Capital Accounts in Small Businesses
Brien Roche
In any small business, the idea of a capital account is important. It is the amount of funds and assets invested by the owners plus a reflection of profit distributions due to that owner. In the case of company losses, it would also reflect monies that may be due by the owner to the company.
When looked at from the company overall, it is the difference between total assets and total liabilities. That is also sometimes called “net worth”.
The capital account is typically maintained on a general ledger. It reflects the owner’s contributed capital. In addition it reflects the amount of company earnings since it was formed minus distributions to each individual owner.
Capital Accounts
Tax Liability
The so-called “retained earnings” is the money remaining after you pay the company’s expenses including distributions to owners.
In an LLC there typically is a different capital account for each owner.
Capital accounts become especially important for tax purposes. They allow the owner to track profits and losses so they know the amount that they owe annually in taxes. The tax form that would be used by the entity may be a 1065. The 5th page of that form has an analysis of the capital account. That analysis applies to all of the partners/owners. The K-1 form that would be given to the individual owners/partners breaks down the owner’s capital accounts individually. What that reflects is the amount that the owner contributed initially. That is then followed by the amount contributed by the owner during the course of the year. The net income(or the loss) of the business proportional to that owner is then added in. Then any withdrawals or distributions are subtracted out. What you end up with is that owner’s capital account at the end of the year.
Each capital account is added to or subtracted during the course of the year. At the end of the fiscal year, the account should reflect the owners’ share of net profit.
Losses
For example assume that two people form an LLC. Each person puts in $50,000. Their capital account therefore starts at $50,000. In the first year the business lost $10,000. Each owner puts in $5,000. Each owner’s capital account is now $55,000.
If there is a profit during the year, then that proportional profit is calculated for that owner’s capital account.
During the year, each owner took out money in the form of distribution of profits. This would result in a decrease in the capital account. Owner #1 took out $5,000, therefore her capital account went down by that much. Owner #2 took out $10,000. His capital account is now down by that same amount.
At the time of formation of the entity, it’s important to value each party’s contribution. That way everybody knows how much they have added to the overall capital account.
If the company loses money, each capital account is deducted from. That is, the money in the capital account is used to cover those losses. If there is no money in the capital account and the owner has to contribute, then the capital account increases.
As the business makes money, each owner’s capital account grows proportionately. The owner then may be entitled to distributions which qualify as deductions from that owner’s capital account.
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Call, or contact us for a free consult. Also for more info on capital accounts see the Wikipedia pages. Also see the post on this site dealing with contract issues.