There’s a lot to think about when you start a new business – especially if you have created a limited liability company (“LLC”). For one thing, you’ve got to keep track of each owner’s, or member’s initial and subsequent investments. You’ve also got to keep track of any adjustments to each member’s contributions. You can do so by designating a capital account for each member. Keep reading to learn more about how to create this type of account and how it works.
For starters, it’s important to understand what makes this type of account different from others typically used in business. The key difference is that a capital account is not a physical location where money is actually kept. Instead, it is an accounting or bookkeeping tool like a ledger or balance sheet.
Your business accountant or bookkeeper can easily create a capital account for each member using:
- Accounting software
- A computer generated worksheet
- Similar accounting systems
Once he or she has created the accounts, your bookkeeper or accountant can use them to log each member’s financial activities.
Establishing each member’s initial balance
The initial balance in each member’s capital account is equivalent to his or her initial investment. This means if you contributed $50,000 in cash to help get the business off the ground, your capital account will reflect that amount as the initial balance.
But what if your initial investment included $50,000 cash and property In that case, the initial balance in your capital account would reflect: 1) the cash contribution; and 2) the fair market value of the property as determined by you and the other members.
Alternatively, what if your initial investment consisted of personal property or services in lieu of cash? If so, the initial balance in your capital account would reflect the value of those contributions as set forth in applicable provisions of the LLC’s operating agreement.
Making relevant adjustments
Adjustments to each member’s capital account reflect:
- Distributions from the LLC
- Withdrawals from the LLC
- His or her share of profits
- His or her share of losses
- Any additional contributions
Here is another way to look at it. Let’s say you own 50 percent of XYZ Graphics, LLC. You have gone into business with an old college roommate, who owns the other 50 percent. Now let’s say you initially invested $50,000 in cash to start the business as we discussed above. As you now know, the initial balance in your capital account is $50,0000. Now let’s say you take a $10,000 owner draw. The amount reflected in your capital account dips to $40,000. Fast-forward to the end of the first fiscal year, when the LLC has generated $30,000 in profit. Your share of the profits is $15,000, so your capital account balance is now $55,0000.
As an aside, the allocation of profits and losses in most LLCs is based on each member’s percentage of ownership – as demonstrated in the example above. However, this rule is not necessarily set in stone. Members can split profits and losses in other ways, as long as they follow allocation methods in the LLC’s operating agreement.
What happens to capital accounts upon dissolution of the LLC?
Certain steps are required to dissolve an LLC when the business is no longer viable. First, you must take care of any outstanding financial obligations. Once that has been done, each member receives the amount reflected in his or her capital account. If there is not enough money to cover each person’s capital account balance, the LLC makes ratio-based payments.
Clearly, creating and maintaining a capital account for each owner of an LLC is a critical component of starting and running a successful business. If you have questions or concerns about this or any other aspect of starting your own business simply contact the office of Parag L. Amin, P.C. to schedule a free consultation. We’re happy to help.