What is the role of Capital Accounts in the LLC Operating Agreement?
The taxation of limited liability companies (“LLC”) cannot be understood without a rudimentary understanding of capital accounts. The term “Capital Account” appears many times in a typical LLC Operating Agreement and it is important that all LLC members understand its meaning.
The total members’ equity in the LLC is expressed as the “capital accounts” of the members. Each member of a LLC has a separate capital account that represents the equity that member has in the LLC. It relates back to a basic concept:
Assets – Liabilities = Equity
A member’s share of equity is the amount he/she would receive if the LLC was liquidated and all of the assets were sold at their book value, all liabilities paid, and the net proceeds distributed. As the LLC carries on the trade or business, these capital accounts will change depending on how the members agree to share in the net profits and net losses of the LLC. The capital accounts should reflect the economic arrangement between the members.
A member’s book capital account is calculated as follows:
|
+ Fair market value of asset or cash contributed - Liability on asset assumed by the LLC = Initial Book Capital Account Balance |
Then LLC operations are taken into account during the year.
|
Beginning Capital Account Balance: + Additional cash and property (at fair market value) contributed by member + Allocations of LLC income or gain + Allocations of LLC tax exempt income - Cash distributed to the member - Fair market value of property distributed to member net of liabilities secured by the property - Allocations of nondeductible LLC expenses - Allocations of LLC losses and deductions = Book Capital Account Balance at the End of the Year |
For example, Steve and Jane form a LLC. Steve and Jane will each have a 50% interest in the LLC. Steve contributes $100 and Jane contributes property with a basis of $50 and a fair market value of $100. Accordingly, Steve and Jane would each have a capital account balance of $100. If in year 1 the LLC generated $50 of profits, Steve and Jane’s capital account (equity in the LLC) would be increased to $125 respectively (Steve and Jane’s capital account is increased by the $25 of LLC profits they were allocated). In year 2, if the LLC generated a $20 loss, Steve and Jane’s capital account would be reduced by $10 respectively bringing their capital account (equity in the LLC) to $115 respectively.
