Many small business owners operate all too casually when it comes to money. They fail to keep their business operations apart from their personal life, especially if they are just starting out or it’s a sideline activity. They use personal funds to pay business expenses and deposit business checks in personal bank accounts.
Here are five reasons why it is essential to be careful about observing boundaries with money:
Unless you separate your finances, how can you really know whether your business is profitable. You see money coming in the door and may assume that you’re making money, but are you fully aware of what it’s costing you to operate? Only by putting things in black and white can you be sure.
The tax law says businesses must keep books and records. While there is no fixed description of what books and records are, it’s clear that it is a separate accounting for business income and expenses. Receipts alone stored up for the year don’t equate to the necessary recordkeeping. If the IRS questions your return, you surely will lose some or all of your legitimate deductions because you lack the clarity to support your write-offs. (The tax law is very specific about certain recordkeeping rules, which you can find in my book J.K. Lasser’s Small Business Taxes 2011.)
3. Hobby activities
If you sustain losses, something all too common in start-up years or when the economy is bad, you may not be able to deduct all of them. A special “hobby loss rule” applies to limit losses (expenses in excess of income) to the amount of income earned from the activity. You may spend real money on supplies, advertising, and other costs to run the activity, but you won’t be able to deduct the expenses unless you can show that you’re in the activity with the intention to make a profit. How do you prove profit motive? One of the key factors that the IRS looks to is whether there are good books and records for the business, as well as a separate bank account and a separate credit card for the business.
If you need to borrow money or seek equity investors, the only way you’ll be successful is if you can display your business’ financial picture. Vague claims of profitability won’t cut it. You need detailed financial statements, such as a balance sheet and a profit and loss statement; these can only be generated if you maintain accurate information about your business finances.
5. Exposure to creditors
Many businesses are formed as corporations or limited liability companies (LLCs) in order to give owners personal liability protection. This protection is lost if the owner co-mingles finances. Creditors can argue that there really is no distinction between the owner and the business and can “pierce the corporate veil” (or take similar action for an LLC).
Three simple steps can save a business owner considerable grief:
- Use an accounting system to track business income and expenses
- Set up a separate business bank account
- Obtain a separate business credit card