Why You Shouldn't Mix Business and Personal Finances
Money is one of the most important aspects of our lives, and it's essential to manage it wisely to achieve financial stability and success. As a business owner, it's even more critical to ensure that your finances are in order, both personally and professionally. Unfortunately, many entrepreneurs make the mistake of mixing their business and personal finances, which can lead to severe consequences.
We know the title of this blog may seem obvious. But do you know exactly why, besides the basic fact that it just sounds like a bad idea?
Besides being extremely confusing if you combine the two, there are several types of risks involved by mixing personal and business finances. Education is the first step in avoiding this potentially costly mistake, so you are definitely in the right place.
We will break down for you the importance of keeping personal and business finances separate, the types of risks and potential consequences involved if you don’t, and tips on how to keep them separate and maintain each one as its own entity, so that you can protect your personal and business’s financial futures.
The Importance of Keeping Personal & Business Finances Separate
It's easy to think that mixing finances will simplify things, but in reality, it can create more problems than it solves. When you mix your personal and business finances, you run not just one type of risk, but multiple – legal, tax, financial, and personal issues.
We will dig through each of those four main types of risk when it comes to mixing personal and business finances, and then provide practical tips to avoid falling into those risks. We believe that it isn’t enough to inform you of the risks involved – we want to make sure you are educated on how NOT to succumb to the associated risks, too!
Legal Risks of Mixing Business & Personal Finances
Mixing personal and business finances can lead to significant legal risks that can negatively impact your personal and professional life. When you combine your personal and business finances, it can be challenging to distinguish between personal and business assets, which can lead to legal issues and disputes.
One of the most significant legal risks of mixing personal and business finances is that your personal assets could be at risk if your business faces legal issues, all because your finances weren’t appropriately separated. If your business gets sued or faces financial difficulties, your personal assets could be seized to cover any debts or liabilities. In simpler terms, this means that your home, car, or other personal belongings could be at risk if your finances are mixed.
Also, if you're a sole proprietor, mixing personal and business finances can expose you to unlimited personal liability. This means that if your business gets sued, you could be personally responsible for paying any debts or liabilities, which could lead to bankruptcy or financial ruin.
Another legal risk of mixing personal and business finances is that it can make it difficult to comply with tax laws and regulations. When you mix your finances, it can be challenging to distinguish between personal and business expenses, which can lead to tax issues and audits. This can result in fines, penalties, and legal fees that can be costly and time-consuming.
Mixing your personal and business finances can also lead to legal disputes with partners or shareholders. If you have business partners or shareholders, it's crucial to keep your finances separate to avoid disputes related to personal expenses or assets. This can help you avoid legal battles that could hurt your business's reputation and financial stability, and cause partners to back out.
Tax Risks of Mixing Personal & Business Finances
Several of the tax risks associated with mixing personal and business finances criss-cross with the legal risks and financial risks, but there are certain tax risks that stand out, too. Here are some of the key tax risks associated with mixing personal and business finances:
- Loss of tax deductions: When personal and business expenses are combined, it can be difficult to determine which expenses are tax deductible and which are not. If a business expense is mistakenly classified as a personal expense, the business may miss out on valuable tax deductions that could lower their tax liability.
- Possible IRS audits: The IRS is more likely to audit businesses that have combined personal and business finances. If the IRS determines that a business has improperly claimed personal expenses as business expenses, the business may be subject to penalties, interest, and additional taxes.
- Double taxation: If a business is structured as a pass-through entity, such as a sole proprietorship or partnership, the business income is generally not subject to federal income tax. However, if personal expenses are mixed with business expenses, the business income may be subject to double taxation. This means that the business income will be taxed at both the business level and the personal level.
- Underreporting income: When personal and business finances are mixed, it can be difficult to accurately report business income. If business income is underreported, the business may be subject to penalties and interest.
- Failure to pay estimated taxes: If a business owner is not tracking their business income separately from personal income, they may not be making the appropriate estimated tax payments throughout the year. This can result in penalties and interest for underpayment of taxes.
All in all, separating your business finances from your personal finances is essential to avoid tax penalties, audits, owing extra, and heightened interest.
Personal Risks of Mixing Personal & Business Finances
It’s not just tax and legal risks that go along with mixing your personal and business finances – there are a whole host of potential personal consequences that can happen, too. Here’s a list of the top seven:
- Increased Personal Liability: When personal and business finances are mixed, it can be difficult to determine which funds are used for which purpose. This can expose personal assets to business liabilities in case of legal issues or lawsuits.
- Compromised Credit: When personal and business finances are intertwined, it can become difficult to keep track of credit scores and credit history. Any financial difficulties that the business may face can affect the credit score of the individual as well. This can make it difficult for the individual to obtain loans or credit cards in the future.
- Tax Issues: Mixing personal and business finances can create confusion when it comes to taxes. The individual may end up paying more taxes than necessary or face penalties for failing to report the correct amount of income.
- Personal Financial Instability: Mixing personal and business finances can lead to a lack of financial stability for the individual. This is because the individual may end up relying on business finances to cover personal expenses, which can lead to a lack of emergency funds.
- Loss of Personal Assets: In case of business bankruptcy or legal issues, the individual's personal assets may be seized to pay off business debts. This can include personal bank accounts, investments, and even property (car, house, etc.)
- Strained Relationships: One wouldn’t normally count this as a risk, but mixing personal and business finances can put a strain on personal relationships. This is because personal and business interests may clash, causing disagreements and conflicts within personal or business relationships. (i.e. using business credit cards to pay for personal items, etc.)
- Decreased Business Credibility: Mixing personal and business finances can decrease the credibility of the business. This is because it can create the impression that the business is not well-organized or is not operating on its own merit. Employees may notice this one especially, and it may be a factor in their leaving the company.
Financial Risks of Mixing Personal & Business Finances
Again, some of these are intertwined with the risks mentioned above. This is because mixing personal and business finances creates a complex, sticky web where the areas of risk leak into one another. (Even more reason to do your best to avoid doing it!)
Here are some of the financial risks of not separating your personal and business finances:
Difficulties in Tracking Expenses: When personal and business finances are mixed, it can be challenging to track expenses and income accurately. This can make it difficult to determine how much money is being spent on personal expenses versus business expenses, which can lead to overspending and financial instability. (Red flag to potential employees and potential credit lenders!)
Loss of Tax Deductions: When personal and business finances are mixed, it can be challenging to determine which expenses are tax-deductible. This can result in missed tax deductions, which can increase the amount of taxes owed.
Legal Issues: When personal and business finances are mixed, it can be difficult to determine who is responsible for paying debts and liabilities. This can lead to legal issues, such as lawsuits and bankruptcy, which can be financially devastating.
Credit Problems: When personal and business finances are mixed, it can be challenging to maintain a good credit score in regards to both your personal and business credit scores. This can result in difficulties obtaining loans and credit cards in the future, which can make it difficult to grow the business or invest in personal projects.
Personal Financial Instability: Mixing personal and business finances can lead to a lack of financial stability for the individual. This is because the individual may end up relying on business finances to cover personal expenses, which can lead to a lack of emergency funds.
Increased Risk of Fraud: When personal and business finances are mixed, it can be easier for fraud to occur, as there is no clear boundary between the two. A hacker may be able to gain access to both the personal and business information and finances easier since they aren’t separated.
How to Avoid The Risks of Mixing Personal & Business Finances
Avoiding all of the risks mentioned above shouldn’t be reactionary. Avoiding the mentioned risks starts the day that your business starts. You must take a proactive approach in keeping your personal and business finances separate. Setting yourself and your business up for success from the get-go ensures that your personal and business finances start separate and stay separate.
One of the best things you can do to ensure this happens is to apply for a business checking account, business credit card, and business line of credit/loan when you first launch your business. These simple acts make sure that any financing, credit terms, payments, and purchases are done through your business, and not through your personal credit and finances.
Here are other practical steps you can take to avoid the mess that mixing personal and business finances creates:
Establish a Budget: Create a budget for both personal and business finances. This will help ensure that funds are being used appropriately and that expenses are not exceeding income in both areas.
Maintain Accurate Records: Keep accurate records of all financial transactions, including receipts, invoices, and bank statements. This will help ensure that all expenses and income are tracked correctly (personal in the personal records and business in the business records) and can be easily accessed in case of an audit or legal issues.
Consult with a Professional: Consult with a financial professional or accountant to ensure that all financial decisions are sound and legal. This will help mitigate the risks of legal issues, tax problems, and financial instability. A financial pro can help you elevate both your personal and business finances. They can also act as a set of third party eyes to ensure that things are truly on track to staying separate.
In essence, keeping personal finances separate from business finances and vice versa may seem like a simple feat. However, it can be so easy to mix the two if you let your guard down and don’t practice good habits to keep them separate.
You’ve learned all about the numerous risks involved if you do mix business and personal finances. However, you’ve also learned practical ways to avoid those risks and making those mistakes. That’s what counts.
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