In the dynamic world of small business, entrepreneurs often wear multiple hats and juggle various responsibilities. One common mistake that many small business owners inadvertently make is commingling personal and business assets.
While this might seem like a convenient way to manage finances, it can lead to significant legal and financial consequences.
Let’s discuss what commingling is, the associated risks, and practical steps on how small business owners can effectively separate their personal and business assets so that they can thrive professionally and personally.
Commingling Defined
Simply put, commingling is when personal expenses and assets are intertwined with business expenses and assets. This can take a variety of forms.
Some common practices include purchasing groceries with a business debit/credit card, using a vehicle titled in a person’s name for business purposes, and improperly taking a home office tax deduction.
When this happens, the business could be said to be an “alter ego” of its owners. Meaning, there is no real distinction between the business entity and the people who own and operate it. This is not just a problem for organization and taxes, but also for the legal protections that come with business entities like the LLC.
The Risks of Commingling Personal and Business Assets
Commingling personal and business assets may appear harmless at first, but it can have severe consequences for your business. Here are some of the risks this common practice carries.
Piercing the Corporate Veil
When personal and business assets are commingled, it is challenging to distinguish between the two. This can expose your personal assets, such as your home or personal bank accounts, to potential legal claims against your business.
If there is no real separation between you and the business, if there is a legal dispute, a judge may determine that limited liability no longer applies. This is especially a risk when a small business is a corporation or an LLC. And small businesses are where most of the veil piercing happens when there is litigation.
In essence, creditors or legal entities could go after your personal assets to satisfy business debts or liabilities if there is significant commingling. This puts your personal financial security at risk.
Tax Implications
Commingling assets complicates your tax obligations. The Internal Revenue Service requires clear separation of personal and business expenses for tax purposes. One can only deduct ordinary and necessary expenses in the course of carrying on a trade or business.
Failure to diligently track your expenses can lead to penalties, audits, and a potential loss of tax deductions that your business may otherwise be eligible for. It’s crucial to maintain precise financial records to substantiate your business expenses.
Difficulty in Financial Management
Mixing personal and business finances often leads to confusion when managing cash flow, budgeting, and financial planning. This lack of clarity can hinder your ability to make informed business decisions, stalling growth and success.
By separating your business and personal expenses, you can better understand your business’s cash flow and operating needs, as well as have a better idea of what your household needs for personal expenses. This enables you to focus on getting your profit margin up so that you can confidently grow your business.
Separating Your Business and Personal Finances
Commingling is clearly a significant risk to small business owners. To safeguard your business from the risks associated with this practice, consider the following steps to separate things out effectively.
Establish Separate Accounts
Open separate bank accounts for your personal and business finances. This clear division ensures that funds are kept distinct and simplifies financial tracking and reporting. When opening a business account, you generally will need to bring certain formation documents with you to the bank.
For a corporation, this will be the corporate charter or articles of incorporation, depending on the state of formation. For LLCs, this will be the articles of organization. You will also need to bring the tax identification number assigned to your business. Businesses with multiple owners may also need to bring the bylaws or operating agreement as well.
By having all business accounts in the business’s name and under its own tax identification number, you will have a clearer distinction between yourself and the business.
Maintain Detailed Financial Records
Keep meticulous records of all financial transactions related to your business. This includes invoices, receipts, and expense reports. Well-organized records will help you prove that you’ve maintained separation for tax and legal purposes.
We recommend using accounting software like QuickBooks to track your business expenses and clearly define what constitutes an operating expense, such as payroll, owner distribution, professional fees, etc. A CPA who manages payroll and bookkeeping may also be a good resource for you to handle this administrative aspect of your business.
Set a Salary or Distributions
Pay yourself a salary or regular distributions from your business profits instead of commingling. This approach ensures that you receive compensation while keeping personal and business finances separate.
Whether you do salary, distributions, or a mix depends on your business’s tax status and internal governing documents. A corporation needs to determine who the corporate officers are in addition to the board of directors. Shareholders receive distributions in accordance with the terms laid out in the bylaws. Corporate officers will receive a regular salary for performing their duties.
An LLC can have one of two options for this. An LLC is a “disregarded entity” for tax purposes by default. Profit and loss flow to its members’ personal tax returns. In such case, the members generally take distributions as their “salary,” which is generally subject to self-employment tax.
But you can change this by timely electing corporate tax status with the IRS. If you choose to do so, then you will need to run payroll for regular salary, and then determine what your procedure will be for owner distributions on top of that. Consult with a CPA to determine which tax status is best for you and your business.
Work with Trusted Professionals
Seek advice from financial planners, CPAs, and legal experts who work on small business matters regularly. They can provide guidance on proper accounting practices, tax compliance, and asset protection strategies tailored to your unique business needs.
Final Thoughts on Commingling Personal and Business Affairs
In the competitive landscape of small business, it’s vital to prioritize separation of personal and business assets. Commingling personal and business affairs exposes your household to substantial risks. These include legal liabilities, tax complications, and general financial disorganization.
Adopt a proactive approach by establishing clear financial separation and seeking professional guidance when needed. At Connell Law, PLLC, we understand the unique challenges faced by small business owners in Tennessee. We practice small business law and can provide you with legal solutions and general business consulting to help your business thrive and safeguard your personal assets.
Take the first step towards greater business and personal financial security. Reach out to Connell Law, PLLC today for a free consultation. Plan today for a more peaceful tomorrow.
