Separating business and personal money, properly

Everybody knows they should keep business and personal money apart. Plenty of contractors do not, usually because the business started as one truck and one account and never got reorganised.

It is worth understanding what it actually costs, because the answer is more than "it makes bookkeeping annoying".

What mixing actually costs you

Your profit figure is wrong. Personal spending coded to business expenses makes the business look less profitable than it is. Every decision downstream — pricing, hiring, what you can afford — is made on a number that is not real.

Your tax return is wrong, in both directions. Personal costs claimed as business deductions are disallowable. Business costs paid personally and never recorded are deductions you paid for and did not take.

Deductions become arguable. This is the underrated one. In mixed accounts, every entry has to be defended individually because the account itself proves nothing. In clean accounts, the account is the first line of evidence.

Liability protection weakens. If you formed an LLC or corporation to separate the business from you personally, treating its money as your own undercuts that separation. The general principle is that an entity you do not respect as separate may not be treated as separate — and that is the entire reason the entity exists.

Lenders discount you. An underwriter who cannot tell what the business earns will assume the less favourable reading. See getting a line of credit.

The setup, which takes an afternoon

A business checking account. Every dollar of revenue in, every business cost out.

A business card. Not for credit — for the clean statement. It removes the single biggest source of mixing, which is the emergency supply run on whatever card was in your pocket.

A personal account you pay yourself into. Money moves business account to personal account as a draw or a wage, on a schedule. Then you spend from the personal account like anyone else.

That third step is the one people skip, and it is the one that makes the rest hold. If there is no deliberate way to pay yourself, you will keep taking money ad hoc from wherever it is.

Paying yourself properly

Money you take out is a draw — equity, not an expense. Booked as an expense it understates profit and produces a wrong return. It is one of the first things we look for in a new file and it is there more often than not.

If you have made an S-corp election, part of what you take must run through payroll as wages, and the rest is a distribution. Those must be genuinely distinguishable in the books or the election is difficult to defend. More in LLC or S-corp.

What to do about the history

You cannot unmix last year, but you can classify it correctly, and that is what matters.

Go through the mixed period and identify the personal items. Reclassify them as draws rather than leaving them as expenses. The profit figure changes — usually upward, which people find alarming until they realise it means the business was doing better than they thought.

It is tedious, it is not difficult, and it is exactly the work that gets done during a catch-up. See catch-up bookkeeping.

The ongoing habit

Business card for business, personal card for personal. No exceptions, because exceptions are the whole problem.

If you slip, note it immediately. A card payment mis-tapped is fine if it is flagged that day. The damage comes from silence.

Pay yourself on a schedule, so there is never a reason to improvise.

Related

• How much should I pay myself?
• LLC or S-corp?
• What contractors can actually deduct

General information, not legal or tax advice. How entity separation is assessed depends on your structure and your state.