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Most new business owners forming an LLC don't understand how to deal with capital accounts. Here is a simple guide to working with capital accounts.

What is a Capital Account?

Important Tip The most important part of capital accounts is to make sure the members of the LLC have a clear understanding of capital needs, what to do if additional capital is needed, and how capital accounts affect distributions from the LLC.

All limited liability companies that I have worked with have capital accounts set up for its members.  The capital accounts track the initial members contributions to the capital of the LLC, adjusted over time for additional contributions.  Sometimes, capital accounts are adjusted upwards or downwards for the income or losses of the LLC, although we like to separate the capital accounts and maintain separate income accounts for tracking this.  On the dissolution of an LLC, capital accounts are distributed back to the members in order of priority (after payment of all liabilities of the LLC).

Capital accounts are different than bank accounts.  Capital accounts are simply tracked in the bookkeeping records of the LLC, there is no requirement for a separate bank account for the capital accounts of an LLC.

Contributions to a Capital Account?

The capital accounts are initially established by contributions from the members, usually in the form of cash or property.  If contributions are made in the form of property, the members should agree as to the fair market value of the property for the purposes of crediting the contributing member’s capital account.  Sometimes capital contributions could be in the form of assumed liabilities as well.  Services are also sometimes used as capital contributions, but the value of the services could then be considered taxable income to the individual that provides them so usually the value of services is not credited to a member’s capital account.

How Much Should I Contribute to the Capital Account?

For most small businesses, the initial amount isn’t so important – it should be enough to pay for the initial expenses of the limited liability company until its earnings take care of the ongoing expense needs of the LLC.  Many LLC’s are formed with as little as $100 or so of initial capital.  If further contributions are needed from the members to pay the expenses of the LLC, the capital accounts should be credited to reflect the later contributions.

In some cases, inadequate capitalization could be a factor in disregarding an LLC and finding the members personally liable for the debts or obligations of the LLC (piercing the veil).  If your LLC has particularly significant risks or liabilities, it may be necessary to have a greater capital contribution.

Capital Accounts and Income/Loss or Distributions

Some LLC’s are set up so that the relative percentages of the members’ capital accounts dictate the amounts of income and loss allocations and distributions.  For example, if one member contributes $100 to his capital account and the other member contributes $50 to her capital account, he would receive 2/3 of the income/losses and distributions and she would receive 1/3 of the income/losses and distributions.  Some people want capital contribution percentages to be different from the way income is distributed so we usually separate the capital account percentages from the income/loss allocations and distributions in the operating agreement.

 

Additional Information
Important Tip: 
The most important part of capital accounts is to make sure the members of the LLC have a clear understanding of capital needs, what to do if additional capital is needed, and how capital accounts affect distributions from the LLC.
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