LLCs And Capital Accounts: An Introduction
Lawyers advising LLCs and their members must understand capital accounts from a tax perspective. When LLCs are taxed as a partnership, a member’s capital account reflects a portion of a member’s economic interest in the LLC. The tax regulations surrounding capital accounts are lengthy and complex, but understanding the basics allows practitioners to fully counsel their clients, whether entities or individuals, as to the implications of each and every move they make.
Capital Account Basics
First and foremost, do not conflate a form of “contribution” from a state law perspective, with a capital contribution from a tax perspective. RCW 25.15.191 provides that a member’s “contribution” to an LLC:
“may consist of tangible or intangible property or other benefits to the limited liability company, including money, services performed, promissory notes, other agreements to contribute cash or property, or contracts for services to be performed.”
From a tax perspective, capital contributions take only the form of money or property. In other words, contributions of services performed are not considered capital contributions from a tax perspective, even though they are “contributions” under state law.
In a simplistic manner, four items impact a member’s capital account:
- Contributions to the partnership;
- Distributions from the partnership to the members;
- Allocations of profit of the partnership; and
- Allocations of loss of the partnership.
Contributions and allocations of profits increase a member’s capital account, while distributions and allocations of loss reduce a member’s capital account.
Why do Capital Accounts Matter?
Although capital accounts are not bank accounts, capital account balances typically determine what a member will receive upon liquidation of the LLC. Some consider a capital account as a measure of a member’s equity in an LLC. In addition, some state LLC laws and LLC agreements provide that voting occurs in proportion to the member’s capital accounts. Also, what if the capital account goes negative? In my experience, most members of an LLC do not even realize they have a capital account, or, if they do realize it, they have no understanding of how a capital account impacts them.
In a short post such as this one, a complete description of capital accounts is not possible. In fact, the pages of regulations surrounding allocations and treatment of capital accounts number in the hundreds. Many lawyers simply ignore the “tax stuff” in an LLC agreement. They do so at their peril because the “tax stuff” matters to the LLC and the members.