Negative Owner's Equity After Draws: Is It a Problem?

Is negative owner's equity after draws a problem?

Often not, by itself. Owner's equity, which Publication 583 calls net worth, is what a business owns minus what it owes, and draws or distributions take assets out without lowering profit. Negative owner's equity means the owner has taken out more than the business earned plus what the owner put in. The balance sheet shows that fact. It is not a tax. A lender or buyer who reads the balance sheet will see it.

It becomes a problem when the entries behind it are wrong, or when the business is a partnership, S corporation or C corporation and a distribution has passed the owner's basis or come out of a corporation's earnings and profits. Three different numbers get called "equity", and they rarely match:

Basis is the owner's tax-side stake: roughly what the owner paid in or left in, adjusted each year for income, losses and distributions. Earnings and profits is a tax measure of what a corporation has earned, separate from the books.

A negative books or capital-account balance does not by itself create tax. A distribution above basis does, and so does a dividend paid out of a corporation's earnings and profits.

A case is not simple if:

• the business is a partnership or multi-member LLC, an S corporation or a C corporation;
• the balance has been negative for more than one year, or keeps growing;
• draws were booked as expenses on a return already filed;
• nobody has tracked the owner's basis.

Gather the balance sheet for each year, the detail of every equity account, the last return's Schedule L, Schedule M-2 or K-1 item L, and every transfer from the business bank account to the owner.

Where does an owner's draw go on the balance sheet, and why does it reduce equity?

An owner's draw is charged to owner's equity, which is assets minus liabilities, the "net worth" account in a double-entry system (Publication 583). Profit and money the owner puts in raise equity. Losses and money the owner takes out lower it.

A draw is not an expense. A sole proprietor cannot deduct personal withdrawals (Publication 334), so the draw skips the profit and loss statement and is charged straight to equity. Publication 334 describes a drawing account as a separate account for business income withdrawn to pay personal and family expenses. On its own it normally shows a negative balance. That is expected: it totals the money taken out and is usually closed into equity at year end. Total equity, not that one line, shows whether the business is negative.

To record a draw correctly, see recording an owner's draw. For the accounts themselves, see LLC equity accounts.

Why did my owner's equity go negative?

Either the draws really exceeded what the business earned, or an entry is wrong. Read each equity account year by year and match the pieces to this table.

Why do my withdrawals to a personal account show as expenses?

Software can code a transfer to a personal account as an expense. Total equity comes out the same, because lower profit lowers equity too, but the profit and the tax return are wrong. If personal and business money are mixed, see fixing commingled funds and personal bills paid from the business account. If the negative figure sits in a plug account, see Opening Balance Equity.

Does negative equity change my tax as a sole proprietor or single-member LLC?

Negative equity does not change a sole proprietor's or single-member LLC owner's tax by itself. A single-member LLC that has not elected corporate treatment is not taxed separately from its owner (the tax code calls this "disregarded"), and its activity goes on the owner's return, usually Schedule C (IRS). Tax is figured on net profit, which is income minus expenses (Publication 334), and self-employment tax is figured from the same Schedule C. A draw larger than profit does not add tax and does not reduce it. Interest on money borrowed to fund personal draws may not be deductible on Schedule C, because interest follows how loan proceeds were used (Schedule C instructions).

Basis rules for distributions do not apply to a sole proprietor. A single-member LLC that elected S or C treatment follows the corporation sections below. Incorporating, or electing S or C treatment, transfers the business's assets and debts to a corporation. If the debts exceed the tax basis of the assets, the excess is gain, with exceptions (section 357(c); Regulations section 301.7701-3). See changing your business structure. To pay yourself from an LLC, see paying yourself.

Partnership or multi-member LLC: is a negative capital account the same as negative basis?

A negative capital account is not the same as negative basis. A domestic LLC with two or more members is a partnership for federal income tax unless it elects corporate treatment; an LLC owned only by spouses as community property may instead be treated as disregarded (IRS). The partnership keeps each partner's capital account in its books and reports it on Schedule K-1, item L, using the tax-basis method. That figure is based on the partnership's records and "can't be used to figure the partner's adjusted basis" (K-1 instructions). Basis is determined without regard to any amount in the books as capital or equity (Publication 541).

One reason they differ: basis includes the partner's share of partnership liabilities, while a tax-basis capital account does not (K-1 instructions). So a partner can have a negative capital account and positive basis.

Basis is never reduced below zero by distributions (section 705). A partner generally recognizes gain only when money distributed exceeds basis, usually as capital gain (section 731; Publication 541). Marketable securities can count as money. Draws against the year's expected profit count as taken on the last day of the year, after the year's income has raised basis (Publication 541; K-1 instructions). A decrease in a partner's share of partnership liabilities is treated as a distribution of money, so gain can arise with no cash paid when that deemed distribution exceeds basis (Publication 541). The partner, not the partnership, has to track basis (K-1 instructions).

For keeping each partner's account, see partner capital accounts. For a K-1 that already shows a negative balance, whether you must pay a deficit back to the partnership, or loss limits, see negative capital account. For draws versus pay, see guaranteed payments and partner draws.

S corporation: when is a distribution taxed if equity or retained earnings are negative?

An S corporation distribution is usually taxed when it exceeds the shareholder's stock basis, not when the books turn negative. If the corporation has accumulated earnings and profits, for example from C corporation years, part of a distribution can be a taxable dividend even inside basis (see the accumulated adjustments bullet below). A non-dividend distribution is tax-free up to stock basis, and the excess is capital gain, long-term if the stock was held longer than one year (IRS; section 1368).

Books and basis are kept separately:

• Stock basis starts with the shareholder's contribution or the cost of stock bought, then moves with the corporation's income, losses and distributions. The shareholder, not the corporation, tracks it (IRS). Unlike a partner, a shareholder gets no basis from the corporation's own borrowing. Only a loan the shareholder personally made creates debt basis (a guarantee does not), and debt basis is not considered for distributions.
• Where Schedule L is required, it should agree with the corporation's books and records, so a wrong equity entry travels to the return (Form 1120-S instructions).
• Distributions do not replace pay. A shareholder who works in the business must be paid reasonable compensation before non-wage distributions, and the IRS can reclassify payments as wages (IRS). See S corporation owner salary.
• The accumulated adjustments account on Schedule M-2 is a separate calculation again. An S corporation with accumulated earnings and profits must keep it to determine the tax effect of distributions, and section 1368(c) then sets a different order (Form 1120-S instructions; section 1368). A one-year election under section 1368(e)(3), made on the timely filed Form 1120-S with the consent of every shareholder paid that year, can put earnings and profits first; it cannot be undone (Regulations section 1.1368-1(f)).

For the tax on excess distributions, the filing steps and debt basis, see S corporation distributions above basis. For Form 7203 and working out basis from the books, see S corporation shareholder basis. For the entries, see recording S corporation distributions.

C corporation: what does a deficit in retained earnings mean for distributions?

A deficit in retained earnings is a book figure. Tax turns on earnings and profits. A distribution is a dividend to the extent of the corporation's earnings and profits for the year or accumulated earlier (section 316). The part that is not a dividend reduces the shareholder's stock basis, and any excess over basis is gain, usually capital gain (section 301; Publication 542).

So a corporation with a book deficit can still pay a taxable dividend if it has earnings and profits for the year. If the year's earnings and profits exceed the year's distributions, all of them are dividends from current earnings and profits (Publication 542). Earnings and profits are figured on their own worksheet, which starts from the year's taxable income, not from the balance sheet (Form 5452).

The corporation reports distributions on Form 1099-DIV (the nondividend part in box 3, if determinable) and attaches Form 5452 to its return for nondividend distributions. If it cannot tell by the next year's filing deadline for Form 1099-DIV (February 28 on paper, March 31 if filed electronically) whether any part is a dividend, it reports the whole payment as a dividend (Instructions for Form 1099-DIV; Publication 542; Form 5452). For how the corporation itself is taxed, see how C corporations are taxed. For paying yourself through dividends, see owner dividends from a C corporation.

How do I fix negative owner's equity?

Fix only what is wrong. If draws really exceeded profit, the negative balance is accurate and the entries behind it need no correction, though a partnership, S corporation or C corporation may still have a tax question (see the sections above). A wrong entry is normally corrected with a dated entry, not by editing a closed period.

Recording a contribution or loan that did not happen would misstate the books and the owner's basis records. Moving a distribution into a loan to the shareholder to lift equity does the same unless a real loan exists.

For an S corporation, repaying a shareholder loan is not a distribution. If losses earlier reduced the shareholder's debt basis, part or all of the repayment can be taxable (IRS).

Which cases need a preparer before I change the books?

A preparer should look first when the fix could change a return or when tax may already be owed:

• A partner or S corporation shareholder may have taken distributions above basis, or a C corporation may have paid distributions without working out which part is a taxable dividend.
• Personal withdrawals were deducted on a return already filed.
• An S corporation owner took distributions and no salary.
• The balance has been negative for more than one year, and there are no yearly balance sheets or basis records.
• The books do not tie to Schedule L, Schedule M-2 or K-1 item L.
• The IRS sent a notice about a K-1, a Form 1099-DIV or an unreported gain.
• A distribution may have left the entity with more liabilities than assets. State law can limit distributions, with a test that is not book equity. Delaware's LLC Act, for example, bars a distribution to the extent that afterward liabilities, with some exceptions, would exceed the fair value of assets, and a member who knew is liable to give it back, in general for 3 years after the distribution (6 Del. C. section 18-607). Delaware corporations may pay dividends out of surplus or, if there is none, out of net profits, and directors who wilfully or negligently approve an unlawful dividend are liable for it for 6 years after it is paid (8 Del. C. sections 170 and 174). Each state sets its own rule, and this is a legal question.
• A corporation owes federal income tax and has paid out its property. A shareholder who received it can be assessed for that tax as a transferee where law makes the shareholder liable, generally within one year after the time to assess the corporation ends (26 U.S.C. 6901).

Example

These examples are illustrative. Figures are in US dollars.

Sole proprietor, two years

A sole proprietor starts with $5,000 of equity. In year one profit is $60,000 and draws are $75,000, so equity falls $15,000, to -$10,000. In year two profit is $40,000 and draws are $50,000, so equity falls to -$20,000.

Each year's tax is figured on that year's profit, $60,000 and then $40,000, not on the draws. If the entries are right, the negative balance reflects the draws, and no correcting entry is needed for them.

Two-member LLC

At the start of the year, a member's books capital account is -$10,000 after draws, and item L on her last K-1, figured on the tax-basis method, shows the same. Her share of an LLC loan used to buy equipment is $30,000, which counts in basis but not in a tax-basis capital account. Her basis is about $20,000. Assume no income this year; income would raise her basis first.

A $15,000 cash distribution is within basis and brings basis to $5,000. A $25,000 distribution instead passes basis by $5,000, and that $5,000 is gain.

S corporation, two years

A shareholder who does not work in the business pays $20,000 for stock. In year one the corporation earns $50,000 (book and tax income are the same here, and it has no earnings and profits from C corporation years) and distributes $90,000. Stock basis before distributions is $70,000, the $20,000 paid in plus the $50,000 of income. The first $70,000 is tax-free and takes basis to zero. The last $20,000 is capital gain, and basis stays at zero. The books show paid-in capital of $20,000, retained earnings of -$40,000 and total equity of -$20,000. The corporation borrowed the extra $20,000 it paid out, and that loan adds nothing to the shareholder's basis.

In year two the corporation earns $30,000 and distributes $10,000. Basis is $20,000 and there is no gain. The books show retained earnings of -$20,000 and total equity of $0. Retained earnings were negative in both years, but only year one had a taxable distribution.

Different for you?

• The balance is large, has grown for more than one year, or sits in a partnership, S corporation or C corporation: basis, capital accounts and earnings and profits decide whether any distribution was taxed, and entries may be wrong in several years. Untangling that takes the books and the returns side by side. See bookkeeping help.
• Personal withdrawals were deducted on a filed return, the IRS sent a notice about a K-1, a Form 1099-DIV or an unreported gain, or the books do not tie to Schedule L, Schedule M-2 or K-1 item L: the books and the filed return may both need correcting. See retained earnings that don't match the return, with bookkeeping help.
• S corporation distributions may exceed stock basis: see S corporation distributions above basis.
• Partnership capital accounts were never kept: see rebuilding partnership capital accounts.
• Books are behind or returns are missing: see catching up on overdue books and catching up on unfiled business returns, with bookkeeping help.
• You plan to incorporate, or to elect S or C treatment, while debts exceed what the assets cost: the move can be taxable. See changing your business structure.
• A foreign person owns your US LLC or corporation: contributions to and distributions from a single-member US LLC owned by a foreign person are reported on Form 5472 (Form 5472 instructions). A corporation paying a distribution to a foreign shareholder generally must withhold on the whole amount and is liable for what it fails to withhold (Publication 515). See records for a foreign-owned LLC and missed withholding on payments abroad, with bookkeeping help.
• Your corporation is Canadian: see dividends with negative retained earnings.