It can be hard to think of the business that you own as an independent entity. But separating personal and business finances is key.
Chances are, you probably work odd hours and are used to paying for business expenses out of pocket (at least in the beginning). When you think about your monthly expenses, you most likely consider everything—including mortgage or rent, car payments, school loans, groceries, and business expenses.
However, as your business grows, it’s important to keep your personal and business finances separate. In this post, we’ll discuss why it’s so important for small business owners to maintain this sharp distinction and offer some tips on how to do it.
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What Does It Mean to Pierce the Corporate Veil?
Piercing the corporate veil means breaking through the protective layer of a corporation and exposing individual shareholders to personal liability.
This can be a bad thing for a corporation, as it can lead to lawsuits and financial instability. There are several ways to prevent this from happening, including maintaining good corporate governance practices and keeping accurate records of company finances.
5 Reasons to Avoid Piercing the Corporate Veil
There are several reasons why piercing the corporate veil is bad for business entities and their shareholders.
1. Tax-Time Headaches
If you have been running a small business or freelancing for several years, you know how hard it can be to track down all your business income and legitimate expenses at tax time.
This task is exponentially harder when you’ve been using the same checking account for your groceries, household bills, and office expenses. Maybe you have to dig through receipts to find one that might include a purchase for office stationery, or check each month’s credit card statement and figure out which furniture purchase was for your living room and which was the new desk for your office.
Keeping a separate bank account and credit card account for your business keeps everything organized. When it’s time to file your returns, it will be easy for you or your accountant to clearly identify all relevant income and expenses.
2. Audit Difficulties
Separating your accounts won’t just facilitate your tax filing, it will also prove useful should the IRS ever audit your business. As certified financial planner Richard Salmen explains, “If there’s ever a question as to whether it’s a hobby or a business, the IRS looks to see if you have a separate checking account.”
3. No Clear Picture of Your Business’s Financial Health
When your business expenses are mixed with your personal monthly expenses, it’s challenging to see a clear picture of your business’s finances.
Separating your finances can go a long way to better understanding how much you’re spending on your business, what you’re spending it on, and where you could cut back.
4. Lack of Business Credit
Most small business owners rely on their personal credit and assets to fund their businesses. The reason is simple: Banks won’t even think about granting a loan or credit to any person or entity that doesn’t have a credit history. When you open a business bank account and credit card, you’re taking a very important step toward building your business’s credit profile.
Using a business credit card wisely will help increase your business credit card limit. This, in turn, can help boost the borrowing power of your business so you can get bigger loans with lower rates down the road.
Moreover, a business credit card won’t always impact your personal credit score and, in some cases, the interest paid on a business credit card is deductible as a business expense.
5. For Corporations and LLCs, It’s the Law!
If you formed a corporation or LLC for your business, then you’ll need to keep your business and personal finances separate to stay on the right side of the law.
Here’s why: A corporation or LLC (limited liability company) is considered a separate legal entity from the business owner. It’s this separation that may have compelled you to incorporate or form an LLC in the first place, as it helps minimize your personal liability.
But since the corporation or LLC is a separate legal entity, it needs its own bank account and tax identifier number. In fact, should your business ever be sued, the plaintiff may try to show that you’ve mixed your personal and business finances, thus making the case that they’re entitled to pierce the corporate veil and hold shareholders personally liable.
In short, if your business is structured as an LLC or corporation, you must separate your business and personal finances. And if you have a sole proprietorship, it’s still a smart idea for the 4 reasons mentioned above.
How to Maintain the Corporate Veil
Once you recognize the significance, you might be wondering how exactly you should separate your business and personal finances to maintain the corporate veil. Here are 5 steps to take to keep corporate and individual property separate.
1. Set Up a Business Checking Account
There are tons of free checking accounts out there. You may want to open a business bank account where you already have a personal account in order to facilitate transfers between the two. Just be sure to understand all the fees, minimum balance requirements, and other fine print for the account.
As a general rule, you need an employer identification number (EIN) in order to do this, and sometimes your business formation documents.
2. Open a Business Credit Card
Run all business activities through this credit card or your company checking account rather than your personal credit card or checking account. This helps establish that the company is a separate entity from corporate shareholders.
Protect it as you would your personal card and use it wisely!
3. Stay Disciplined
Put all your business expenses on the business credit card or checking account. If you’re accustomed to throwing all your purchases together, this can be a hard habit to break. Just remember that you’re a business owner, not just a freelancer, and you need to treat your work as a business.
4. Observe Corporate Formalities
If your business is structured as a corporation (as opposed to a sole proprietorship or LLC), observing corporate formalities is one of the most important things you can do to protect yourself and your company.
Corporate formalities are a set of rules that must be followed in order to maintain the separate legal status of a corporation. If these rules are not followed, the corporation can be treated as a mere extension of its shareholders, and they will be held personally liable for business debts and obligations.
- Steps you can take to follow corporate formalities include:
- Keeping accurate records of all annual meetings and resolutions
- Issuing stock certificates to all shareholders
- Filing annual reports with the state government in a timely manner
- Complying with any other regulations that apply to your state or industry
5. Adequately Capitalize the Company
Another key way to keep the corporate veil intact is to ensure that the company is adequately capitalized. This means that the company has enough money to cover its debts and legal expenses, in the event that something goes wrong. Inadequate capitalization can be a major factor in why a company becomes vulnerable to piercing the corporate veil.
Piercing the corporate veil can have a number of negative consequences for businesses. It can be expensive and time-consuming and lead to disputes among shareholders. New shareholders may be less likely to invest in a company if they know that their personal assets are at risk, and piercing the corporate veil can lead to a decrease in confidence in the company. All of these factors can have a negative impact on the business’s value and its ability to attract new investors.