Business owners can easily create legal structures themselves using services like LegalZoom. What these business owners don’t understand, however, are the accounting or tax ramifications of choosing one structure over the other. A business owner may hear from a friend that a certain structure is good, and then adopt that structure without understanding what it means for their business.
Depending on the structure you choose, the way you represent capital contributions on your books is different. This article discusses how capital contributions are treated by the sole proprietorship, partnership, and corporation (this also applies to s corporations).
Single owner
A sole proprietorship is the simplest entity to manage when it comes to accounting for wealth. In a sole proprietorship, the owners’ contribution and retained earnings (money you’ve earned in your business over time) are considered one. The total is charged to the owner’s capital account. For example, if a sole proprietorship earns $2,000 and contributes $500 to his business, owner’s equity will be $2,500 and is represented in the balance sheet’s equity section as follows:
Owners Equity $2,500 (alternatively, you may choose to use the owner’s last name)
camaraderie
The partnership is similar to the sole proprietorship when it comes to reporting equity on the balance sheet. The difference is that each partner has a different capital account. For example, if James Doe ($2,500 net worth) and Julie Moe ($5,000 net worth) are partners, the capital structure would be represented as follows:
Moe, Principal $5,000
Doe, principal $2,500
Corporation
The corporate structure is the most complicated and regulated entity when it comes to capital transactions. To understand how contributions are represented I’ll first need to explain some terms.
by value
Most states require corporations to assign a par value to shares. The nominal value was initially created to represent the maximum liability of the investors. The par value multiplied by the number of shares issued must equal the minimum capital requirement intended to protect creditors. This is also known as legal capital. To ensure that every corporation has legal capital, most states require corporations to have equity. Any initial shareholder would have to pay at least par value to acquire the shares/ownership of the business.
However, corporations found a way around this rule by minimizing face value: in other words, most corporations do not issue face values that exceed $1. Due to the popularity of this practice, for its value it has very little relevance in today’s society.
set value
Instead of par value, a corporation could have declared the value of each share. This is another random number decided by the board of directors. Similar to value, declared value also has very little meaning.
authorized stock
Authorized shares are the maximum number of shares that a corporation can legally issue. This is established when the articles of incorporation are filed. Modifications can be made to change the authorized actions.
stock market issues
Issued shares are authorized shares that have been purchased by shareholders. For example, if a corporation is approved to issue 1,000 shares, but its shareholders only purchase 500 of those shares, then the corporation has 1,000 authorized shares and 500 issued shares.
Stock in circulation
Shares outstanding are the shares owned by investors minus the amount held in treasury (these are the shares repurchased by the corporation). For example, if a corporation issues 500 shares and then buys back 100 shares, then the shares outstanding are 400.
Share capital and financial status
Issuing worthless shares is different from issuing valuable shares. If a stock is at par value, the total amount received from the purchase of the stock is divided between two capital accounts. The amount of per value that is recorded is recorded in the common stock account and the amount paid per value is recorded in the paid-up capital account. For example, Joe Inc. is authorized to issue 1000 shares at $1 per. During the year, Joe Inc. issued 500 shares at $3 per share. To record this transaction in his book, Joe Inc. would need to record the amount received at face value which is $1*500 and the excess $2 is recorded in paid-in capital as follows:
Now let’s take a look at what a stock session for a corporation will look like:
Corporate Stockholders’ Equity
Common shares, $1 each, 1,000 authorized, 500 issued and outstanding
$500.00
Paid in excess principal per value (1500 cash received)
$1,000.00
Retained earnings
$2,000.00
full equity
$3,500.00
Note: As an S corporation, you can only have one class of shares, this means that all shares must have the same treatment. By treating a stock differently, another class is created, which means it loses its corporate status.