Partner Capital Accounts in a Multi-Member LLC: How to Track Them

How do you track each partner's capital account in a multi-member LLC?

Keep one capital account for each partner. It goes up with what the partner puts in and the partner's share of income, and down with the partner's share of loss and what the partner takes out. A multi-member LLC is taxed as a partnership by default, and item L on each partner's Schedule K-1 reports this account on the tax basis, unless the small-partnership relief below applies (K-1 instructions).

The lines follow item L in the Form 1065 instructions.

This is straightforward when the partners put in cash, the agreement is simple and the books were kept from the first day. Because item L carries the account onto each partner's K-1, it needs professional judgment when:

• a first Form 1065 is due and there is no prior K-1 to start from;
• the books hold one "owner's equity" account for the whole LLC, or balances were never carried forward from year to year;
• the operating agreement has special allocations or a preferred return, or says capital accounts follow the regulations;
• a partner put in property instead of cash;
• a partner is joining, leaving or selling;
• this year's opening balances do not match last year's K-1s.

Gather before you start:

• the operating agreement and every amendment;
• a dated record of each contribution, with the tax basis of any property;
• bank statements showing every draw;
• last year's K-1s and Schedule M-2.

Does my multi-member LLC need partner capital accounts?

Yes. A multi-member LLC taxed as a partnership needs a capital account for each partner, because the K-1 reports one unless the small-partnership relief described below applies. A domestic LLC with two or more members is classified as a partnership for federal tax unless it files Form 8832 and elects corporate treatment, or files Form 2553 to elect S corporation status (IRS, Form 2553 instructions). A partnership LLC files Form 1065 and gives each partner a Schedule K-1 (Publication 541).

An LLC taxed as a corporation has shareholders for tax purposes, not partners, so partner capital accounts do not apply. A partnership LLC that later elects corporate or S corporation status is treated as contributing its assets to a corporation and liquidating, which ends the partnership and its partner accounts. A Form 8832 election can take effect from 75 days before it is filed to 12 months after, and every member, or one member, manager or officer authorized to make it, signs it (26 CFR 301.7701-3). Form 2553 is due no more than 2 months and 15 days after the start of the tax year the election takes effect (Form 2553 instructions). For an S corporation, see S corporation bookkeeping. An LLC owned only by a married couple can be treated differently: see spouse and family LLCs. For how the partnership and its partners are taxed, see how partnerships are taxed.

Is a capital account the same as basis or ownership percentage?

No. A partner's capital account, outside basis and capital percentage are three different numbers, and they can differ.

The K-1 instructions say the item L amount may not equal basis, mainly because basis includes the partner's share of liabilities, and that item L cannot be used to figure basis. The Form 1065 instructions define the item J capital percentage.

A partner's share of profit and loss comes from the partnership agreement, not from the capital account balance (section 704). To agree shares at the start, see splitting ownership between LLC partners. For a balance below zero, see negative capital account.

Which method do the books use: tax basis or the regulation method?

The K-1 requires the tax-basis method. The Treasury regulations describe a second method that carries property at fair market value, and an operating agreement may require it. When the two differ, the LLC keeps both sets of numbers.

Under the regulation, an allocation has economic effect only if the agreement, for the life of the partnership, keeps capital accounts under its rules, makes liquidating distributions follow positive capital balances, and unconditionally obliges a partner with a negative balance after liquidation to pay it in (a deficit restoration obligation). An alternate test and other exceptions exist (26 CFR 1.704-1). If the agreement mentions capital accounts, book value, a preferred return or special allocations, have it read before the books are built.

What goes in a partner's account when they contribute property?

Under the tax-basis method, the account goes up by the property's adjusted tax basis, not its market value, less any debt the LLC takes over with it (Form 1065 instructions). Neither the partner nor the LLC usually recognizes gain or loss on the contribution (section 721), and the LLC takes over the partner's basis in the property for depreciation and gain (Publication 541). Gain can arise if the debt shifted to the other partners is more than the partner's basis in the property, or if the LLC soon pays the partner back for it (a disguised sale). Check before booking an opening balance (Publication 541).

Record for each contribution:

• the date and a description of the property;
• the fair market value that day, with the evidence;
• the adjusted tax basis from the partner's records;
• any debt attached to the property.

When market value and tax basis differ, the difference is built-in gain or loss. The partnership checks item M on that partner's K-1 and attaches a statement (K-1 instructions). Publication 541 gives an example of books showing a capital account at market value while the partner's basis stays at the lower tax basis.

Section 704(c) also governs later tax years: the LLC must share tax depreciation, gain and loss on that property so as to account for the built-in gain or loss, using a reasonable method (section 704(c), 26 CFR 1.704-3). Item N on each K-1 reports the partner's net unrecognized section 704(c) gain or loss at the start and end of the year (Form 1065 instructions). Keep a record for each property and have the return preparer set the allocations before the tax-basis accounts close.

A partner who receives an interest in return for services is not putting in cash or property. Whether it is a capital interest or a profits interest changes the tax result (Publication 541), so settle that before booking an opening balance. To move property the owner already has into the LLC, see putting personal assets into your LLC.

Do guaranteed payments and partner loans change the capital account?

Not directly. A guaranteed payment is booked as an expense, or a capital cost where required, and a partner loan as a liability, so neither passes through a partner's capital account as a draw or as income. A deductible guaranteed payment does lower the net income all the partners share.

A guaranteed payment is a payment to a partner for services or the use of capital that is fixed without regard to the LLC's income. For income and deduction purposes it is treated as paid to someone who is not a partner (section 707(c)). The LLC generally deducts it and reports it in K-1 box 4 (Publication 541). One paid for organizing the LLC or selling interests in it is a capital expense, not an ordinary deduction, though it is still reported as a guaranteed payment (Publication 541). Book deductible pay as an expense, never as a draw. See guaranteed payments versus partner draws.

Item L is figured without partnership liabilities (K-1 instructions). A true loan from a partner therefore sits in a liability account, and repaying its principal is not a distribution. Whether money a partner put in is a loan or a contribution turns on the facts and the paperwork: see owner contribution or loan to your LLC.

Should the books have one equity account or one per partner?

Keep one capital account for each partner, not one equity account for the whole LLC. That is the standard setup: the regulation gives each partner a single capital account, even for a partner who holds more than one kind of interest (26 CFR 1.704-1), and item L is a per-partner report. One "owner's equity" account cannot show who put in or took out what.

A typical set for each partner, opened from the formation date:

Partner capital, contributions and draws together give the partner's ending balance on item L.

Add an account for guaranteed payments (an expense, or a capital cost where required) and a liability account for each partner loan. For the LLC-level equity accounts, see LLC equity accounts. If a partner paid LLC costs personally, see partner-paid LLC expenses. If Opening Balance Equity holds old balances, see Opening Balance Equity.

How do profit and loss reach each partner's capital (equity) account?

At year end, the LLC's net income or loss is split as the partnership agreement says, and each partner's capital account moves by that share (section 704). For contributed property, section 704(c) can shift tax items between partners, and the tax-basis account follows each partner's tax allocations. Books usually close the year's net income into a single retained earnings account. For a partnership, move each partner's share from there into that partner's own capital account: credit it for a share of income, or debit it for a share of loss. The shares add up to the LLC's net income.

Item L uses income as figured for tax purposes. It includes tax-exempt income and is reduced by nondeductible expenses that are not capital (Form 1065 instructions). When book and tax income differ, for example because depreciation is figured differently, the tax-basis account follows the tax figures. Keep the books so each difference can be traced; the return preparer sets the tax figures. See do we need a CPA for a multi-member LLC.

If the agreement is silent, or an allocation fails the economic-effect tests, the share follows each partner's interest in the partnership, judged on all the facts (section 704). See how partnerships are taxed.

How do the books tie to Schedule M-2 and item L on each K-1?

Schedule M-2 is the return's analysis of all partners' capital accounts. The partners' item L amounts should add up to it. Line 1 should equal the total of all partners' beginning capital, and line 9 the total of their ending capital. If line 1 does not match, the instructions have the partnership attach an explanation of the difference (Form 1065 instructions).

Line 3 comes from line 1 of the Analysis of Net Income (Loss) per Return, not from the total of item L's income lines. Item L counts tax-exempt income and nondeductible, noncapital expenses, which that line leaves out, so they belong on line 4 or 7 as other increases or decreases. If line 3 includes guaranteed-payment income, the instructions have you take it out on line 7, and section 743(b) effects come out on line 4 or 7. Generally the opening total equals the adjusted tax basis of the LLC's assets less its liabilities at the start of the year. If the balance sheet on Schedule L is on the tax basis and differs from the partners' capital, attach a statement reconciling the difference.

A partnership that meets all four conditions of Schedule B question 4 answers Yes and is not required to complete Schedules L, M-1 and M-2 or item L. The conditions are total receipts under $250,000, total assets at year end under $1,000,000, Schedules K-1 filed with the return and furnished to the partners by its due date (extensions included), and no Schedule M-3 (Form 1065). The relief covers the forms, not the record: the account still shows who put in and took out what.

What should I check before the Form 1065 goes out?

Compare these before the return is signed.

A balance that will not tie is a sign to stop and trace it, not to plug the difference into one partner's account.

Example

These examples are illustrative. All figures are in US dollars.

Two partners, cash in, draws out

Two partners share profit equally. Each puts in US$50,000. Year-one net income is US$80,000, the same for the books and the tax return, and each draws US$30,000.

If the partnership completes Schedule M-2, line 9 is US$120,000, the total of the two item L ending balances. Each partner opens year two at US$60,000. The year-end entry for the profit is a debit to retained earnings of US$80,000 and a credit of US$40,000 to each partner's capital.

If Partner A had put in US$70,000 and Partner B US$30,000, with the same equal profit split and the same draws, A would end at US$80,000 and B at US$40,000. Profit is still shared equally, because the agreement sets it, not the capital balances.

A partner contributes equipment

Partner A contributes debt-free equipment with an adjusted tax basis of US$4,000 and a market value of US$10,000. Partner B contributes US$10,000 cash.

The K-1 reports the tax-basis row. The agreement may rely on the market-value row. Keep both, and do not overwrite one with the other. Partner A's K-1 also shows Yes in item M with a statement for the US$6,000 of built-in gain.

A guaranteed payment is not a draw

Two partners share profit equally. The LLC earns US$100,000 before any partner pay. Partner A is paid a fixed US$2,000 a month, whatever the profit, US$24,000 for the year, for running the business, and also draws US$20,000.

The US$24,000 is a deductible LLC expense, so the income to share is US$76,000 and each partner's share is US$38,000. Partner A's account rises by US$38,000 and falls by the US$20,000 draw, a net US$18,000. The US$24,000 never passes through it. It shows in Partner A's K-1 box 4, and Partner A reports it as income. Partner B's account rises by US$38,000.

Different for you?

• You have one "owner's equity" account, a first Form 1065 is due, or the K-1 capital numbers tie to nothing: how far back each partner's account must be rebuilt depends on the records and the agreement. See rebuilding partnership capital accounts, or talk it through with bookkeeping help.
• Your agreement has special allocations, a preferred return, or ties capital accounts to the regulations: which method the books need depends on the agreement's wording. Have it read with bookkeeping help.
• You are deciding whether to keep the books and file the Form 1065 yourselves: see do we need a CPA for a multi-member LLC.
• A new bookkeeper or new software took over: see opening balances after changing accountants.
• The Form 1065 is late: a return filed after its due date, extensions included, generally cannot use the small-partnership relief, so item L is needed. See late partnership return penalty relief.
• A partner is leaving or someone is buying in: see recording a partner buyout for the books and buying out a partner for the tax.
• A partner is receiving an interest for services: the capital or profits interest question is a tax one. See corporate tax help.
• A partner lives outside the US or is a foreign person: withholding and extra forms may apply. See foreign partners and withholding or Canadian partner in a US LLC, and cross-border tax help.
• A capital account on a K-1 is negative: see negative capital account.
• You own a single-member LLC, or the LLC is taxed as an S corporation: see LLC equity accounts and S corporation bookkeeping.