The term capital has several meanings, and it is used in several areas in business. In general, capital is accumulated assets or ownership. The roots of the term "capital" go back to Latin, where the term was capitālis, "head," and Latin capitale "wealth.
Capital is important to businesses because the cost of buying and owning these investments can affect the business's value and tax situation.
- Business capital is all of the long-term assets of the business that have value while the business is operating and in the sale of a business.
- Capital in accounting terms is the accumulated wealth or net worth of a business and the owners, expressed as the value of its assets minus its liabilities.
- Capital in taxes is assets that a business uses to make a profit.
- A business can lower its business taxes by spreading out its tax deductions for capital expenses over several years.
Capital in Business
Business capital is in the form of assets (things of value). Capital is a necessary part of business ownership because businesses use assets to create products and services to sell to customers. Capital can have one of three specific meanings:
- The amount of cash and other assets (owned by a business, including accounts receivable, equipment, inventory, and buildings of the business)
- The accumulated wealth or net worth of a business, represented on a balance sheet by its owner's equity (ownership) minus liabilities
- Stock or ownership in a company, the capital account of a stockholder
Capital for Tax Purposes
The Internal Revenue Service (IRS) uses the term capital assets to describe assets that are used to generate a profit. These assets aren't easily turned into cash and they are expected to last more than one year. A building, equipment, and vehicles are examples of capital assets for tax purposes.
Capital Structure of a Business
The capital structure of a business is the mix of types of debt (borrowing) and equity (ownership). Business capital is shown on the business's balance sheet. The format for this report shows all the asses of the business in one column and the liabilities and owner equity in the other. Total assets must equal total liabilities plus total owner equity.
Another way to express capital in business is through its debt to equity ratio. This ratio divides the company's total liabilities by its shareholder equity, measuring how much of the company is financed by debt. An acceptable ratio is 2:1, meaning that debt can be two times equity.
Other Terms for Business Capital
Other associated terms which relate to capital in business situations are:
- Capital gains: Capital gains and losses are increases or decreases in the value of stock and other investment assets when they are sold.
- Capital improvements: Improvements made to capital assets, to increase their useful life, or add to the value of these assets. Capital improvements may be structural improvements or other renovations to a building to enhance usefulness or productivity.
- Venture capital: Private funding (capital investment) provided by individuals or other businesses to new business ventures.
- Capital lease: A lease of business equipment that represents ownership and is shown in the company's balance sheet as an asset.
- Capital contribution: A contribution to the business by an owner, partner, or shareholder in the form of money or property. The contribution increases the owner's equity (investment) in the company.
Business Capital and Taxes
Businesses with capital assets must deal with two types of tax reporting. The business must report depreciation, amortization, and deductions for income taxes during the time the business owns the asset. It must also report and pay capital gains taxes when the asset is sold.
The expense of buying or improving an asset must be capitalized for income tax purposes. That means the assets must be spread out over a number of years, rather than being deducted in one year. Each year, the business can take a tax deduction for the yearly deduction for all capital assets.
The two processes for capitalizing assets are:
- Depreciation: For tangible assets like vehicles, equipment, furniture, and buildings
- Amortization: For intangible assets like patents, trademarks, and trade secrets
Capital improvements on an asset, which add to an asset's value and must be capitalized, are distinguished from repairs, which are deductible.
Some deductible repairs are painting, repairing a roof, or fixing an elevator. Some capital improvements that must be depreciated including replacing a roof or improving a storefront.
Business startup costs are considered capital assets and they must be amortized. But you may be able to up to $5,000 of business startup costs and $5,000 of organization costs (for forming and registering your new business) in the first year you are in business.
Capital Gains Tax
Businesses that have capital assets must pay capital gains tax on those assets when they are sold. Capital gains taxes are payable at a different rate from ordinary business gains. Short-term capital gains are taxed as ordinary income to the individual, and corporations pay short-term capital gains tax at the regular corporate tax rate of 21%. Long-term capital gains (held more than a year) are taxed at different rates, depending on the individual's income.
Gathering Asset Information for Taxes
Capitalizing business assets is probably the most difficult and complicated part of business taxes; it's not something you should attempt yourself. Before you turn over your yearly records to your tax preparer, gather all the information you can on the original costs of each asset, called "asset basis."
Information for asset basis for physical assets includes:
- Sales price
- Sales tax
- Installation and training
- Recording fees
- Permits and inspection fees
The asset basis for intangible assets like patents, copyrights, trademarks, trade names, and franchises is usually the cost to buy or create it. For a patent, for example, the basis is the cost of development, including costs of research and experiment, drawings, working models, attorney fees, and application fees. You can't include your time as the inventor, but you can include the time for workers you paid to help you.
Frequently Asked Questions (FAQs)
What is capital in business?
Capital is the assets (things of value) in a business that the business uses as collateral for loans and to pay expenses. For tax purposes, business capital assets are the long-term assets (like equipment, vehicles, and furniture) used to make a profit.
You can see the types of business capital by looking at the "Assets" column on a business balance sheet. A balance sheet shows assets on one side and liabilities (what's owed to others) plus owner's equity (ownership) on the other side, with total assets equal to total liability + owner's equity.
What is an example of capital in a business?
Here's a list of all the types of business capital as they are shown on a business balance sheet. They are in order by how quickly they can be turned into cash, and categorized by short-term and long-term assets.
Short-term assets are used up or paid within a year.
- Accounts receivable (money owed by others)
- Prepaids (like insurance)
Long-term assets (capital assets) are used over a number of years:
- Furniture and Fixtures
- Equipment and Machinery
- Land and Buildings
How do businesses use capital?
Capital is important to a business in both short-term and long-term situations. In the short term, it's used to fund operations. For example, cash is an important asset to a business because it is used to pay expenses.
In the long term, capital assets like buildings and can be used as collateral for a business loan. For example, the equity in a business building can be used to get a second mortgage. To finance short-term cash flow shortages, a business can sell accounts receivable to a factoring service for quick cash.
Why do businesses need capital?
Businesses need capital to attract investors. Investors can use capital to analyze the strength of a business, using a debt-to-equity ratio. This ratio compares long-term capital to owner's equity; an acceptable ratio of 2:1, meaning that debt is twice equity.
Capital is also important in selling a business because buyers also look at the strength of business assets and their usefulness to fund the business purchase or make changes. For example, a buyer could sell off several buildings to get cash to expand into other markets.