Consider keeping personal and business expenses separate

If you organize your business as a limited liability company (LLC) or corporation to shield your personal assets from debts and other financial obligations incurred by the business, consider keeping personal and business expenses separate and let the business use separate checking, credit card and other accounts to pay its expenses.

Your personal and business tax returns are also a lot less likely to be audited, according to many accountants.

But what if you are among the millions of construction contractors, landscapers, caterers and other small construction businesses that operate as sole proprietorships and you report your business income on your personal income tax return using a Schedule C? While many banks offer low-cost or even free business checking and credit card accounts, is it worth your time and effort to open them if creditors can still come after your personal assets to satisfy a debt or judgement?

That’s a determination every sole proprietor has to make on his or her own based on the circumstances of the situation. If you are a freelance writer and you work from home, rarely use your vehicle and have minimal equipment expenses, keeping personal and business expenses separate like opening separate accounts to pay for business expenses may not make sense.

If you are a sole proprietor who uses trucks and other equipment exclusively for business, keeping personal and business expenses separate like opening checking, credit card and other accounts for your business may be worth it.

Consider the following benefits when keeping personal and business expenses separate

• Easier tax preparation: If you use business accounts exclusively to pay business expenses, you will no longer have to sort through your personal checking and credit card accounts for legitimate business expenses and deductions. Keeping personal and business expenses separate can save you hours when it’s time to sit down and prepare the Schedule C and state forms you must file with your personal tax returns.
• An aura of professionalism: Printing the name of your business on checks, invoices and credit cards sends a signal to potential clients, vendors and partners that you are a serious professional. And it’s easy to do. Many banks will open a checking account in the name of a business as long as the sole proprietor, LLC or corporation can produce a business license, assumed name, or registration of trade name. Check county or state government websites for instructions on how to register, renew and change a fictitious name. Filing fees generally range from $5 to $50.
• Cost accounting: Paying business expenses exclusively with business accounts makes it easier to determine the true costs of running your business and whether you are making a profit and reaching your financial goals.
• Reduced audit risk: While the Internal Revenue Service (IRS) audited just 0.9–2.1 percent of Schedule C income tax returns in 2016, that was still two to four times the audit rate for individual income tax returns overall, according to the 2017 IRS Data Book. While reduced funding has curtailed audit rates significantly in the last four years, the IRS remains focused on catching errors in Schedule C returns. Consistently using separate accounts to run your business will make it easier to respond to IRS record requests.

Notice the use of the words “exclusively” and “consistently” above. Setting up separate bank and credit card accounts to run your business won’t help you avoid or prevail in a tax audit if you use the accounts inappropriately. While the IRS generally does not require sole proprietors to follow a specific record-keeping system, it does expect them to prove their business expenses are legitimate regardless of what accounts they use to pay them. Whether you report your business income on a Schedule C or your business files a separate tax return, auditors will want to see receipts, canceled checks and other evidence to support your assertion that the reported expenses and deductions are legitimate.

According to the IRS website, “To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business.”

While “ordinary” and “necessary” vary depending on the business, accountants say that home office deductions, car expenses and travel and entertainment expenses draw the most scrutiny from tax authorities.

If you have organized your business as an LLC or corporation, it’s important to note one other hazard of using business accounts to pay for personal expenses. Attorneys can, and have, successfully argued that paying personal expenses from business accounts invalidates your corporate shield and makes you personally liable for the business’ liabilities, including creditor debts and court judgements.