How a Does a Business Owner's Capital Account Work?
Business ownership is complicated, but it's an important part of your business. How exactly does a business owner's account work? This account is sometimes called owner's equity or the owner's capital account.
This article discusses the capital account of a business owner and how it works for you. We'll start with the definition of capital and see how it gets added to and taken away. We'll also look at how the terms of the governing agreement of the business dictate ownership rights and responsibilities.
What Is Capital?
Capital is assets and cash in a business. Capital can be cash, or it can be equipment or accounts receivable, land or buildings. Capital can also represent the accumulated wealth in a business, or the owner's investment in a business.
What Types of Business Owners Have Capital Accounts?
How the business owner's account is structured depends on the type of business.
Capital accounts are ownership accounts for partners in a partnership or members of an LLC (both single-member and multiple-member). Sole proprietors also have capital accounts. Shareholders in a corporation have shares, which work a little differently from other types of capital accounts.
If a business owns another business (for example, if a corporation owns all or part of an LLC), the capital account may not be simply a one-person account. This subject is complicated, so check with your tax and financial professionals.
What Goes Into and out of an Owner's Capital Account?
Each owner of an LLC or partnership has a 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:
- The account is added to by owner contributions. These might be initial contributions when joining the company, or later 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 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 joined 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?
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.
When you start a business, you will have to put in money to get it going. This money is your capital contribution.
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. But there are restrictions on how much you can take out and when.
What Determines Capital Account Requirements for Owners?
The amount and frequency and other details relating to capital contributions are usually determined by the guiding documents of a business. For example:
In the case of a shareholder, the contribution does not increase the number of outstanding shares, but it adds to the shareholder's basis. Capital contributions are not counted as business income unless the contributions are in the form of a loan that is expected to be repaid.
If you own a sole proprietorship business, there is no guiding document; you can make capital contributions at any time.
To understand the concept of capital contribution, it helps to have a knowledge of the concept of capital.
Why Are Capital Accounts and Capital Contributions Important?
When you start a business and want a bank loan, the bank likes to see that you have invested in a business. If the owner has no stake in the business, he or she can walk away and leave the bank holding the bag.
If you are starting a business, you should figure 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. This is working capital, which is money to keep going until the business starts to pay its own bills.
In an LLC, the owner's capital contribution should be recorded. The laws regarding LLCs say that an owner's liability is limited to the amount of his or her capital contribution. So you can't lose more than you have put in.
How Does a Capital Contribution Differ From an Owner Loan to a Business?
As noted above, a capital contribution creates an equity account and it represents ownership in the business. A loan by an owner to a business, on the other hand, represents a debt of the business to an individual; no ownership is established. This article explains more about the difference between an owner loan to a business and a capital contribution.