There are a million meaningful reasons to operate an arts business, from creating revelatory art experiences for the public, to a commitment to a tradition, to the love of making hand-crafted objects. But at the end of the day, if it is a business (and not, say, a non-profit), a major purpose is to make money to pay for the expenses of living. And if the purpose of the businesses’ earnings is to pay for our personal expenses, why then is it so important to keep the business financial transactions separate from our personal ones?
The reasons are simple. It protects you from tax trouble and legal trouble. And it’s the law.
Here is an example to illustrate the tax trouble scenario. Let’s say you operate a letterpress. Your core income is from printing high-end wedding invitations, but your true love is printing full color publicity posters for rock bands. This is a totally respectable business model, and while you love what you do, you are definitely earning a living. But the business part has never been your strong suit, and you have been depositing your printing business money into your personal checking account, and using that same account for personal expenses like buying groceries and clothes, and paying rent.
Now let’s say that after a string of bad years in your printing business due to forces beyond your control—a boycott of your state because of a recently passed piece of homophobic legislation, say—you get audited. So far this is all pretty normal—people with a string of losses in their arts business will tend to get targeted for audit, because the IRS wants to check that the business is legitimate, and not a hobby or a tax shelter. Because your printing business is generally sound, and the recent downturn is explainable and not within your control, you can probably expect to come out of this audit unscathed.
But when the IRS looks at your bank records, they see one account where business and personal items mix together. To them, this is a strong indication that your business is a personal hobby, and not something you take seriously or treat in a businesslike manner. They deem it a hobby, and disallow your recent losses, resulting in you having to pay back the difference in taxes, plus penalties and interest. It totally sucks to be in this boat, and you could likely have avoided it if you had a separate business account, and you kept it clean of personal expenses. The IRS has a nine-point list of factors they consider when judging whether your arts business is a bona fide business or a hobby. And they give a lot of weight to the separation of your business and personal accounts.
Here’s an even more serious example of how mixing your business and personal expenses can hurt you.
But first, a little background on corporate entities. Business are run by individuals. When you operate a sole proprietorship and file a Schedule C for it on your personal tax return, you have no legal separation between yourself and your business. Millions of small business in the US operate this way, and when you’re small and not incurring much liability, it’s perfectly fine to do so. But a snag arises when you get in legal trouble.
Let’s say that you, Arty McArtist, are operating a sole proprietorship arts business. You make large wooden sculptures, and during your latest installation, one of the installers is crushed when your sculpture falls on top of him, and he can never work again. The worker decides to sue. Because there is no legal separation between you, Arty McArtist the person, and Arty McArtist the arts business, when he sues you, he can not only go after the assets of your business – your tools, your studio, your inventory – he can also go after your personal assets – your home, your car, and your kids’ college fund. Ouch.
There is a way to eliminate the personal legal exposure that this nightmare scenario illustrates. You can make your business its own separate legal entity. This has other benefits on top – some corporate structures allow you to raise capital by issuing shares, and potentially reduce your self employment tax – but the liability protection is the major consideration for most smaller businesses. There are different options, including partnerships, C corporations and S corporations, (and I won’t go into detail on them here), but a very common and flexible one is the Limited Liability Corporation (LLC). The main point of becoming an LLC for most small businesses is to protect their personal assets from a lawsuit. This separation between the individual and the business is referred to in law (and rather poetically, at that) as “the corporate veil.”
However, as an accountant, I want to warn you against the mistake that people make here. When you form an LLC, it becomes critically important that the business entity really is separate from the person running the business. The “corporate veil” must be real. Among other things, this means you must track your business books and keep a separate business bank account. If you go to the trouble and expense of forming an LLC (or one of the other types of separate entity), you are agreeing to maintain that separation.
So what happens if you don’t? If you don’t bother maintaining separate bank accounts, or if you make frequent personal purchases out of your corporate account, and you use the company car for all kinds of personal errands (or the corporate jet…) and then you get sued, the court can “pierce the corporate veil.” In other words, in a lawsuit, your business practices will come under scrutiny, and if you’re found to be acting as one and the same as your business, not as a separate, distinct entity, then that legal protection you thought you had drops away, and the plaintiff can come after your retirement fund, your house, your art collection, and your vacation fund.
So now that I’ve scared you, what can you do to prevent these awful scenarios from happening? Primarily, you want to operate in a businesslike manner. You need to keep your business accounts and personal accounts totally separate. If there are any credit cards that you use for both business and personal expenses, cut it out, and get a corporate card for the business.
A happy side effect of keeping your accounts separate is that your bookkeeping becomes a lot easier. When you have a separate business credit card and checking account, and you use them strictly for business reasons, there is no more combing through bank statements to figure out what is business and what is personal. Your hardest problem is just figuring out which legitimate business expense category to put each purchase into.
So if I’m earning money in my business and the point of having it is to make a living, how do I pay myself from my business account?
Great question. You are allowed (and even reasonably expected) to move money in between your accounts. When you invest your personal money into your business (a common occurance!), it’s called a “capital contribution,” and that’s the category you put it into in your books. When you take money out of your business to pay for your personal living expenses, it’s called an “owner’s draw,” and likewise, you record it as such in your books. The point? You track it in your bookkeeping. Note that you shouldn’t be using the corporate card to charge a gorgeous leather jacket at Prada and then booking that transaction as “owner’s draw” after the fact – though this is the way to correct that mistake, if you make it. The best practice is to withdraw a chunk of money, in a predictable, periodic fashion (like you’re paying yourself a salary).
So the simple takeaway here is clear. Keep your business books clean and businesslike. Separate your personal and business accounts. It simplifies your bookkeeping, it’s not hard to do, and the trouble it can keep you out of is worth all the effort.
DISCLAIMER: True tax advice is a two-way conversation, and your accountant needs to hear your full situation to apply the rules correctly in your case. This post is meant for general information only. Please don’t act on this alone.
Bio: Hannah Cole is an artist and Enrolled Agent. She is the founder of Sunlight Tax.
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