To a small business owner, the line between personal and business finances can be fuzzy. New ventures often start out with seed money taken from personal funds, and it can seem like both a hassle and a needless expense to open separate banking and credit accounts for the business, when your personal accounts work just fine. In tax terms, for sole proprietorships, LLCs, and other “pass-through” entities, the distinction can seem unimportant — if the IRS is going to tax your business income the same as your personal income, what does it matter if you combine your finances?
In fact, it matters a great deal. Speaking as a bookkeeper and business advisor specializing in supporting small businesses, the commingling of business and personal accounts is the most common mistake I see potential clients make. There are at least three strong reasons why you should avoid making it with your business.
The first reason is legal. Commingling can threaten the limited liability protection afforded by LLCs and other business entities, putting your personal assets at risk in case of a lawsuit. In court cases where the plaintiffs seek to “pierce the veil” of liability protection and go after personal assets, a key legal test is whether there is a clear distinction between the business and the business owner. In other words, the business must both function and appear like a standalone entity, clearly distinguished from the owner’s personal assets. An owner that treats the business accounts like a personal piggy bank could see that distinction disallowed in court.
The second reason is financial. Commingling creates confusion, increases risks of significant errors, and creates more work for your bookkeeper and accountant. More work means higher fees you’ll have to pay them to decipher the puzzle and provide clear and accurate financial reporting — not to mention the potential cost of filing amended returns if the commingling was not correctly reconciled in past tax years.
The final reason is strategic. Your business books are more than a set of records to be used at tax time. They are the fundamental data set tracking the health of your business. If properly constructed and accurately maintained, they can provide a roadmap showing you how to improve your business performance. A trusted business advisor can analyze your financial performance and identify opportunities to improve on critical dimensions like cash flow, profitability, and cost control. Having personal financial transactions muddy the waters can prevent this kind of meaningful analysis, and paint a misleading picture of the business’s performance and overall value.
In sum, business and personal finances should be kept almost entirely separate. Personal transactions should be reflected only in your personal bank accounts and credit lines. Business transactions should impact only business accounts. The only link between the two should be whatever regular transfers you make to pay yourself throughout the year, be it in the form of owner’s distributions from equity, or a regular salary.
Beyond that, as Kipling’s bookkeeper alter ego might have said, personal is personal, and business is business, and never the twain shall meet.