To fully understand what is involved in a capital account, the reader must first understand how partnerships and limited liability companies (LLC’s) are structured. Next, you must learn about the contributed value and the terms ‘Inside Basis’ and ‘Outside Basis’. From here, we’ll talk about earnings and withdrawals from the capital accounts. I’ll close out with an introduction to other terms used with capital accounts.
For the purpose of this article, Limited Liability Companies will be referred to as Partnerships. In effect LLC’s are structured just like partnerships except that legally they use the term membership instead of partners. In addition, LLC’s are customarily treated as partnerships from the Internal Revenue perspective. Finally, the financial reports provided by LLC’s are very similar to partnerships except in the equity section. There the term partner accounts are replaced with member accounts.
So let’s get started.
Financial Structure of Partnerships and Limited Liability Companies
There are four Types of Business Entities. Partnerships and Limited Liability Companies (LLC’s) use capital accounts instead of stock (corporations) or equity (sole proprietorship) in the equity section of the balance sheet. The capital account is the book value of the financial balance for the respective partner(s). It includes the original contributed capital, lifetime accumulated earnings, and the cumulative withdrawals.
The following illustrates the equity section comparison between a stock company and a partnership:
Stock Entity . Partner ‘A’ Partner ‘B’ Total
CS Par Value $1,000 Contrb Capital $5,250 $4,000 $9,250
Capital in Excess 8,250 Prior Earnings 3,700 2,500 6,200
Retained Earnings 10,500 Current Earnings 3,200 1,100 4,300
Dividends/Distrbs (4,000) Guaranteed Pymnts (2,000) (2,000)
Withdrawals (500) (1,500) (2,000)
Total Equity $15,750 Capital Accnts $9,650 $6,100 $15,750
In the stock entity format, the individual shareholder accounts are NOT broken out by shareholder. The reason for this is that individual values to the shareholders are based on their respective number of shares. Whereas in the partnership and membership entity format; the partnership/membership agreement dictates the value assigned and withdrawals allowed. Look at the equity section of the partnership. Notice how Partner ‘A’ contributed more initially. In addition, earnings are assigned based on the terms of the agreement (this is explained in a later article). In some partnership relationships, some partners may work full time while others may only work part time or are silent in nature. One of the positive attributes of the partnership entity over the corporate format is the ability to assign earnings in any formula desired. Corporate entities do not assign income to shareholders; the income is added to the overall accumulated earnings and each shareholder’s value is based on their respective stock ownership.
Most partnerships allow the partners to withdraw money from the business in any amounts desired up to their respective balances. That is illustrated by Partner ‘B’ withdrawing much more than Partner ‘A’ in the above example. Again, the terms of the partnership/membership agreement identifies what is allowed and disallowed, percentage held.
Finally, I want to point out guaranteed payments. In some partnership agreements, some partners may have advantages in their industry or may do more work for the business. So the business may guarantee him a regular payment. When the guarantee is earned it is assigned to that partner in the current earnings row (note how Partner ‘A’ earns at least $2,000 more than Partner ‘B’). When the payment is actually made, it is subtracted from that partner’s account as illustrated above.
When the partnership is formed the partners agree to contribute capital in order to get the business financed and operating. The most common form of capital contributed is cash. However, sometimes partners contribute fixed assets they may own. A perfect example is two guys going into landscaping. One may contribute a trailer and the other may contribute his riding lawnmower. So how is this accounted for in their capital accounts?
The first step is for both partners to agree upon the value of their respected contributed assets. You need to understand that this is important because the partnership agreement may distribute the earnings based on the value of the capital accounts. If you overprice an asset, then that partner has an overvalued account balance and in turn he is allotted more of the earnings due to his capital account balance. So the two partners really need to look at the facts and even better, get an outside third party to value the respected contributed assets. Below is an example of how the equity section looks for this particular partnership based on the agreed values by the partners:
Often partnerships are formed and the fixed assets contributed have a note attached. The most commonly contributed asset to a partnership with a loan assigned to the asset is an automobile. So how is this handled within the framework of the contributed capital account balance? To help you understand, think of the balance sheet overall, How to Read the Balance Sheet – Simple Format.
When the asset is contributed, the fixed assets section is debited and the dollar value is placed on the balance sheet. The offset or credit is to the equity section in the capital account subsection. Now if a loan is attached and the partnership agrees to assume the loan, then a long term liability exists too. Now the fixed asset remains the same, but a long term liability is created offsetting the value of the fixed asset. The difference is recorded to the capital account of the partner donating the asset. Let’s use an example to illustrate this for an engineering firm:
Straight Line Surveying
Contributed Capital Partner ‘A’ Partner ‘B’ Total
Cash $7,000 $18,494 $25,494
Truck 23,675 -0- 23,675 *FMV
Note on Truck (12,181) -0- (12,181) *Note’s Principle Balance
Sub-Total $18,494 $18,494 $36,988
The balance sheet will look like this:
Now the partner that contributed the truck has a problem. Because he is converting his asset from a personal asset to a business asset, he will have to address tax issues and personal basis issues. In effect, he needs to know his basis for the particular asset. Cash is easy, it is the dollar amount contributed. But fixed assets bring problems. So the reader needs to understand the two primary terms used with basis – ‘Inside Basis’ and ‘Outside Basis’.
Inside and Outside Basis
These terms refer to the value of the particular asset as it exists in the hands of the bearer. Typically, ‘Inside’ basis refers to the value as held by the business. ‘Outside’ basis refers to the value as held by the donor of the asset. Inside is in the company, outside is the investor’s value to him. Most often, they are the same. However, the values can be affected by outside forces such as the market or even prior use by the donor. Both parties are responsible to track their respective basis in the investment.
So let’s go back to the landscaping example above. Remember I said to have the assets appraised by an outside third party? Well, this sets the inside basis for the partnership. The partnership set the value of the trailer at $2,350. But what if Partner ‘D’ paid $4,290 for this asset. Obviously, he has used the asset since he bought it and the value has decreased. So his basis (outside of the partnership) is the $4,290. His partnership basis (inside) is $2,350. Why is this important? Well, at some point in the future, the business may stop conducting operations and it may dispose of the assets by either selling them or distributing them back to the original owners. If the asset is sold in the future, then Partner ‘D’ will be assigned either a capital gain or loss depending on the results of the sale. He now has basis in the capital gain or loss to him personally related to the difference between the original purchase price and the donated value at the beginning of the partnership.
This may not seem like a big deal, but believe me, it is a huge deal. Think of professional firms when they merge. The contributed assets get complicated and the basis becomes essential for the respective partners. The goal of this article is to introduce you to the terms. Later articles will get involved in the more complicated nature to the basis values and adjustments. But before I move on, I am going to cover an issue that is a bit more complicated than the trailer example. I’m going to explain basis in an asset when a loan is involved. Review the example above related to the donated truck with a note.
Partner ‘A’ originally bought the asset for $31,000 and borrowed $16,000 when he took it off the lot. To do this, he must have paid $15,000 in cash or a combination of cash and a trade-in when he bought the truck. The trade-in value is included in the $15,000 starting basis for the truck. Over a period of time, he paid down the note from $16,000 to $12,181. Therefore, he must add $3,819 ($16,000 – $12,181) to his basis of $15,000 as this was principle paid in the purchase of the truck. Now his basis in the donated truck to the partnership equals $18,819. This is referred to as his outside basis. His inside basis for that truck is $11,494. To the partnership, it is worth $11,494. The key for you is to understand how these two terms are used and in general how they are calculated.
Now that I’ve explained contributed capital and ‘Inside’ and ‘Outside’ basis, you need to learn about how the capital account increases and decreases in value as the business progresses.
Earnings and Withdrawals
The goal of every business is to make a profit. In the partnership world, as the profit is generated it is assigned to the respective partners. This assignment of income is based on the terms of the partnership agreement (remember this is also true in limited liability companies, they just use the term membership capital accounts). Most partnership agreements are written to provide for an equal split between the partners. I have written several articles in regards to this issue, if you desire to gain a better understanding of the partnership relationship please read The Basic Principles of a Partnership. Hopefully, you have or will negotiate an equitable distribution relationship with your partner or partners. For the purpose of this section I’m going to first illustrate with an equal assignment of earnings and then an assignment based on other conditions.
Equal Assignment – In my example of Straight Line Surveying, their capital accounts start out equal. The partnership agreement states that income is assigned equally between the two existing partners. So, in year one the partnership has a profit of $143,000. Based on the terms of the agreement each partner is assigned $71,500. See below for the results of the capital account balances:
Like any individual out there, you have personal bills to pay. So the partners have to withdraw (Draws is the most commonly used term) money to pay their personal bills and pay their taxes including Self-Employment Tax. So what really happens is about once or twice a month the partners write checks to themselves to transfer to their personal accounts for personal use. Let’s assume that both agree to take $5,000 per month for $60,000 for the entire year. Now what do the Capital Accounts look like? Let’s see:
Equitable Assignment – As with most partnerships, some partners either work harder or generate more value for the business than other partners. Over time an equal distribution is unfair and believe me, feelings get going. This is where partnerships go wrong. To resolve this issue, partnership agreements should be written for equitable distribution of profits based on performance and other criteria. So in my example with the surveying company, Partner ‘B’ carries a marine surveying license that generates higher paying jobs than Partner ‘A’ with a land surveying license. Now the annual profit is closer to $232,000 and the difference is strictly related to the value generated by the marine license. The partnership agreement is written to allot the profits as 65% to Partner ‘B’ and 35% to Partner ‘A’. Both agree to $60,000 of draws for the first year of business. Now let’s look at the Capital Accounts at year end:
Look at the difference in the ending balances. Partner ‘B’ has a much higher balance than Partner ‘A’. Over time, he is going to get upset at the fact that his difference in balance of value is retained by the partnership. In addition, the agreement assigned him only 65% of the total earnings when under a normal and equal relationship, he wants a partner with a marine license earning the same amount of money. In effect Partner ‘A’ received an additional $9,700 of value ($81,200 of assigned earnings vs. $71,500 in the prior example). Remember, I said the difference in earnings ($232,000 and the $143,000), $89,000 was disproportionally assigned. Partner ‘B’ only received $79,300 of the value generated by his marine license. Partner ‘A’ picked up $9,700. Partner ‘B’ should have received $71,500 under the equal method plus his marginally generated value of $89,000 for a total of $160,500. He was only assigned $150,800 per the agreement which is the $9,700 picked up by Partner ‘A’. How do we deal with something like this? The answer is guaranteed payments.
Guaranteed Payments – To address disparity in earnings between partners, many partnership agreements are written to allow for guaranteed payments or assignment of income. In this example, Partner ‘B’ wants his marginal value generated by his marine license assigned to him as a guaranteed payment. Then any leftover profit is split in equal shares. So now let’s look at the Capital Accounts using guaranteed payments:
Summary – Capital Account
There is a lot more to this than what I illustrate above. Over time, partners that carry balances on the books greater than others are basically financing the operation. So partnership agreements are written to pay interest to these partners at certain rates for certain balance excesses. In addition, even the inside basis is different than the tax basis assigned to the partner. This is information for a different article. I just want to highlight some of the various basis issues for you to get introduced to the terms and the corresponding meanings. In this article I explained the ‘Inside’ and ‘Outside’ basis. So here is a short list of the various basis terms used in partnership and limited liability companies:
- Inside Basis
- Outside Basis
- Capital Account Basis
- Tax Basis
- Capital Gains/Losses
- Book Basis
- Fair Market Value Basis
Quite a few, huh? For now, you need to understand the terms ‘Inside’ and ‘Outside’ basis.
Capital Accounts are required in Partnerships and Limited Liability Companies. They are used to track each partner’s value on the accounting books for the purpose of designating a financial amount to the respective partner. All capital accounts start with a beginning balance and to this is added contributed capital and earnings from operations. From this total is subtracted withdrawals taken by the partner and any guaranteed payments to arrive at the ending balance for the partner’s capital account. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If you desire me to help you analyze or evaluate your basis situation; go to the ‘My Services’ page and contact me.