How a Does a Business Owner's Capital Account Work?
What does it mean to own a business, how exactly does a business owner's capital account work, and why is it important? Before answering these questions, it's important to first understand what capital is, then explore how capital accounts work for each type of business owner.
What Is Capital?
Capital is the financial resources (money and other assets) a business owner uses to fund their operations and make a profit. It can consist of cash, equipment, accounts receivable, land, or buildings. Capital can also represent the accumulated wealth in a business, or the owner's investment in a business. Essentially, it's how much the business owner has at any one point in time.
What Types of Business Owners Have Capital Accounts?
How the business owner's capital account is structured depends on the type of business.
- Sole proprietors: A sole proprietor has 100% ownership in the business. The owner's capital account is shown in the business balance sheet as "[owner name], capital account."
- Partnerships/LLCs: Partners in a partnership and members of a limited liability company (LLC) have capital accounts. The person makes a capital contribution to the business when they join, investing in the business. Partner share of profits and losses is determined by the partnership agreement or LLC operating agreement, based on their capital share.
- Shareholders: Shareholders in a corporation have shares of ownership. They buy shares and get dividends based on the number of shares they own. They also have voting rights based on their shares.
- S corporations: An S corporation owner is also a shareholder, but the account works differently from a C corporation owner account, and actually works similar to a partnership.
It's possible for a business to own another business. For example, a corporation may be a part-owner of an LLC. In this case, the capital account may not be simply a one-person account. This subject is complicated, so check with tax and financial professionals.
How Does Owner's Capital Account Change?
Each owner of a business (except corporations) has a separate capital account, which is shown on the balance sheet as an equity account. (Equity is another word for ownership.)
This capital account is added to or subtracted from for the following events:
- The account is increased by owner contributions. These might be initial contributions when joining the company, or later investments as required or decided upon by the owners.
- The account is then added to or subtracted from at the end of each fiscal (financial) year, to reflect the individual owner's share of the net income (profit) or loss of the business.
- The account is also subtracted from for any distributions taken by the owner for his or her personal use.
For example, let's say two people join to form an LLC. Each puts in $50,000, so each capital account starts out with $50,000. They are also 50% owners and they agree to distribute profits and losses using this percentage.
At the end of the first year of business, the business lost $10,000, so each owner's capital account now has a balance of $40,000.
But during the year, each owner took money out of the business for personal use. Owner A took out $5,000 and Owner B took out $3,000. So Owner A's capital account now is $35,000 and Owner B's capital account is now $37,000.
What Kind of Contributions Can Be Made?
When you start a business, you will almost certainly have to put in money to get it going. This money is your capital contribution. A capital contribution is a contribution of capital, in the form of money or property, to a business by an owner, partner, or shareholder. The contribution increases the owner's equity interest in the business.
You might also contribute other assets, like a computer, some equipment, or a vehicle that will be owned by the business. These assets must be valued at the time of the contribution, so everyone knows how much they add to your capital account.
You may also add more to the balance in your capital account at any time during the life of your business, and you may also take money out of your capital account.
What Determines the Capital Account Requirements for Owners?
There are restrictions on how much you can take out of your capital account and when you can take it, based on the governing documents of the business. These documents can include a partnership agreement, an LLC operating agreement, or S corporation bylaws.
In the case of a shareholder in a corporation, meanwhile, the contribution does not increase the number of outstanding shares, but it adds to the shareholder's basis.
If your business is a sole proprietorship, however, there is no guiding document; you can make and take out capital contributions any time.
Why Are Capital Accounts and Capital Contributions Important?
When you start a business and want to take out a bank loan, the bank likes to see that you have invested in the business. If the owner has no stake in the business, they can walk away and leave the bank holding the bag.
If you are starting a business, you should plan on putting something in to get started. You may need to take out a personal loan to get the money to put into the business as an investment.
A loan by a business owner to their business increases the business's liability; it doesn't affect the owner's capital account.
How an Owner's Capital Account Is Taxed
Sole proprietorships, partnerships, and LLCs don't pay business taxes; the taxes are passed through to the owners. The owners pay tax on the profits of the business that are distributed to them.
The owner pays tax on these distributed profits through their personal tax return, and the capital account of each owner changes by the amount of the profit or loss.
A corporation pays corporate income tax. Shareholder income is taxed as capital gains, in two ways:
- If the shareholder receives a dividend, it's considered a capital gain, which means capital gains taxes are due.
- If the shareholder sells shares of stock for a gain, capital gains tax also applies in this case.
Consult Tax and Legal Professionals
Capital accounts can be complex, and because each business situation is different and tax laws are continually changing, it's best to consult with tax and legal advisors before making any business decisions.