How to Separate Personal and Business Expenses

Oct 2nd 2019
VP, Corporate Strategy and International Expansion, FreshBooks FreshBooks
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Your contractor client stopped at Home Depot to pick up supplies for their job, but used money from his personal account to cover it and his expense reporting would have showed it as a business expenditure. To do it right, it needs to be recorded as an accounting transaction – and things can get complicated fast.

For some, especially those starting as sole proprietors, it can seem easier to use a personal checking account that’s already in place to manage finances. In fact, a 2015 survey from Citizens Bank found that 26 percent of small business owners use a checking account for both business and personal finances.

As their accountant, you can advise your clients on the key reasons for setting up separate accounts for their business, and how to start separating their expenses. It’s all part of helping them understand the responsibilities of self-employment.

1. Streamline Recordkeeping for Tax Time

Recordkeeping isn’t always top-of-mind for solopreneurs who are working hard to cement existing customer relationships and bring new ones on board. And if they’re not prepared, tax time can be a real scramble.

When your clients are using one checking account for their home and office expenses, they need to dig through their receipts to find one for an office printer, or sift through credit card statements to figure out which furniture purchase was for their rec room and which was for their office. You don’t want your clients to miss out on important deductions that will put money back into their business.

Direct your clients to set up dedicated checking, savings and credit card accounts for their business and use them only for business-related expenses. So, when it’s time to file their returns, it will be much easier to identify all business income and expenses.

You can also suggest they start a designated file or box with all business receipts so they don’t get lost in a purse or wallet, or else they can scan them and store a copy digitally. If they use accounting or expense tracking software, they can also easily save and categorize their expenses so they’ll be fully prepared come tax season.

2. See Cash Flow More Clearly

Most small businesses follow a similar ebb and flow of funds throughout each month. Many online services like Internet and utilities, for example, are billed the same day each month. But business cash flow is more difficult to follow when the account includes personal expenses such as the cable bill at the first of the month.

When your client has a clear view of their business cash flow, they can be proactive about managing it and make regular business health checks to spot problems before they happen.

Reducing the risk of errors makes a small business that much easier to run. Tracking expenses separately gives your clients a good idea of how money is spent and helps them plan for the future with confidence. They can look at their expenses, determine which ones take up the bulk of their cash flow, and figure out where they may need to look for cost-savings.

3. Have Everything in Order for an Audit

Separate business accounts are not only important for accurate tax filing – they’ll also keep things in order if the IRS audits your clients’ business. Stress that if there’s a question about whether their venture is a hobby or a business, the IRS checks to see if they have a separate checking account. If they’ve comingled business and personal expenses, there’s a bigger chance of incorrectly categorizing transactions.

In fact, many correspondence audits focus on one area of the return. If your client’s Schedule C is chosen for an audit, they’re required to submit bank statements to the IRS. Do they really want to submit their personal financial information if they don’t have to? Separating finances will make for a less painful tax audit.

Advise your clients to set up a business checking account where they understand the fine print, fees, and balance requirements. Make sure they also have the supporting documentation the IRS can request for any business deduction claimed, including the expense amount, where and when it was made, and the business purpose.

4. Build Business Credit and Profile

Small business owners typically rely on their personal credit and assets to fund their business. Banks won’t consider okaying a loan or providing credit to any person or entity that doesn’t have a credit history. Opening a business bank account and credit card is an important step that will build their business’ credit profile.

Using a business credit card shrewdly for business expenses only helps to increase their business credit card limit. This is especially critical when it comes time to make significant business purchases down the road with lower interest rates.

It’s also worth noting, a business credit card won’t always impact a personal credit score. In some cases, the interest paid on a company credit card is deductible as a business expense.

5. Know the Sales Tax Obligations

Is your client’s business classification a good fit? If they’ve started as a sole proprietor, they may have grown so that it makes sense to file as an LLC or take advantage of tax savings by making an S-Corp election.

If your client formed a corporation or LLC, then they are required by law to separate business and personal finances. That’s because a corporation or LLC is a distinct legal entity from the business owners. So it also needs its own bank account and tax identifier number.

This separation also minimizes a business owner’s personal liability. If the company is sued, the plaintiff can try to show that your client has mixed their personal and business finances, and come after their personal assets.

Talk to your clients about whether it makes sense to change their business entity. There are costs to do this, so your professional advice can help them with a cost-benefit analysis and get their financial ducks in a row.

The nice thing about these five steps is that these are all relatively simple changes that can really help your clients from a taxation point of view and set up their business for growth.

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How to Help Self-Employed Clients Manage Their Cash Flow

Help Your Self-Employed Clients Proactively Prepare for Tax Season

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