Divorce your small business? Really? You may not need to be this drastic but you need to avoid this common mistake.
Take Joe Entrepreneur, for example. Joe paid for his business bills with personal funds. He though “What’s the difference?” He didn’t have the funds in his business account at the time and thought it would be inconvenient to make a bank transfer. While reconciling Joe’s accounts, his Accountant noticed that payments were not being reflected on Joe’s QuickBooks software. Not only that, if the Accountant had not caught this, Joe would have missed out on tax deductions for his business because the expenses were not reflected on Joe’s QuickBooks.
One mistake that I see small business owners like Joe Entrepreneur make on a regular basis with their small business accounting is that they fail to separate their personal and business income and expenses. This is called “co-mingling of funds.”
So what do you need to know about co-mingling of funds? First, you must understand how the IRS defines business income and expenses. Business income refers to money you have earned in your business. Business expenses refers to money you have spent on your business. The IRS also defines business expenses as “the cost of carrying on a trade or business.” The IRS also indicates that business expenses must be “ordinary and necessary.” The IRS points out that “an ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business.”
The reason that you want to separate business from personal funds has to do with legal, tax, and accounting purposes. First, a business that is organized as a limited liability company, corporation, or partnership is a separate legal entity from its owner or owners and it should have separate accounting records. Second, co-mingling of funds can potentially result in a lot of negative consequences in case of an IRS audit. Third, your small business accounting can get really messy if it doesn’t reflect all business income and expenses. You will miss out on tax deductions and your accountant will spend a lot of extra time trying to reconcile your accounts.
The best way to keep your business income and expenses separate from your personal income and expense is to:
- Open a separate business bank account.
- Make sure that all business income and expenses are handled through business bank account.
To read more about what the IRS has to say about this topic, check out IRS Publication 334 – IRS Tax Guide For Small Business.
Here’s an infographic that you can download and save: