Overpaying on your taxes or getting audited by the IRS aren’t fun prospects for you or your small business, but those are two scenarios you could face if you don’t have the discipline to separate your business and personal expenses.
While separating these expenses sounds easy enough, it can get complicated, especially if you operate a pass-through business such as a sole proprietorship, limited liability Corp. (LLC), partnership or S corporation and are taxed as an individual rather than a corporation.
Commingling your business and personal assets could also get you into trouble if your business is sued, and you may face personal asset exposure in such a scenario. The IRS also demands stringent records of business expenses at tax time, so if you’re keeping your business receipts in a shoe box, you could face tax penalties at the end of the year or end up missing out on tax deductions because you paid for business expenses from your personal account and forgot about them.
The good news is that with some planning and discipline, there are definitive steps you can and should take throughout the year to separate those expenses so you won’t be facing major headaches at tax time.
#1 Get Your Paperwork in Order
If you haven’t done so already, declare the type of business you are with the IRS, be it a sole proprietor, LLC partnership or an S Corp. Doing so will affect how you pay taxes, your legal and personal liability, and your ability to raise capital. Becoming an LLC or an S corp. gives your business a distinct legal identity and separates you from your business’ shareholders, if you have any.
Additionally, create an Employee Identification Number (EIN). Much like a Social Security number, this is a unique, nine-digit identification number that allows you to conduct tax-related business and open bank accounts in your business’ name, thus making it easier to separate business and personal expenses.
#2 What’s the Difference?
Before you even start, you need to understand what a business expense is and when the best time is to take a deduction on that expense. Like with most things, the IRS is not very helpful in identifying a business expense.
“To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business,” according to the IRS’ website.
While many business expenses are obvious, such as the costs of business travel and office equipment, you should consult with an accountant or attorney on other expenses of which you may not be sure. For example, if you set up a home office in addition to your place of business, or if you buy your best client an expensive birthday gift, you may need to be creative in justifying those as business expenses.
#3 Get Payment and Expense System Software
You can create a business expense system on a spreadsheet program such as MS Excel or Google Sheets. However, If you have a number of employees that are all filing business expenses, you might want to turn to expense tracking software that can make the job fairly easy. Some of the most popular software packages out there include Intuit QuickBooks, Emburse Abacus and Expensify.
Most of these software packages make it easy to identify expenses as business and personal, and most will allow you to process payments directly into accounts that you’ve set up specifically for your business and will make it easy to amortize payments and expenses (spread them out over multiple years) if you and your accountant deem it beneficial to do so. Of course, it’s crucial that you maintain the discipline to record your expenses as soon as you can so that you don’t forget to do so.
No matter what program you are using, whenever you record a business expense, you need to note the date and time of the expense, separate the cost of the expense from the tax you paid on it, and file the receipt. Most importantly, you need to explicitly state how the expense relates to your business.
#4 Open Business Accounts
Once you’ve received your EIN, you should open a checking and savings account in the name of your business. Doing so will create an efficient way to separate your personal and business expenses by having them in two separate accounts. Having accounts in your business’ name will allow for transparency in business activities and expenditures, as well as make it easier to file taxes at the end of the year and check on your business’ financial health.
Having business accounts, however, does not mean you can stop itemizing your business expenses, as you will still need to explain to the IRS how those expenses relate to your business. Additionally, having business accounts will require you to be disciplined with your personal finances as well, as it may be tempting to withdraw funds from your business account if you suddenly find yourself with a large personal expense, such as unexpected medical bills or home repair projects. It’s important to talk to your accountant about the process you need to go through and the tax implications if you need to withdraw money from your business account for personal reasons.
#5 Get a Business Credit Card
Most small business owners need a tolerable amount of debt to operate, and there are expenses such as purchasing small pieces of office equipment and paying for business meals that can be conveniently financed with a business credit card. Having a business credit card will not only allow you to more easily separate business and personal expenses, it will also prevent you from maxing out your personal credit cards on your business, thus eliminating the risk of hurting your personal credit score if your business expenses pile up.
Business credit cards sometimes carry lower interest rates than personal ones depending on your credit score, and many offer perks like travel rewards. Some even carry no annual fee. Before you apply for one, you should shop around for the best possible rates and rewards.
#6 Pay Yourself!
How you pay yourself as a small business owner can have both personal and business tax implications. Even if you’re a pass-through business, you may want to put yourself on the payroll if you have more than one employee and have a payroll system already setup. When you put yourself through your company payroll, personal income tax will automatically be deducted from your paycheck, saving you a headache when you file your year-end taxes. If your company has an especially strong year, you can pay yourself (and perhaps your employees) an annual or quarterly bonus to make sure that you are rewarded.
The one factor to be wary of when paying yourself as an employee is the IRS’ Reasonable Compensation rule, which states that an owner must be paid a salary comparable to others in the same industry and with the same job.
You can also pay yourself via an owner’s draw, in which you withdraw money from your company’s profits on an as-needed basis throughout the year. This type of salary will probably give you more immediate cash throughout the year, but you will have to pay taxes on those withdrawals at the end of the year.
Should you File Separately?
The question of whether you should separately file your business and personal taxes depends on what type of business you own. The IRS views pass-through businesses, such as LLCs, and their owners as a single entity, so in most cases, you wouldn’t need to file separately. Some multi-employee pass-through businesses, such as S corporations, partnerships and C corporations, do require separate filings, so it’s important to speak with your accountant on which action would be best for you.
Separating business and personal expenses throughout the year requires discipline and attention to detail. You may want to invest in a small filing cabinet and separate your business receipts into categories, as well as find time to properly record them. Taking these steps while consulting with your accountant or financial advisor throughout the year will save you a very complicated headache at the end of the year, and prevent you from overpaying on taxes because you missed out on business deductions.