If you’re like many entrepreneurs, you likely used your own finances to start your business and didn’t bother to open a separate bank account. However, whether you started your business as a side hustle, wanted to test out a business idea, or are working as an independent contractor, mixing business and personal finances is never a good idea. Once you start making money and/or accumulating expenses, you’re taking unnecessary risks.
Keeping Business and Personal Finances Separate
As the business grows, it’s crucial to set up boundaries between your business and personal finances. Here’s what you need to know:
Hobby Vs. Business
The IRS assumes businesses are started to make a profit. Hobbies may or may not make a profit. Any profits you make from your hobby are listed as income on your personal tax returns and you have to pay income taxes on them. The drawback for a hobby is you cannot claim any business deductions for expenses you may incur related to the hobby.
If you want to claim business expenses as deductions, you must report any income or loss on a Schedule C (Form 1040). Keeping business and personal finances separate supports your intention of actually running a business and not a hobby in the eyes of the IRS, allowing you to make those deductions.
Choosing a Business Entity
The legal structure of your business also requires you to keep business and personal finances separate. If you set up your business as a corporation or Limited Liability Company (LLC), the business is considered a separate legal entity and therefore requires a separate accounting ledger and bank accounts. If you structured your business as a sole proprietorship and all profits/losses are tied to you personally, it’s even more essential to keep business and personal finances separate in the event the IRS decides to audit you. An audit requires you to disclose proof of your business expenses and income, so it’s important to keep good records. Separate business finance records also makes it easier to manage bills and tax responsibilities.
Businesses aren’t only at risk of an audit by the IRS. Other state and federal agencies could ask for financial records in regard to registration, corporate compliance, employment and sales taxes.
CARES Act Funding
When COVID-19 hit and the government created the CARES Act, small and large businesses across the country scrambled to get paperwork together to apply for disaster relief funding. Businesses with their financial and legal paperwork ready to go got the first crack at the money. Businesses struggling to show profits and losses from the business missed out. In addition, some lenders required businesses to have business bank accounts, while others only accepted incorporated businesses.
If you were lucky enough to receive money from the Paycheck Protection Program (PPP) and/or the Economic Injury Disaster Loan (EIDL), you will eventually be required to show how the money was spent. Already, the Justice Department has filed fraud cases against businesses that received disaster relief funding and spent the money on illegitimate expenses.
The PPP requires 75 percent of the loan must be used for payroll costs; 25 percent can be used for rent, interest, and business utilities. EIDL funds must be used for fixed debts (rent, etc.), payroll, accounts payable and other bills unpaid due to disaster. When your lender comes back to you for proof of what the funds were used for, having separate finances is even more crucial to prove monies were properly allocated.
Independent Contractors and the AB5
For independent contractors, now more than ever before, it is important to show business finances as separate from personal finances. As of January 1, 2020, California’s Assembly Bill 5 (or AB5) requires new guidelines for determining whether a worker is considered an independent contractor or an employee. So far, the backlash by employers and independent contractors alike has resulted in many categories being exempt from AB5—most recently freelance writers and translators.
However, many contractors will have the burden of proof to retain their independent status. To be considered an independent contractor, the person must show they control their own time, tasks, and techniques; work in a separate industry; and have established business operations. Maintaining separate business and personal finances goes a long way to support that position.
Many independent contractors are also changing the legal structure of their businesses by setting up a corporation or LLC. As a separate legal entity, the work being done is paid to the business and not the individual, further proving the contractor is not an employee.
Across the country, the classification for the gig economy workers is under close scrutiny. Keeping separate finances, setting up the business as a separate entity and keeping good records can keep your business protected from unnecessary risks.
The Corporate Veil
As noted above, when you form an LLC or corporation it means the business is regarded as its own legal entity and the shareholders, officers, and directors will not be held personally liable for the actions of the corporation. In order to keep that “Corporate Veil” or “Corporate Shield” in place, the business is accountable for any debts and legal responsibilities it incurs and must maintain its own finances.
When kept in good standing, the corporate veil helps protect owners from having to surrender personal assets to pay the debts or settle the legal issues of the company. If a court determines that the corporation or LLC has compromised the separation, it is referred to as “piercing” or “lifting” the corporate veil and the liability protection no longer applies. Mixing business and personal finances is one way business owners put the corporate veil in jeopardy. Once the corporate veil is pierced, the individuals behind the business entity are then personally accountable for any debts or legal wrongdoing of the business.
Other ways to pierce the corporate veil are by failing to maintain LLC or corporate records required by the state, using business assets for personal purposes, paying for personal purchases with a company credit card, and personally guaranteeing a business loan or using personal property as collateral for a business loan.
Not only should business and personal finances be kept separate, the business should also conduct all business correspondence using the business’s name, and that includes proposals, contracts, invoices, sales receipts, marketing materials, and all financial documents.
This article, “The Crucial Reasons to Keep Business and Personal Finances Separate” was first published on Small Business Trends