Small business finance ABCs: Separate accounts
This post introduces the accounting concept of separation, the first the three keys to managing your small business finances properly. In the next post, I will discuss the importance of keeping accurate and precise financial records for your business. The last post covers how you pay yourself and other owners of your business. Together, these form the ABCs—Accounts, Books, and Compensation—of small business finance.
Why you need separate accounts
Each business needs its own bank accounts, separate from the owner's personal accounts. If you run multiple businesses, each one should have its own accounts.
You may think your side gig too small to need its own accounts, or that income from your freelance operation should deposit straight into your personal checking account. Small operations like these especially need separate accounts.
The main reason for this involves taxes. In case of an audit, the IRS—and your state tax authority—will want you to verify each business deduction from your taxable income. Having separate accounts, and using your business account solely for business expenses, greatly eases the process of differentiating legitimate business deductions from personal spending.
Setting up a separate account
Separation of your assets from business assets makes the first key to managing your business finances well. This simply means setting up a new checking account for your business and routing all of the revenues and expenses through this account.
Most banks and credit unions offer business checking accounts as a standard, free service. In most cases, you will need two things to open the account:
- The Employer Identification Number, shown on the letter you received from the Internal Revenue Service (technically Form SS-4), and
- The Certificate of Formation (or Organization) for your Limited Liability Company (LLC). Have digital or printed copies of these ready when you arrive at the bank.
The bank also needs signatures from everyone whom you want to have access to the account. Early on, keep this number small: no more than you and a trusted relative or friend. I recommend having one other signature on the account, even for a solo operation, just in case something happens and you cannot get to the bank.
Managing the business account
I recently discussed the difference between income and cash. You pay taxes on income, not on cash. If your S Corporation made $50,000 net income (after expenses) last year, and you left all that money in the business account, you paid personal income tax on that $50,000, even though you haven't personally taken that money yet.
Now say this year you completely shut down your business, so you have no net income. You withdraw the $50,000 into your personal checking account. Do you owe taxes on that money? No! You already paid taxes on that income last year.
The point is this: if you could put that cash to good personal use, such as paying off debt or saving for a goal, then don't leave it sitting in the business account. Leave enough to cover upcoming business expenses between now and the next time you deposit revenues, plus a reasonable cushion if you want.
Now that you have separated your business and personal accounts, you need to maintain accurate and precise records of your business assets, liabilities, revenues, and expenses. The next post covers how to set up and keep your company's books.