Originally posted on the "InBetterWeTrust" website: https://inbetterwetrust.com/1863-2/

Understanding LLC Capital Accounts

Question:

I'm thinking about starting an LLC, I've been doing some research into how they work, and I keep hearing the phrase "capital accounts" getting thrown. What is a capital account???  Is it a special bank account I need to open?

Answer:

Not a special bank account! 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).  In that way, capital accounts are essentially like ledgers, with a few caveats.

Why Are Capital Accounts Important?

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!

Let's walk through a hypothetical situation to illustrate what a capital account really is:

You and your friend start an LLC to sell widgets.  Let's make a capital accounts timeline!
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:
So, Where Is This 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 your friend 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 your friend chose to, you could have 80% of the ownership and your friend the other 20%, regardless of your actual capital contributions.

Why Are Capital Accounts Necessary?

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:


LLC Member Capital and Distribution Accounts

QUESTION:

I am setting up a new multi-member LLC and need to track member capital contributions (both cash and service) as well as member distributions. Does anyone have recommendations for setting up the proper accounts in the Chart of Accounts to track this information year to year?Thank you.

ANSWER

An LLC with multiple members that is taxed like a partnership files must file the informational IRS Form 1065. You track the members equity the same as a Partnership.

You need to create new Equity accounts for each partner as follows:
Retained Earnings each year are zeroed out into each partner's Equity account in his proportionate share.

The Contributions and Draws for each year are also closed out to the Equity account for each partner and begin anew each year.

These closing entries are best done with a January 1 date so last year's reports remain correct if you are looking at them later on. The above partner's equity activity is shown on their individual forms K-1 that they receive from the partnership when the tax return is done. They show the partner's beginning equity balance, any contributions, draws and their share of the income and an ending equity balance. So your books should have the same information.