10 Apr Why Must Business and Personal Expenses Be Kept Separate?
One of the most repeated tips for business owners is for them always to separate their business expenses and personal expenses.
Why is it important to separate business expenses from personal’s?
It’s less messy that way!
First of all, separating the two transactions makes it easier for you to track and organize your budget and spending, both for your own personal life and that of your business. Although it may require additional steps for you to set-up at the onset (e.g., creating separate bank accounts or getting different credit cards), this will save you a lot of headaches later on when it comes time to do your accounting or file your taxes.
It makes for reliable financial reporting
One of the fundamental accounting assumptions is that of “economic entity,” which views the business enterprise as separate and distinct from its owners or any other business unit. This means that the activities of the business must be recorded separately from that of the personal activities of the owners so that the reported financial position of the business will be kept independent from and unaffected by the financial position of the owners. This way, the financial statements of the business would be able to accurately and reliably reflect the performance of the business itself, making the financials more understandable and useful for decision making, not just for the owners but also for potential lenders or investors.
It keeps you on the right side of the law
The IRS allows business expenses to be claimed as deductions for tax purposes. Although the type of business structure employed would impact how the tax obligations will be imposed, the burden of proof is always on the taxpayer to justify and evidence why an expense is considered to be business-related (ordinary and necessary in the course of business) as opposed to personal.
For example, in the case of sole proprietorships, it is often difficult to disentangle the personal transactions of the owner from the transactions of the business. This is because for tax purposes, the IRS doesn’t distinguish the business from the owner and, therefore, commingling of business and personal property is allowed. However, since the IRS still requires the sole proprietor to report the income and expenses arising from the business as part of his/her personal income tax return, proper separation and bookkeeping of business-related transactions would be extremely crucial for accurate filing.
In partnerships, partners are considered the same tax entity as the business. The business itself does not pay income taxes, but each partner will be taxed at a personal level, based on his or her equity in the business. Thus, proper separation of personal and business expenses is imperative for accurate accounting of the partner’s share of the profits and losses.
On the other hand, Corporations (or C Corp) have separate legal entities from their shareholders, and the business’ tax obligations are separate from the said owners. Given the more sophisticated business structure, it would be easier to distinguish and record business expenses from personal ones.
It could offer protection from liability
Depending on your business structure, separating business and personal finances also help protect your personal assets from creditors who come after you for unpaid business debt (as in the case of C Corps or limited liability corporations).
It helps build business credit
Separating your business expenses and credit lines will enable you to build a separate business credit profile, which would be helpful in securing larger business loans or establishing vendor lines of credit.