It’s often a challenge to separate an entrepreneur from their business. Whether a major company like Tesla, whose identity is so closely enmeshed with Elon Musk, or a local handyman whose one-man operation is known by the owner’s name, it is common for an owner to become one-and-the-same with their brand. Though this may be a positive from a marketing standpoint, from a financial standpoint doing the same thing can be a big mistake.
Let’s take a look at why it is so important for your business expenses to be kept completely separated from your personal expenses.
There are myriad reasons why it is essential that you create a distinction between your personal accounts and your business accounts. Here are just a few important points:
Businesses are formed to earn a profit: That’s the goal. From the IRS’ perspective, there is a difference between a business and a hobby that somebody is making money from pursuing, and one of the distinctions is the way that you file your income taxes. Though you have to report income on your tax return regardless of whether you’re running a business or a hobby, you are not able to deduct expenses for a hobby. By contrast, as a business owner you can take deductions for the costs of operating your business using Schedule C of the 1040 form. Schedule C is a reflection of the separation of the personal and the business, and by completing it and filling it out with your return, you make it clear to the IRS that you have created a separation between yourself and your company.
There are several different types of business structures that you can choose when establishing your business. Though a sole proprietorship ties all of your business’s profits and losses directly to you, if you have chosen to operate as a LLC (Limited Liability Company) or a corporation then your business is an entirely separate entity that is required to keep all of its books and bank accounts separate and distinct from you as an individual. Though it may be tempting to limit yourself to one account, doing so will present a significant challenge if you are ever audited by the federal government or your state or local governments. If that happens you will need to provide proof of what your business brought in and what it spent, as well as that you are in compliance with all rules and regulations and have submitted appropriate sales and employment taxes. Having a ledger that specifically accounts for business income and payments will make everything as clear as possible. It will also help you track and pay for your bills and taxes more easily.
When Congress passed the CARES Act, they provided the opportunity for businesses throughout the nation to avail themselves of much needed disaster relief following the economic devastation of the global pandemic. To apply, companies were required to prepare paperwork on their finances, proving both their need and that they had legal standing to qualify for the funding. While businesses whose records were organized were able to get relief quickly, those that had combined their business accounts with their personal accounts were frequently turned away because of requirements imposed by lenders. In some cases, simply having a separate business account is what would have made the difference.
Not only did having a separate bank account help those in need qualify for the Paycheck Protection Program (PPP), but keeping business and personal accounts distinct from one another is the best way to prove that the monies received were spent according to the plan’s requirements and to qualify for forgiveness. Under the rules of the program, businesses will need to provide proof of how their money was spent, and those that have been unable to do so are likely to find themselves among those that the Justice Department files fraud charges against. Even businesses that legitimately spent the required 75 percent of the monies they receive on payroll and the balance on other business expenses including rent, interest and utilities will be hard pressed to prove that they complied if their bank account is mixed with paying off personal bills.
Likewise, money receive through the Economic Injury Disaster Loan (EIDL) program had similar requirements that monies received be used for accounts payable, payroll, and fixed debts like rent and other bills that business owners were unable to pay as a result of their COVID-19-related losses. Mixing personal and business accounts is simply a mistake.
As a result of California’s Assembly Bill 5 (or AB5), independent contractors in that state have been operating under new rules ever since January 1st of 2020. The law requires that businesses prove whether their workers are employees rather than independent contractors, and independent contractors like freelance writers and translators will need to show their business records in order to be exempted from the law. The state is looking for evidence that these individuals control their own time and work entirely independently, and the best way to demonstrate that their tasks and techniques are their own and that they operate as their own separate industry is to ensure that all business expenses and income are recorded separately from the contractor’s personal expenses.
Another way to ensure that you are recognized as an independent contractor is to switch from a sole proprietorship legal structure to either an LLC or a corporation. Though this step may feel arduous to those who have chosen to be part of the gig economy for its freedoms, closer scrutiny of the industry makes it increasingly likely that more rules like this will be enacted, so it is a good idea to start separating your financial records now so that you can protect your status.
If you’ve chosen to operate as a corporation or as an LLC, there are certain rules and regulations that you are required to adhere to and certain protections that benefit owners. Included among these are the ability to shield all officers, directors and shareholders from personal liability for wrongdoing or negligence by the corporation. That benefit will be harder to claim if you mix your personal and business dealings, finances or accounts. The protection, often referred to as the “corporate shield” or “corporate veil”, makes the business solely responsible for debts and liabilities, but it is only available when the personal and the business are truly separate.
When an individual or business has a claim against a company, it will frequently attempt to hold the owners responsible as well – and this is particularly true if those owners have significant assets. The only way to protect against what is known a “piercing” or “lifting” the corporate veil is to be sure that you operate all of your business actions as entirely distinct from your own or those of your stakeholders. There are specific rules that allow for the piercing of the corporate veil, and if you violate them by not adhering to state rules about record-keeping or use the company’s accounts or credit cards to pay for personal expenses, you are likely to find your personal assets in jeopardy.
Business owners need to be meticulous about everything from correspondence to references of the company’s name when taking out loans or conducting similar financial transactions. Even something as seemingly insignificant as a sales receipt of marketing material needs to be carefully reviewed to ensure that the business is named rather than any individual with an ownership stake.
About Martinez & Shanken, PLLC
Martinez & Shanken, PLLC is a Certified Public Accountant (CPA) firm based in Gilbert, Arizona. We provide a full range of accounting, bookkeeping, consulting, outsourcing and business services. Partners Deborah Martinez and Earl Shanken work to ensure your business accounting is done with integrity and to your satisfaction.
