as business expenses on your tax report, you run the risk of alarming the IRS. And you could get audited. You don’t want those things to happen.
Keeping business and personal expenses from getting too friendly with one another is just a matter of being diligent. Here’s what you should do:
- Consider Your Business Structure
First, it’s important to consider your business structure, because it affects how you should be legally handling business and personal expenses:
- Corporations: As the Small Business Administration (SBA) states, a corporation is “an independent legal entity owned by shareholders,” so you have to keep personal and business expenses separate. But there are still times where the line between a personal and business expense blurs.
- LLCs: A limited liability company is a hybrid structure, with owners referred to as members. An LLC has the limited liability legal features of a corporation, but like an S corporation, profits and losses are “passed through.” With an LLC, they’re passed through to the members; with an S corporation, they’re passed through to the shareholders.
If your business is a sole proprietorship, there is no legal distinction between the business and the owner. That being said, you can still report business expenses. If your business is a partnership where two or more people, business expenses are deducted in the same manner as a sole proprietorship. But since more people are involved, it’s essential that all parties carefully separate personal and business expenses.
While it might seem easier to operate as a sole proprietorship or partnership, you won’t get the legal protection that you would as a corporation or LLC.
- Maintain Separate Bank Accounts & Credit Cards
Money from a friend for dinner shouldn’t be heading to the same place as an invoice payment from a client. Simply put, you need distinct personal and business bank accounts.
You should also do your best not to use your own credit cards for business expenses. Open a business credit card. This will help you keep track of your business expenses and give you access to money when cash flow is slow.
Another benefit of having a business credit card is that you can write off fees that you can’t with a personal card. These include annual fees, late fees, and interest charges.
- Understand the Gray Areas
Sometimes, it can be hard to decipher whether an expense should be classified as personal or business. For instance, many small business owners use their personal vehicles for work. You may even take a vacation with your family that involves some work-related travel.
While you certainly want to write off what you can, you have to be careful not to go overboard when deducting business expenses that are linked to personal expenses. If you’re unsure of how to categorize an expense, consult the IRS website.
In general, the IRS lists the following three business expense categories:
- Business costs: These include labor, materials, storage, and other expenses related to the pricing of goods to be sold.
- Capital expenses: These include start-up costs, business assets, and improvements. For practical purposes, just think of these as business costs, too.
- Personal expenses: Sometimes an expense is partly for yourself and partly for your business. For instance, if you use a home office, you can deduct a portion of the rent or mortgage, utilities, repair, depreciation, and more.
4. Keep Track of All Expenses
This may seem like it should go without saying, but so many business owners have forgotten (or simply ignored) this cardinal rule of business ownership and paid the penalty when the IRS came knocking.
Always track your expenses. Save receipts, and keep them in organized filing folders. Not only is this a best practice, it’s also a great way for you to take advantage of every deduction you can come tax time.
The good news is that you can automate expense tracking with software, which can save you time and money in the long run.
Play it Safe
There’s no reason to let your business and personal expenses mix. By keeping them separate, you can avoid tax problems, protect your personal finances, maximize savings, and improve money management. Just make sure you choose the right business structure for your needs, use separate bank accounts, navigate gray areas properly, and take advantage of available software.