Certain things just don’t mix well — like a good scotch and soda, like Rajnikant and Laws of Physics, like Rahul Gandhi and politics and like your personal finances and your business’s. Keeping these things separate not only helps you reduce problems, it also greatly simplifies things and makes it easier to manage your finances.
When you first started your business, like many entrepreneurs, you may have used your personal assets for startup capital, or may have secured a business loan based on personal assets. As your business grows, creating a clear boundary between your personal and business finances is crucial to staying on the right side of the law.
Even if you’re just starting out, it’s essential to split up these two parts of your money life. Treat your business, no matter big or small, like a viable entity.
Don’t know where to start with separating out your personal and business finances? Let’s start with expenses.
An expense can be defined as money spent or cost incurred in an organization’s efforts to generate revenue which is also known as the cost of doing business. However, there are expenses that are carried for satisfying our wants and needs that are of personal nature and does not result in any incremental revenue.
Therefore, separation of both these expenses is a very necessary exercise. Some of the reasons why this exercise should be carried out:
1) The cost of doing business
As a business person you would always want to ascertain your cost of doing business and to analyze various expenditures carried out during the year. There might be some expenses which you might want to control or avoid altogether, but the same cannot be ascertained if personal expenses are also clubbed with them. There might be even cases where a major portion of a particular expenditure is of personal nature but is clubbed and claimed as an expense in the books of business, hence increasing the cost of doing business unnecessarily. For example, if you travel to your office by your car and also use the same car for personal purposes then the vehicle maintenance and fuel expenses should be allocated between personal and business uses appropriately.
2) Statutory Compliances
Among numerous laws, Companies Act and Income Tax Act particularly require ‘persons’ to separately account for personal as well as business expenses. Income Tax act requires adding back any personal expenses if deducted while ascertaining book profits to arrive at taxable profits as the same. Hence, separation is necessary as well as mandatory to avoid non-compliance with laws in force.
3) Treatment Of Assets
Most of the times, personal assets are added to the block of business assets and depreciation is claimed which ultimately leads to a reduction of tax liability. This is a classic case of tax evasion and many a times laymen don’t even know that they are a part of such activity due to unawareness and improper guidance by their income tax professional. Hence, to avoid unwanted and unexpected repercussions one should maintain separate books of accounts for personal as well as business expenses. For example, you have bought a video game console as a gift to your son and maintained the same as a business asset as you do not maintain any separate personal account. Depreciation on such machine will lead to understating of income which ultimately results in lower taxes. Same goes with all the sorts of personal assets which you are carrying in your business balance sheet.
4) Know your assets and liabilities and ratios
Intertwined books of accounts will not give a proper and fair view of your assets and more importantly your liabilities. This may even lead to chaos and result in delayed and even non-payment of liabilities which require immediate attention. For example, you have deposited a huge amount in a certain portfolio to be used in future only for personal purposes. Such investments do not add any value to the business and mixing them with your business investment portfolios may give you a wrong picture of your business net worth and assets available for business.
5) Claim on assets
Separating personal assets from business assets is a must. For example, you have taken credit by mortgaging your business assets, then if things go south then only your business assets shall be seized and the lending company will not have any right to seize your personal assets. However, non-separation may result in seizing of personal assets as well.
How to separate your personal and business finances?
Make it official
Consider establishing a partnership firm, limited liability company or a private entity for your business.
You can refer to Ministry Of Corporate Affairs’s website or sit down with your advisors – like CAs, lawyers, CPAs or financial planners and determine what entity makes the most sense, how this business will impact your taxes and financial planning.
These business entities will also give your personal finances a new level of liability protection, which could come in very handy of your business is ever sued.
Classification of finances
Keeping separate records of accounts, one for personal and another for business nature of finances is one of the oldest methods. However, maintaining two separate books of accounts can be cumbersome and are prone to errors. Hence, proper classification of heads of accounts is a must for keeping personal and business expenses and incomes separate.
For example, you have purchased two desktop computers of which one is to be used at home. Then in such case, the cost of that one computer to be used at home should form part of the amount drawn out of business for personal purposes and not of business block of assets.
Open separate expense accounts
If you are paying for some services or products which are used for your business as well your personal needs, then you must keep in mind to open separate expense accounts due to the similarity of expenses. For example, UBER cab booking application provides you the choice to select whether a particular trip is for personal or business purpose. Before riding, you can select the appropriate head and avoid either overcharging or undercharging the workplace with cab fares.
Separate bank accounts and credit cards
Separate bank accounts and plastic currency such as debit cards and credit cards enable you to maintain a tally of such finances separately, and there will be no need to group and analyze each and every expense/income from the bank statements, as the process is lengthy and cumbersome.
For example, open a separate bank account and a credit/debit card for that account and it should be solely used for business expenses. Same goes with your personal account and plastic cards, that they should not be used for carrying out business expenses.
Pay Yourself a Salary
One should fix a particular amount to be withdrawn every month from the business as personal drawings for carrying out household expenditure. Open another separate personal account meant only for the purposes of carrying out expenses of personal nature. By adopting this practice, the amount withdrawn as drawings will not affect the profit and loss statement of the business and separation of accounts and bank statements will ultimately provide clarity and proper maintenance.
Separate loan accounts
Imagine, you want to avail home loan from a bank in which you even have your business account with, and the bank official offers you to adjust interest periodically from your business account. This looks good as you will not be required to keep track of your periodical payments and the bank will do the same for you. However, a house is a personal asset and interest on such assets if adjusted from the business account will ultimately end up forming part of business interest expenses.
Therefore, one should adjust the same from the separate drawings account in the bank and linking with business account shall be avoided.
Hire a professional accountant
If you want to manage finances, you ought to hire a professional accountant. A professional accountant will guide you through classification of expenses, accounting treatment, taxation impacts of transactions, etc. Hence, hiring a professional accountant will enable you to keep your books clean and clear.
Implement a dedicated accounting system
If you’re comfortable with a Do-It-Yourself approach, there are a number of tools available for tracking your business income and expenses. For example, ProfitBooks allows you to create invoices, record expenses, track inventory and manage taxes. Its super simple to use and you don’t need any accounting knowledge to operate it.Try ProfitBooks Free Now
Business owners intertwine business and personal finances all too often. After all, you are your business, but muddling up the two will mean a mess at tax time.
Maintaining clear lines between your business and personal expenses doesn’t need to be challenging. Setting up a clear distinction between your personal and business finances, and consistently keeping them separate, is fundamental to your business’s success.
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