Why Your LLC Needs Separate Capital Accounts
October 14, 2015
Does your LLC really need to maintain separate capital accounts?
The short answer is, “Yes!” Why, though, can’t an LLC just pool all the money into one account?
From a purely economic viewpoint, what the capital accounts of LLC members are designed to accomplish is to divide up the total equity in the LLC (very roughly, its current fair market value) among the members in a manner that reflects their economic deal. Broadly speaking, the idea is that if capital accounts are kept accurately, then, if at any given moment the LLC is liquidated and it makes liquidating distributions to its members on the basis of their capital accounts, each member will be assured of getting the member’s agreed-upon share of the LLC’s value. [fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][emphasis added] (John Cunningham’s LLC Newsletter for Tax and Financial Professionals, Issue 10. May 1, 2004.)
Put another way, having separate capital accounts should seem like the natural thing to do, because when you put your money into the company, at some point, you will want to take it back out of the company. That is best accomplished by having an account that tracks your contribution(s) to the company, because doing so will enable you to know what you have put into the company, and, therefore, what you are entitled to take back out, when the time comes.
Tax Ramifications of Separate Capital Accounts
There are a few provisions which need to be included in the operating agreements for multi-member LLCs which have elected to be taxed as partnerships (what the I.R.S. calls “disregarded entities”). I won’t dive into all the details of these provisions, because they are somewhat technical, and your Business Formation attorney should know what to include. When you are reviewing the operating agreement, however, you will want to ensure, at a minimum, the document includes requirements that members’ capital accounts will be:
- “Increased by the amount of cash contributed to the LLC by the member and by the fair market net value of any contributed property;
- Increased by LLC allocations of its profits to the member;
- Decreased by distributions to the member; and
- Decreased by the member’s share of LLC losses.” Id.
One of the primary goals of the I.R.S.’s regulations with respect to capital accounts is to ensure members maintain an arm’s-length pecuniary relationship to their LLCs, and to ensure LLCs base their business decisions on the economic realities of their relationship with their members, not just on tax-related issues. The IRS strives to reach this goal by requiring LLCs taxed as disregarded entities to maintain separate capital accounts for their members and by using these accounts as the basis for member taxation and LLC liquidations.
Improve Your Understanding of Capital Accounts
In some ways, a capital account is like a bank account with your LLC. It’s important to understand, though, that the total value of the capital accounts of all the members of an LLC probably won’t always accurately reflect the fair market value of the whole company. Assets and their values will fluctuate, which affects the value of the company; these values may not have much relation to the combined dollar value of the members’ capital accounts. Id.
In short, capital accounts make the accounting side of operating your LLC easier by “tagging” by member the capital contributions, allocations of profits, distributions, etc. which relate to each member according to the terms and conditions of the operating agreement.
Does your LLCs operating agreement do what it’s supposed to do, when it comes to creating and maintaining separate capital accounts for each member in your LLC? If not, maybe it’s time to update your operating agreement. Contact Executive Legal Professionals, and let us review your LLC’s operating agreement. One of our helpful, friendly attorneys is ready to help you, today.
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