Crypto Accounting 101: Keeping Finances Separate

Crypto accounting can be a complex task, even for veteran CFOs. They must account for, track, and report their Web3 organizations' financial activities across numerous wallets while staying compliant with different jurisdictions' laws.

But wouldn't it be easier to manage all these business finances via a single wallet or CEX account the organization's founder has been using for personal expenses?

While this sounds like an easy solution to bypass the lengthy onboarding process that businesses go through when registering with a Centralized Exchange (CEX), a crucial lesson in crypto accounting is to never mix personal and business finances. Keeping the two separate allows founders to stay compliant with regulations, avoid potential headaches for accountants, and get a clearer picture of their organizations' activities.

This article will dive deeper into separating personal and business crypto transactions, explaining the following topics:

• The difference between personal and business activities

• Why should enterprises keep their finances separate

• The dangers of commingling funds

• How to separate business and personal finances as a Web3 organization

• Taking crypto accounting to the next level

Crypto Accounting 101: Personal vs. Business Activities

To get started, it's essential to explore the key differences between personal and business activities.

A personal activity is carried out by an individual and serves exclusively their interest. The digital asset wallet or the financial account initiating the transactions may belong to someone who owns or is employed by an organization. This person's crypto activity could even earn them revenue (e.g., by trading assets or playing Play-to-Earn games). However, these activities are completely unrelated to the business.

For example, it is considered a personal activity when a Web3 founder uses their own private wallet to purchase an NFT with their savings. Even if they sell the non-fungible token for a profit at a later date, it is entirely separate from their business' finances.

On the other hand, any activity an organization engages in for the primary purpose of generating profit can be considered a business activity. It can include operating, financing, and investing activities, which all have the same goal: to create value for shareholders. In a Web3 context, the latter group consists mostly of the project's community, investors, core development team, and other important stakeholders.

If the Web3 founder in our previous example trades the same NFT but with their organization's funds to generate a profit, it is then categorized as a business activity. This shouldn't come as a surprise. Instead of the founder's personal wallet, the newly-acquired NFT belongs to the organization's balance sheet, and the transaction serves exclusively business goals.

Why Should Web3 Organizations Avoid Mixing Personal and Business On-Chain Activities?

In crypto accounting, it is recommended to keep both the off and on-chain activities of a business separate from its stakeholders' personal finances. Doing so comes with a variety of advantages for Web3 organizations and helps them avoid potential challenges. Think about it in the same vein as TradFi. We never want to use our own personal bank accounts for business purposes because not only does it complicate the accounting process, but it also opens up the individual to greater scrutiny for their personal finances.

The Question of Personal Liability

First, separating activities helps minimize the exposure of founders' and other project stakeholders' personal assets based on the business structure and the jurisdiction. In most cases, owners' private funds are protected, even in the event that their organizations accumulate massive debt or go bankrupt.

Suppose a DAO-governed DeFi protocol's smart contracts are exploited in a $50 million hack. The DAO suffers $30 million of the damage, while the remaining $20 million is taken by users. The protocol can't recover from this loss and shuts down its services.

Despite that, a group of victims files a lawsuit against the DAO, attempting to recoup their losses by seizing the personal assets of the organization's members. If the DAO is legally incorporated in a jurisdiction and its activities are managed separately from its participants', personal liability can be likely avoided for the $20 million damage.

But in case the DAO lacks legal incorporation or fails to separate business and personal activities, it would most probably lead to a court ruling ordering its members to cover users' losses with their own assets.

Inaccurate Bookkeeping

Mixing personal and business activities makes it harder to get a clear and accurate picture of an organization's finances. This can lead to both internal and external challenges.

For instance, the personal expenses of the development team could highly inflate a Web3 organization's financials. In such a case, despite closing the year with record profits, the project's financial reports are not reflecting these positive changes. Instead, the inclusion of the team's personal expenses indicates a significantly lower net income than it is in reality.

Consequently, banks and venture capitalists will likely deny funding for organizations whose financial records can't be accurately read or indicate a different business performance on paper than in the real world.

As global VC funding is down by 49% year-over-year (YoY) in Q2 2023, it is much more challenging for enterprises to acquire capital. For that reason, competition has increased significantly, and Web3 organizations must maximize their chances of getting funded. A factor that can contribute to success in this field is the clarity of a project's books and the separation of its finances.

Simultaneously, Web3 CFOs may find it hard to track business performance if an organization's finances are not separated. Inaccuracies in crypto accounting could lead to tax-related consequences while hindering the decision-making process. Without correct, up-to-date financial data, it is challenging to make informed decisions.

On the other hand, creating and maintaining separate bank accounts and digital asset wallets provides a clear picture for organizations of their cash flows. Doing so also makes it easier to track expenses and helps CFOs and accountants avoid headaches.

Finally, it is imperative to separate business and personal finances to build corporate credit history. Good records make it easier for banks to determine the creditworthiness of Web3 organizations and accurately reflect their performance. This way, stakeholders can make the right decisions while increasing the chances of the project to qualify for financing.

Tax-Related Issues

Commingling finances can lead to different tax-related issues.

Jurisdictions like Canada may enable organizations to deduct some business expenses even if those purchases are made with personal accounts. But even in this best-case scenario, it makes accountants' job a nightmare, as they have to dig through each and every transaction to filter out individuals' private transactions.

In many cases, failing to separate personal and business expenses increases the risk of losing legitimate tax deductions.

With everything mixed together, it is challenging for an accountant to prove that his organization's expenses are deductible business costs. If the IRS or other tax authorities can't filter out the noise, they may decide not to deduct anything. This way, they can avoid deducting personal expenses by mistake.

Moreover, mixing personal and business finances may trigger audits from tax authorities. Even if an organization files tax returns and manages its books accurately and has nothing to hide, it may find itself in the middle of this long and stressful process. Without separate finances, tax authorities will also likely audit personal records alongside business transactions, which can come with different challenges for stakeholders.

Smaller businesses may find themselves in additional trouble if tax authorities classify the revenue from their activities as hobby income.

The above could happen when a Web3 enterprise doesn't look like a serious organization that tracks finances with a profit motive. From the point of view of tax authorities, the project's bookkeeping instead (falsely) indicates that it carries out its activities on a hobby basis.

Commingling finances increases the risk of hobby income classification, which may disqualify the organization from deducting certain expenses. Examples of such can include the cost of crypto mining equipment, office space, or utility costs.

How to Separate Web3 Organizations' Finances?

In the last section, we explored why enterprises should avoid commingling their finances. But how can Web3 organizations and their stakeholders separate business and personal activities?

1. Consider Legal Incorporation

First, Web3 teams should evaluate the business structure of their organizations. Incorporation creates a separate legal entity from stakeholders (e.g., the core team, DAO members, founders), determines taxation, personal liability, and more.

This is an important step, as many jurisdictions don't recognize DAOs as legal entities without formal incorporation.

Consequently, members could become personally liable for the consequences of the organization's actions. It could also increase the tax burden of DAOs by providing more room for tax authorities to determine their tax treatment (learn more about this in Part 1 of our TGE guide).

2. Get a Business Identification Number

After legal incorporation, the next step for organizations to separate their finances is to obtain a unique identification number for their businesses. This is called the Employer Identification Number (EIN) in the US, the Business Number (BN) in Canada, and the Unique Taxpayer Reference (UTR) in the UK.

Most jurisdictions use these corporate IDs to identify organizations for tax purposes. In fact, this practically makes them separate entities from their founders and other stakeholders from the point of view of tax authorities.

Organizations can obtain a business identification number by filling out the following forms:

• EIN: Online between Monday and Friday, 7 am to 10 pm (ET), or by filling out and mailing or faxing the completed Form SS-4 (international applicants have access to further options)

• BN: Online using the Business Registration Online (BRO) service, different web forms, by phone, or either by mailing or faxing the completed Form RC1.

• UTR: The HMRC automatically mails the UTR within 14 days after an organization's corporate registration. In case a business hasn't received one, it can request a copy of its UTR online.

3. Create Separate Bank and CEX Accounts

After acquiring an EIN, BN, UTR, or another form of business ID, the next step is to use it to create a corporate bank account to separate fiat activity.

While it may seem convenient to utilize the same on/off ramp solutions as for personal use (e.g., the private CEX account of the founder), doing so commingles the organization's finances. To avoid making this mistake, it's a better option to establish separate accounts at CEXs, OTC desks, and other providers offering fiat-to-crypto on/off ramp services with the Web3 enterprise's business ID.

The main goal here is to completely separate the bank accounts and the on/off ramp infrastructure the project utilizes from its stakeholders' fiat and CEX accounts. This way, DAOs and other Web3 organizations can segregate their personal and business activities, as well as the respective funds and records.

As a side note, it's not only important to keep personal and business activities separate but also to avoid blending the finances of two or more organizations (e.g., in case they were founded by the same individuals).

4. Establish Dedicated Crypto Wallets

Besides fiat and on/off ramp accounts, Web3 organizations should also create dedicated wallets. These addresses can serve different purposes (e.g., holding the treasury's or the reserve's funds) and should relate exclusively to that specific project's financials.

This means that no personal activity is allowed for dedicated business wallets. At the same time, the Web3 project should also ensure that the address is not utilized to settle the transactions of another enterprise, even if the two organizations share the same development team, investors, or other stakeholders.

5. Maintain Accurate Books

If all finances are kept separate, the last step is to maintain accurate books. This way, Web3 organizations could gain access to better financing opportunities, have a clear picture of their finances, make informed decisions, and ensure compliance with regulations.

Most importantly, clear and up-to-date financial records enable Web3 CFOs to file tax returns accurately. Doing so also comes with the ability to optimize corporate tax filings through expense deductions, using different cost basis methods to calculate capital gains/losses, and other ways.

Be Aware of Local Regulatory Laws

While Web3 organizations should keep business and personal finances separate, each jurisdiction has different rules and regulations for crypto accounting and taxation. So, we can't stress how important it is to carefully check the guidelines of local authorities before engaging in any corporate cryptocurrency activity.

It is always a good idea to seek professional help from an established industry provider to ensure compliance and avoid potential tax-related challenges.

Crypto Accounting Supercharged

Keeping business and personal finances separate can streamline Web3 organizations' bookkeeping, avoid compliance issues, and enhance the decision-making process.

To realize these benefits, managing all the wallet addresses, bank and CEX accounts, and their respective records manually on each platform and service requires time and patience from CFOs. But this doesn't mean that this process can't be optimized.

On the contrary, Integral's powerful Web3 accounting stack enables organizations to integrate all their wallets, CEXs, bank accounts, and other financial services and manage them via a single platform. With minute-by-minute pricing for thousands of tokens and automatic capital gains/losses calculation, this provides real-time visibility into the crypto business to make better and faster decisions.

With automatic classification and the ability to synchronize transactions and balances with their preferred accounting software, Web3 organizations can also save time and achieve blazing-fast month-ends with Integral.

To learn more, book a demo with our team.