New business owners often struggle to differentiate between true company expenses and those that are actually personal. While it’s only natural to seek out ways of cutting costs while your business is growing, owners who fail to separate their personal and business finances could be opening themselves up to IRS audits and other legal consequences.
Here are some tips to help you avoid liability by keeping your personal and business finances distinct.
1. Establish a Legal Entity
As a business owner, one of the best ways to protect your personal liability is to establish a separate legal entity for your organization.
When determining the best business structure for your needs, it’s important to consider all relevant factors, such as number of employees you plan to hire, your business’ financing goals and your business’ long-term tax implications, just to name a few. Not only can creating a distinct legal entity for your business limit your future tax burden, but it also protects you as an individual from legal liability should your company be sued. In this way, incorporating your business creates a veil that safeguards the company owner (and his or her loved ones) from the organization’s debts and obligations.
A key step in creating a separate business entity is obtaining an employer identification number (EIN). Also known as taxpayer identification numbers, EINs enable the IRS to keep track of your earnings in a way that’s distinct from your personal finances.
Once you’ve acquired an EIN, take the time to make sure all your employees and family members understand what does and does not qualify as a business expense. By ensuring no one uses business funds for non-business purchases, you can avoid audits and other unpleasant consequences down the line.
2. Avoid Personal Guarantees
It’s not uncommon for small business owners to seek out commercial financing to get their companies off the ground. Some sources will ask for a personal guarantee, which means that you’re personally guaranteeing the fulfillment of a loan or other financial agreement.
However, the fact is that utilizing personal guarantees to secure a loan can put your personal assets at risk. Thus, instead of using home-equity loans or other personal guarantees to launch their businesses, entrepreneurs should explore alternative financing methods. Additionally, you should invest time and effort into building up your business credit.
In some cases, it may be impossible to avoid personal guarantees altogether as you establish your business. The Small Business Administration (SBA), for example, makes it a policy to require personal guarantees from all borrowers. Additionally, business owners should note that banks and lenders who do provide loans without personal guarantees often compensate for this by commanding higher interest rates.
If you must put up personal collateral to secure a loan, try to limit the scope of the guarantee with a specific list of items instead of making a more generalized personal guarantee. Doing this helps protect your family finances down the line.
3. Build Your Business Credit
To separate personal and company finances, it’s important to build up your business’ credit score. Along with boosting your borrowing power, opening a business credit account helps to distinguish you from your company in the eyes of the IRS and the court system.
For best results, apply for a line of credit before you truly need it. You can also request more credit than you actually need in order to keep your debt-usage percentage low, provided that you aren’t tempted to overspend simply because the funding is available. Finally, you should be sure to pay your bills on time and cancel cards that are going unused, as each practice can bolster your business credit.
A key step toward establishing business credit is setting up distinct accounts for personal and corporate finances. Along with depositing income checks directly into the company account, business owners should make sure that they are using this fund to pay all expenses, bills and employee salaries.
Not only does establishing separate accounts help you keep track of your costs and profits, but it also shows the IRS that you are truly operating a business rather than simply practicing a hobby. While the IRS allows businesses to deduct expenses associated with running a company, individuals are not permitted to deduct costs related to a hobby or other pastime.
4. Track Shared Expenses
As a business owner, it’s only natural to want to deduct every possible expense associated with company operations. However, failing to keep your personal and business deductions separate can result in increased IRS scrutiny come tax time.
To avoid audits and other tax consequences, it’s important to track your shared expenses carefully throughout the year. Whenever possible, obtain separate receipts for your business expenses. For example, if you stop at the supermarket to pick up soft drinks for a client meeting, request that the cashier ring up the toothbrushes and laundry detergent you purchased for your own personal use as a separate transaction. By using your business credit card for company expenses only, you can protect your tax liability while making your accountant’s job easier down the line.
Additionally, today’s business owners can take advantage of modern technologies that make expense-tracking less of a hassle. Along with allowing you to manage business and travel costs, software like QuickBooks Self-Employed can sync up with your charge card to automatically import expenses.
Even if you are the sole employee of your business, the fact is that you and your company are separate entities. If you don’t take steps to keep your personal and business expenses distinct, you may be setting yourself up for tax penalties and even legal repercussions in the years to come.