Capital Accounts… a.k.a I Have a Headache
We’re not going to give you “alternative facts” – this is not an easy subject to get your head around. But it might be one of the most important for you, at least if you don’t want to end up in a total mess of a situation a few years from now.
If you’ve started a limited liability company (LLC), or are thinking of starting an LLC for your business, you’ve probably heard of capital accounts and wondered “are these some kind of extra bank account I need to open? Is it a special trust account where I deposit my contributions to the business? Is my lawyer/CPA just trying to sound smart and confuse me by using ten different words to describe the same thing?” In fact, none of these are accurate (ok, the last one might be for some lawyers, but not us!). Capital accounts are actually best thought of as imaginary accounts that exist only on paper (or in excel) between the various owners of the LLC (LLC owners are called Members, btw).
Yes, we realize it sounds like another totally unnecessary thing to forget to keep track of. However, capital accounts are extremely important if there are multiple members in the LLC, because it ensures that each member gets the economic deal they originally signed up for. The real purpose of a capital account is to keep track of the value that each member contributes to, and takes out of, the LLC during its existence. This allows the members to easily determine what each member should get from the LLC when they eventually leave the business, sell it, or close it down. Note that we didn’t say how much money the member has contributed – LLC members can contribute assets as well as cash, and the fair market value of the asset is added to their capital account balance…
Alright alright, we’ve gotten ahead of ourselves, we know. Let’s walk through a hypothetical situation to illustrate what a capital account really is.
You and Billy Banana start an LLC to sell candied bananas. You put up $4,000 to pay for legal assistance and an accountant, this is your initial capital contribution. Billy Banana puts up $6,000 to pay for a banana candying machine, or contributes a $6,000 machine that he had lying around (if this isn’t a real thing, we’re totally patenting it tomorrow). This is Billy Banana’s initial capital contribution. At this point in the LLC’s life, your capital account balance is $4,000, and Billy’s is $6,000, and your respective membership interests are in proportion to those contributions – you own 40% of the LLC and Billy owns 60%. Now, let’s say 6-months down the line you add an additional $1,000 of your own money to purchase a freezer for the LLC, and Billy takes out $1,000 from the LLC because he needs to pay his rent. At this point your capital account balance is $5,000, and Billy’s is $5,000, and both of your membership interests are now 50% (note: not to complicate things, but LLCs are very flexible, so you can arrange for a situation where these changes in capital accounts wouldn’t affect the ownership interest in the LLC).
As you can hopefully see, it wouldn’t make much sense to track this number simply by using what is in the LLC’s bank account at a given point, because the LLC will (presumably) be making money from its activities and depositing all of this in its bank account, meaning everything will get mixed together. This is also where things get a little conceptually tricky, because whatever profits the LLC makes is added to each member’s capital accounts in proportion to their ownership percentages. The best way to visualize this is in two stages – money coming into the LLC, and money going out to the members.
Let’s build on the example above. Currently, you and Billy both have capital accounts of $5,000 each, and 50% membership interest in the LLC. Let’s say the business had a fantastic month and made $20,000 in profit. Because you both have equal membership interests, you split this $20,000 evenly. However, you don’t immediately pay each member out. First, you add $10,000 to each member’s capital account so that both are now on $15,000 ($5,000 initial, plus $10,000 in profit). Next, you decide whether each member should receive a distribution. If both members want to be paid out the $10,000 in cash, both of your capital accounts will be reduced by $10,000, back down to the initial $5,000. We know – math gives everyone headaches. But understanding the purpose and function of capital accounts is definitely worth the cranial irritation needed to get there.
So, where is this mysterious capital account and how is it maintained? Well, it can be maintained on a simple spreadsheet by your business secretary or assistant, or even by you. Alternatively, your accountant can track your capital account balances (highly recommended). At the end of the day, the capital account is simply a means to track money/assets you put in, and money/assets you take out, during the life of the LLC, or your involvement with it.
Now, why do I need to track the amount contributed if we have ownership percentages within the LLC for each member? Good question! Traditionally, as we touched on above, the ownership percentage interest for an LLC are based on the initial capital contributions. In the first example above, you would initially have 40% ownership and Billy Banana would have 60% ($4,000 / $10,000 and $6,000 / $10,000, respectively). When members contribute additional capital, the ledger is updated and the percentages adjusted (as shown above). Now, as we hinted, the beauty (and added complexity) of an LLC is that the ownership percentages do not have to be directly proportional to the capital contributions. In the example above, if you and Billy Banana chose to, you could have 80% of the ownership and Billy Banana the other 20%, regardless of your actual capital contributions.
Why is this necessary? Thanks (again) for asking! As we’ve not so mysteriously alluded to above , when/if it comes time to close down the LLC, or for a member to leave, you will need to distribute money and assets in the LLC in a way that makes economic sense and doesn’t result in one or more members getting short-changed. When an event like this happens, the capital accounts, if maintained accurately, should represent the respective percentages of the remaining money and assets that each member is due.
To recap – LLCs have capital accounts (corporations do not!). These accounts can be maintained by tracking each member’s contributions to, and withdrawals from, the LLC, as well as the percentage of the LLC’s profit attributable to each member per their percentage membership interest. Remember that you include both cash and assets in these calculations. There are some nuanced ways LLCs can deal with capital, distributions of profits and losses, and closing down, but for the most part, that’s the gist!
By: Kieran de Terra, Esq. – 02/06/17
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