Finances and Taxes

What is a Capital Account and How Does It Work?

Kim Porter  

NOTE: This post is relevant to disregarded entities, partnerships, and S corps. It is not relevant to C corp owners.

When you open a business, you and any business partners might chip in money or other assets to get things started. You’ll track how much each partner contributes using a capital account. Throughout the lifecycle of your business, the capital accounts show each partner’s monetary interest in the company. 

Just so we’re all 100% clear: we’re talking about capital accounts as it relates to bookkeeping and accounting—not tax basis capital accounts. Here’s a closer look at how capital accounts work.

What is a capital account?

When you hear the term “capital account,” you might think of a business checking or savings account—but they’re not something you open at the local bank. Capital accounts are written records of each business partner’s financial stake in the company. 

This is important for your business bookkeeping, of course, and it could also make a difference if you need to borrow money from a bank. The bank will want to see your capital accounts, which show owner equity. When an owner invests in a business, there’s less of a chance that they will walk away when things get tough. Banks may use information found in your capital account records when deciding if they’ll approve your business loan request and even whether or not they’ll give you a reduced loan rate.  

Capital account balances change over time. As the company grows, each account grows according to the proportion of the partner’s initial capital investment. The balances can also shrink. When the business dissolves, capital accounts show how much money each partner should receive. 

The structure of the capital account depends on the type of business you have: 

  • Sole proprietors: There’s only one business owner in a sole proprietorship, so the owner’s capital account will include 100% of the business’s contributions, distributions, profits and losses
  • Partnerships (LLCs, LPs, GPs): Each partner who invests in the company will have a capital account made up of their contributions and distributions, and the partnership agreement should spell out each member’s share of profits and losses.
  • S corporations: The capital account for an S corporation shareholder reflects their share of contributions, distributions, profits and losses, for their current basis in the company. You’ll need to divide the corporation’s net income in proportion to their shares of ownership, similar to a partnership or LLC. 

Capital account rules

In the early stages of setting up your small business, you’ll create governing documents. Depending on the setup of your business, these documents may include a partnership agreement, LLC operating agreement, or S corp bylaws. Within these documents, you’ll need to decide how much owners can withdraw from a capital account and when they can take it. 

Sole proprietorships and single-member LLCs typically don’t create these guiding documents, so they can choose to make and take out capital contributions any time.

How do capital accounts change over time?

When it comes to bookkeeping, your company might decide to create separate capital accounts for each partner or combine all partners into one account. Either way, the accounts are usually recorded on the balance sheet as “equity accounts” and capture increases and decreases over time. “Equity” here is another word for ownership.

Below are some ways the balance could change, but keep in mind that there can be accounting complexities and fine print, so you’ll definitely want to discuss your situation with your accountant.

  • Owner contributions: The value of a capital account increases when an owner makes contributions. For example, an owner might invest money or contribute other types of assets when the business opens. The owner may also make regular contributions throughout the life of the business. 
  • Business losses: When the business loses money, each capital account is reduced according to the business’s governing documents.
  • Business income: As the business earns money, each capital account is increased proportionally. 
  • Owner distributions: Owners might be able to withdraw money from the capital pool for personal use. You’ll subtract from an owner’s capital account when they take distributions.
  • Annual reconciliation: At the end of your business’s fiscal year, your bookkeeper should add or subtract from the capital account to reflect the owner’s share of the net profit or loss. 

Each capital account should track the partner’s:

  • Cash contributions or the fair market value of assets—like property, vehicles, and equipment—contributed during the year 
  • Share of the partner’s profits and losses
  • Distributions for personal use 

Take a look at one example: Let’s say two people form a limited liability company and decide to split ownership down the middle—each taking 50% of the profits and losses. Each owner invests $25,000, so each capital account starts out with $25,000. 

The business does well during the first year and earns $60,000. Each owner’s capital account increases by $30,000 for an account balance of $55,000 per owner. But during the year, Owner A and B each took $10,000 out of the business for personal use. Here’s a simplified look at how the changes might be tracked:

Owner AOwner B
Initial contribution+ $25,000+ $25,000
Profit allocation+ $30,000+ $30,000
Distribution– $10,000– $10,000
Ending capital account balance$45,000$45,000

Bear in mind that this simple calculation is intended to give you an idea of how capital accounts work and what they look like. If the ownership isn’t a 50/50 split or if one owner takes a larger distribution, the numbers will get complicated—and depending on the parameters outlined in your governing documents, your business may need to abide by some unique rules. Talk to an accountant to be sure that you’re setting up and tracking your capital accounts properly.

Reporting capital accounts on tax forms

Owners typically keep tabs on each member’s capital account and basis throughout the year using spreadsheets or accounting programs. At the end of the fiscal year, the ending balance in the account represents any money or assets that have not been distributed to the partners. The tax you pay depends on the distributions you take and the structure of your business. 

If you have a pass-through entity like a sole proprietorship or a single-member LLC,  any profits or losses are passed on to the owners. If your business is set up under one of these structures, you’ll record profits on your personal tax return via Schedule C of Form 1040.

Partnerships will prepare  Schedule K-1 as part of Form 1065, while an S corp prepares  Schedule K-1  as part of Form 1120S. This tax form reports changes to the capital account to the IRS. It’s important to get this right because the tax agency uses the information on Schedule K-1 to make sure the account changes match your income and balance sheet reporting. If you’re unsure, talk with your accountant to see if you need to file this form and whether you must fill out a state-specific Schedule K-1.

Kim Porter
Kim Porter Kim Porter covers personal finance topics for AARP The Magazine, Bankrate, U.S. News & World Report, Reviewed, Credit Karma, and more. When she’s not writing, you can find her training for her next race, reading, or planning her next big trip. Twitter | LinkedIn
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