Tuesday, January 19, 2010

Keep your business and personal finances separate to avoid IRS problems

Many entrepreneurs start out with little up front capital and therefore think that it will be “easier” (or just don’t think about it at all) to not separate their business finances from their personal finances. By not separating your finances, you blur the lines between business and personal which can create some major IRS headaches down the road. By law, corporations, LLCs, LLPs, and partnerships are required to have separate business accounts, but not sole proprietorships (the most popular type of small business).

As a small business owner, you will want to deduct purchases on your taxes that are business-related. If your personal and business expenses are coming from the same pot of money, the IRS may question if what you are claiming as “business expenses” are legitimate. This could lead to an audit which NO ONE wants. Not only will an audit cause personal grief, it can also hinder you from getting a business loan. Kay McDermott, a New York City-based CPA reported to, "Banks want to see clear, clean business accounts before they lend you any money. You need to demonstrate to the bank that not only is your business generating enough revenue to repay the loan, but that you are running the business professionally enough to keep that revenue coming in."

How does one keep business separate from personal? A recent article on from Trent Hamm, author of “Six Steps to Audit-Proofing Your Small Business” and “The Simple Dollar” describes the steps you should take to separate.

1. Erect a wall- Make it very difficult for money to cross the boundary between your business finances and your personal finances. For example, house your personal money in a completely different bank from your business money.

2. Document everything extremely carefully- Something can easily fall through the cracks unintentionally. Take it slow, do it carefully, and keep track of every single dime.

3. Once the separation is in place, cash should only flow directly over this wall- Do not directly pay business bills from your personal accounts. Don't put personal income into your business accounts. Handle everything by direct transfers from your personal account to your business account and allow no other financial contact between yourself and your business.

As a current business owner, do you keep your finances separate? Have you always done so? If you did not always keep personal and business finances separate, when did you change and why?