The first thing that you do when you start a business is open a checking account. This is a fantastic introduction into the world of entrepreneurship because it turns out to be more complicated, take longer, and cost more than you think it should.
Before that, you may have started your business using your personal accounts and maybe a few credit card charges. Now what you have is a blended mix of personal and business expenses running through the same accounts. Why not right, your entire life is blurred between personal and business.
Is Combining Personal and Business Expenses a Problem?
Like anything, it depends.
Assuming that you don’t have partners or other obligations, what your business pays for its entirely up to you. If you want to pay your dad’s electric bill out of your busines account, there’s not a single legal or ethical reason you can’t do just that. Before you do though, there are a few things that you should consider.
You Do NOT Want to Be a Hobby
Taxes as always, are the complicating factor. If the IRS decides that your business is a hobby, the tax penalties are astounding. I can drag you down the whole sordid story, but we can all thank uber rich people breeding race horses for this particular regulatory snag.
No one makes money racing horses so the owners were able to take huge losses against their obscene wealth and reduce their taxes. The IRS caught onto that little trick and fixed the glitch.
They fixed it good too so now, just sort of swept along everyone who had a little side gig, what I am very careful NOT to call a “monetized hobby”.
Fortunately, one of the easiest steps you can take to avoid this disaster is to maintain separate business and personal bank accounts. Even if you are losing money, having bank records and financial statements goes a long way towards LOOKING like a business.
I’d rather not do financial statements on my knitting and crochet hobby – best not to know how much money I spend on yarn.
You Don’t Want to Make an IRS Auditor Happy
I worked as an auditor in Big 4 accounting and spent years in corporate accounting so believe me when I say that NOTHING annoys me more than an auditor who has FOUND something. Oh memories of that smirk alone will jack my blood pressure to dangerous levels.
To avoid that, we just need to make sure there is nothing to find.
In my example above, we’re going to pay dad’s power bill out of company funds. I set that up to come out of owner’s pay. For tax purposes, that just means that this bill is coming out of my own salary and since we’re dealing with a pass through entity, it’s perfectly legit to do that.
BUT one month something goes wrong. Normally it hits the company credit card, but one month the credit card is expired so the payment doesn’t go through. To keep dad’s lights on, an ACH is sent from the company checking account.
It hits “utilities” and no one catches it until an audit.
In short, the more complex your financial system, the easier is it for something to go wrong. I spent 15 years dealing with the systems at Duke Energy so I’ve seen this in action. There is a sweet spot between enough data to make decisions and getting buried by minutia.
You May Undervalue Your Business
There are a few reasons why making sure that your business books show the true value of the business. Taking out a loan, buying a house, bringing in angel investors, all require you to show solid financial statements.
If you run personal expenses through your business books, even if you are making tax adjustments so it’s all above board, it still appears as though you are not as profitable as you really are.
What’s The Fix?
There are a few ways to accomplish what you want with your business income and still satisfying the IRS and standard accounting practices.
- Start with today. Don’t worry yet about how you’ve been running your books in the past, go ahead and open that business account to deposit all of your sales.
- Open a second business bank account for all of your business expenses.
- Twice a month, look at your sales balance and decide how much you need to transfer to the expenses account to pay all of your bills.
- When you pay a business expense out of your personal accounts, take a picture of the receipt so you can reimburse yourself.
- When you take pay a personal expense out of your business account, classify it as owner’s pay.
That’s it, that’s all you need to do for now.