LLC Equity Accounts: Contributions, Draws and Retained Earnings

What equity accounts does an LLC need?

An LLC's equity accounts depend on how the IRS taxes it, not on the word "LLC" or the state's label. The IRS treats a domestic LLC with two or more members as a partnership, and an LLC with one member as part of its owner's return, unless the LLC files Form 8832 to be taxed as a corporation. Except in a few cases, the law requires no specific kind of records, so account names are bookkeeping practice. What each return reads is fixed.

A case is not simple when the LLC has two or more members or an S or C election, the classification is unknown, an election was filed but the books never changed, a member joined or left, or owner money has run through the business account for months without labels. Gather first: the formation date, the operating agreement, any Form 8832 or 2553 with the IRS's reply, dated owner deposits and withdrawals, and the last balance sheet. For a brand-new LLC, start with setting up books for a new LLC.

Which equity accounts does a single-member LLC need?

A single-member LLC usually keeps three equity accounts: owner's investment for money put in, owner's draw for money taken out, and owner's equity for the owner's accumulated stake. The LLC's activity is reported on the owner's return and Schedules C, E and F have no equity section, so these accounts serve the owner, a lender and next year's opening balances.

Publication 334 describes a drawing account as a separate account for business income withdrawn for personal and family expenses. Publication 583 says income and expense accounts close at the end of each tax year, while asset, liability and net worth accounts stay open. In practice, profit closes into owner's equity, and many books also close investment and draws into it so each year starts at zero; ending equity is the same either way. Software often calls the owner's equity account Retained Earnings. For a one-owner LLC it holds accumulated profit, and also draws and money put in once those accounts are closed into it.

Why does each member of a multi-member LLC need their own capital account?

Each member should have a separate capital account because contributions, draws and shares of profit differ by member, and the partnership return reports each member's account, unless the partnership is small enough to skip it (see Schedule L on a corporate return). Item L of each Schedule K-1 shows the member's beginning capital, capital contributed, share of net income or loss, other increases or decreases, withdrawals and distributions, and ending capital. One combined owners' equity line cannot produce those figures.

In the books, give each member one capital account with a contribution and a draw sub-account. Net income is generally split as the operating agreement provides, and members may owe tax on their share whether or not it is distributed. Item L counts contributed property at its adjusted tax basis, not its market value, so the method matters; see partner capital accounts.

Two traps:

• Capital is not basis. The item L amount might not equal the member's adjusted basis in the LLC interest (basis is the member's tax investment in it), so each member keeps a separate basis record.
• Capital can go negative. An ending capital account may be negative when losses and distributions exceed contributions and income share; see negative owner's equity.

Accounts never kept are in rebuilding partnership capital accounts, and pay to a member for services in guaranteed payments versus partner draws.

Which accounts does an LLC taxed as an S or C corporation use?

An LLC taxed as a corporation uses paid-in capital, retained earnings and distributions in place of contributions, owner's equity and draws. Paid-in capital and retained earnings match equity lines of Schedule L, the balance sheet on Form 1120-S and Form 1120; distributions are reported on other schedules (Schedule K and each K-1 for Form 1120-S, Schedule M-2 for Form 1120).

An LLC that files Form 8832 for corporate status files Form 1120. An LLC that timely files Form 2553 (within 2 months and 15 days after the tax year begins or during the prior year, with each owner's consent) is treated as having elected corporate classification from the S election's effective date, if it meets the small business corporation requirements, and files Form 1120-S. An LLC issues membership interests, not shares, and Schedule L has no line for them, so confirm with the return preparer which line holds contributed capital.

An S corporation may have only one class of stock. The regulation tests that by whether the governing provisions, including binding agreements about distributions, give every share identical distribution and liquidation rights, and distributions that differ in timing or amount are given tax effect based on the facts. Compare each shareholder's distributions with ownership, and have a professional read the operating agreement against them.

A distribution does not replace pay for work. The Form 1120-S instructions say distributions and other payments to an officer are wages to the extent they are reasonable compensation for services. See S corporation bookkeeping and paying yourself from an LLC.

The owner's tax on a distribution differs too. An S corporation distribution is generally untaxed only up to the owner's stock basis (section 1368); see recording S corporation distributions. A C corporation distribution is generally a dividend to the extent of earnings and profits, reported to the owner on Form 1099-DIV (Publication 542); see C corporation owner dividends.

How do I record an owner's contribution to my LLC, and is it income?

Record money an owner puts in as an increase in equity (owner's investment, a member's capital contribution or paid-in capital), not as income. It is a loan, and a liability instead, only if it is a real debt: the LLC is legally bound to repay it, both sides intend repayment and the owner is a true creditor (Publication 334). Publication 583 suggests a checkbook with room to note whether each deposit is business income, personal funds or a loan.

The tax rules point the same way. Publication 541 says neither the partner nor the partnership usually recognizes gain or loss when property is contributed for a partnership interest. Publication 542 says contributions to a corporation's capital are paid-in capital and not taxable to the corporation. Money from a bona fide loan is not income either, but it is a liability, not equity.

1. Move the money by bank transfer and keep the statement.
2. Decide whether it is a contribution or a loan before posting; see owner contribution or loan.
3. Increase the bank account and the equity account, with the date, the amount and which member or shareholder.
4. For property, record its market value, the contributor's adjusted tax basis and any debt that goes with it. Item L and Schedule M-2 use adjusted tax basis net of liabilities.

A business bill paid from a personal account is still a business expense in the books. Post the other side to owner's investment, or to a payable to the owner if the LLC will repay it. The tax treatment of a cost an owner paid and was never repaid depends on the facts. A partner required by the partnership agreement to pay a cost may be able to deduct it on Schedule E instead, in which case the LLC should leave it out of its expenses; see partner-paid LLC expenses. For an S corporation, see S corporation expenses never reimbursed. A deposit booked as sales overstates income.

How do I record a members draw, and why is it not an expense?

Record money an owner takes out in the owner's draw, the member's draw or the shareholder's distributions account, not in an expense account. Each reduces equity, so none touches the profit and loss. Publication 334 says a sole proprietor cannot deduct their own salary or personal withdrawals, and Publication 583 says to write checks payable to yourself only for withdrawals for personal use.

For members, a draw against profit is not a deductible guaranteed payment: the Form 1065 instructions limit that line to payments for services or the use of capital determined without regard to partnership income. Publication 542 shows that a corporation does not deduct the dividends it pays.

The traps are a draw coded to an expense account, which understates profit, and personal charges on a company card, which are draws too (personal charges on company cards). Entry by entry: recording an owner's draw.

What are retained earnings, and how do profits reach equity at year end?

Retained earnings are profit earned in earlier years and kept in the business. Current-year earnings are profit so far this year, usually shown as a net income line in the equity section until the year is closed. At year end the profit moves into retained earnings for a corporation, and into owner's equity or each member's capital account for a pass-through LLC.

In a multi-member LLC, allocate each year's profit to the members' capital accounts as the operating agreement provides, so the capital accounts add up to total equity.

The corporation column follows Schedule M-2 of Form 1120. Money an owner puts into a corporation goes to paid-in capital, not retained earnings. On Form 1065, Schedule M-2 runs the roll-forward for partners' capital accounts, contributions included. On Form 1120-S, Schedule M-2 is a different analysis: it tracks the accumulated adjustments account, a tax account that is not the same as book retained earnings.

If opening equity does not match last year's return, see retained earnings that don't match last year's return.

What must the equity section of the balance sheet equal each month?

Total equity on an LLC's balance sheet must equal total assets minus total liabilities at every month end. Publication 583 describes a balance sheet as assets, liabilities and your equity in the business, and net worth as the excess of assets over liabilities.

The Form 1065 instructions ask for an explanation when total assets at the start of the year differ from the prior year's close. A balance left in Opening Balance Equity means a missing entry; see clearing Opening Balance Equity.

Which tax-return schedules read my LLC's equity accounts?

Schedules C, E and F read no equity accounts; partnership and corporation returns do, on the schedules below. Schedule L should agree with the books and records, per the instructions for Form 1065 and Form 1120-S.

Sources: Form 1065, Form 1120-S and Form 1120. A skipped schedule does not skip the books: Publication 583 notes that financial statements help in dealing with a bank or creditors. Small entities may skip some of these schedules. For who may, or if a return asks for Schedule L and your books cannot produce it, see Schedule L on a corporate return.

What happens to the equity accounts if the LLC changes its tax classification?

A change in tax classification ends one set of equity accounts and starts another on the effective date. The regulation treats each elective change as a deemed transaction, treated as happening immediately before the close of the day before the election takes effect:

Going the other way takes a new Form 8832 election; ending an S election alone leaves the LLC taxed as a C corporation. The corporation is then deemed to distribute everything to its owners in liquidation, which can produce gain or loss for the corporation and its owners (section 336, section 331). A Form 8832 election can take effect up to 75 days before it is filed and 12 months after, so the books may need re-cutting from a date already past, and the LLC generally cannot elect again for 60 months. Gain or loss, basis and the opening numbers depend on the facts; see how LLCs are taxed.

Adding or losing a member also moves an LLC between the one-member and multi-member defaults, and a member's opening capital account differs depending on whether the member joined by contributing or bought an existing interest; see recording a partner buyout.

Example

These examples are illustrative, in US dollars.

One member

An owner deposits US$5,000 to start, draws US$2,000 a month for six months (US$12,000) and earns US$30,000. Owner's equity ends at US$23,000 (5,000 − 12,000 + 30,000). The profit and loss shows US$30,000 and no draws, because draws are not deductible.

Two members

Two members each put in US$10,000, and the first draws US$3,000. Before income the capital accounts are US$7,000 and US$10,000. If the LLC then earns US$20,000 and the agreement splits it equally, they are US$17,000 and US$20,000. A single owners' equity line of US$37,000 hides that.

S corporation election

An LLC taxed as an S corporation starts the year with US$50,000 of retained earnings. The owner puts in US$8,000 cash, recorded as paid-in capital, not income. A US$20,000 cash payout is recorded as a distribution, not as wages or an expense, and retained earnings fall to US$30,000 before the year's profit. If part of it pays for work the owner does, that part is wages and goes through payroll. Whether the payout is taxed depends on the owner's stock basis.

Different for you?

• Two or more members, an S election, or owner money run through the business account for months without labels: the right equity structure depends on the tax classification, and entries already posted may need restating before a K-1, a Form 1120-S or a balance sheet goes out. See untangling mixed personal and business money and bookkeeping help.
• A member joined or left, or an election was filed but the books never changed: equity may need to be re-cut from the effective date. See recording a partner buyout, books after an S corporation election and bookkeeping help. For a late or failed election, see late LLC tax election relief.
• Capital accounts were never kept and Form 1065 is late: see rebuilding partnership capital accounts and bookkeeping help.
• The LLC has a foreign owner: an LLC wholly owned by a foreign person, or taxed as a corporation and at least 25% foreign-owned, may have to report the owner's contributions and distributions on Form 5472, so dated records matter; see foreign-owned single-member LLC filing. A multi-member LLC with a foreign member generally must pay withholding tax on that member's share of income connected with a US business, and the payment counts as a distribution to that member. See foreign partners and withholding and bookkeeping help.
• Spouses are the only owners: community property and the spouses' reporting position decide between one equity account and a capital account for each spouse. See spouse-owned and family LLCs.
• A lender or investor asked for a balance sheet: see financial statements for a bank loan.
• You are unsure whether a deposit was a contribution or a loan, or a balance sits in Opening Balance Equity or equity is negative: see owner contribution or loan, Opening Balance Equity and negative owner's equity.