When your business is your life, it’s easy to sometimes blur the distinction between personal and business expenses. We know that building and running a small business is challenging enough without the additional need to defend yourself in an IRS audit. But the impact of coming out on the wrong end of that unpleasant experience could erase your bottom line — and then some.
Even if you didn’t have to worry about the IRS, there are other reasons to separate business and personal finances. But here’s the good news: It’s not as hard as you might think.
Here are some basic reasons sound bookkeeping is essential to running a successful business and securing small business financing.
Avoid a Nasty Audit
Let’s start with the IRS. Let’s say you’re audited and the IRS decides that you’ve overdone it on expenses, writing off items like personal use of your car, meals and similar kinds of personal expenses. In the best-case scenario, the IRS disallows the improper expenses, adds those amounts back to your taxable income, and taxes you on it. It could come as a nasty surprise, but probably not the end of the world.
However, if that adjustment results in a big jump in your tax liability, you might have to pay interest on the amount of the underpayment, depending on how much you paid in your quarterly estimates over the course of that tax year.
But here, the IRS lists three serious potential consequences if the revenue-collecting agency decides (rightly or wrongly) that your errors weren’t innocent mistakes:
- If you file an erroneous claim for a refund or credit, you could incur a 20 percent penalty of the disallowed amount.
- You could face a $5,000 penalty for filing a “frivolous tax return” — one that lacks sufficient information to determine the correct tax, or a tax return that clearly shows the information reported is largely incorrect.
- On top of the tax you already owe, you could face a penalty of 75 percent of the amount owed if you underpayed due to tax fraud.
Make it Easier to Secure Funding
So much for doomsday scenarios. A far more likely problem you’ll run into is that by not separating your business and personal finances, you’ll find it much harder to know how your business is performing. And without that knowledge, it can be hard to decide which way to steer the ship.
It could also make things tougher from a small business financing perspective. That is, it could be harder to borrow funds to smooth out your cash flow to better manage day-to-day operations. Similarly, you could face an uphill battle to secure adequate funding for capital expenditures to expand your business. It could even lower how much someone would want to pay for your business, if and when you wanted to sell it.
Let’s say you’re writing off the entire annual cost of a car that you only use half the time for your business. That might mean you’re overstating your auto expenses by $5,000 in a given year. And let’s say you’re also claiming that while $6,000 in travel expenses was for your business, only $3,000 of it was actually attributable to the business part of the trips you took. Right there your businesses is looking $8,000 less profitable than it actually was.
Also, cleaner accounting might tell you that you need to cut back a bit on your discretionary personal spending to build a stronger track record of business profitability.
Simplify Your Accounting
Keeping separate business and personal finances doesn’t always mean accumulating a mountain-high pile of receipts and adding them up one-by-one. Take auto expenses. You could keep all those receipts and separate them out. But as long as you keep tabs on the mileage of your business trips, you can just take a mileage-based deduction (54.5 cents per mile in 2018).
Or suppose you use part of your home to run your business, and you don’t want to add up all your home expenses to calculate the business portion. An “optional safe harbor method” allowed by the IRS lets you write off $5 per square foot for up to 300 square feet.
Finally, there are plenty of user-friendly business expense tracker apps out there that you can use from a mobile device, just to avoid letting it all get away from you.
Yes, even with those apps the accounting can be a bit tedious. But when you weigh the costs and benefits of keeping your business and personal expenses straight, there’s really no contest.