Generic

Owner Distributions, Contributions, and Loans Part I – An S Corp Case Study

by Don Leininger April 22, 2009

Owners of small companies live and breathe their businesses. This is particularly true when it comes to the relationship between owners and the cash flow of the company.  Cash to fund operations often comes from the owner, and most owners also take cash out of the company as distributions. It is common to see both cash inflows and outflows on a frequent basis throughout the year.

In this first part of a two part series, we look at methods of tracking this activity as it relates to S Corps in a QuickBooks file.  We are also limiting the discussion to one-owner situations, as multiple-owner businesses bring additional complexity.  While the treatment of these transactions is similar for partnerships and LLC’s, there are some important differences.  The treatment with owners of C corporations differs significantly. As such, the discussion below relates only to one-owner S corporations, and it is very important that you not attempt to stretch this advice to any other ownership situation.

Involve the tax preparer in these decisions.  It is strongly advisable to involve the company’s outside tax preparer throughout the year. They have the ultimate responsibility, so you should not be making tax decisions. Your job is to identify and accumulate owner transactions, while the tax preparer’s job is to tell you where they want them posted for the tax return. Just make sure you identify and accumulate owner transactions in one or a few specific accounts so the tax preparer can easily identify them at tax time.  It is also a good idea to contact the tax preparer right away if you notice owner transactions during the year that are out of the norm for the business.

Background

I am commonly asked whether it is proper for owners to make cash contributions and cash distributions throughout the year.  The simple answer is yes – in most situations.  There are no legal or tax rules that prohibit an owner from doing so.  This flexibility in funding the company brings both good news and bad news.  We will discuss the basic situations we encounter in this article - the good news.  In a future article we will discuss several situations that result in tax problems if not handled properly - the bad news. 

The Basic Situation

The cash to fund the business comes from the owner, and debt with outside parties is not significant.  As profits are earned, the excess cash is distributed to the owner. If there are losses, the owner contributes the cash necessary to keep the company afloat.  What is the best way to record these transactions?

Solution One – Track in an Equity account

The first solution we will look at is tracking the transactions in an Equity account.

Distributions:  The most common method for the owner to remove profits or excess cash is through distributions.  These payments to the owner are recorded as debits in an equity account commonly labeled “Current year distributions”. 

The end-of-year total in Current year distributions is closed on January 1 of the following year into the Beginning retained earnings account via journal entry.  That way, only one year’s distributions are reported in the account for each fiscal year.  This is the same method followed in the tax return. 

Contributions:  When the owner puts money back into the company, the deposits are commonly recorded as offsetting credits to the Current year distributions account. If there are no net current year distributions, meaning the owner put more money into the business that year than they took out in distributions, credit an equity account commonly named Additional paid in capital (APIC) if no stock is issued.  This is commonly the case when there is a net loss for the year, when significant cash is needed to fund inventory or equipment purchases, or to fund increases in accounts receivable.  You should avoid having cash contributions create a negative balance in the Current year distributions account.

The cumulative balance in Additional paid in capital is not closed into Beginning retained earnings, so the balance carries from one year to the next.  If profits provide cash available for distribution in a subsequent year, most often these future distributions are handled as regular distributions per the discussion above, rather than being posted as a reduction to APIC.  While retained earnings may still remain negative as a result, the equity provided by APIC will normally create an overall positive total equity balance. 

  • Alternative one:  When profits become available for future distributions, some tax preparers will first treat distributions as reductions of APIC until the balance in the account is zero, treating APIC more as a general capital account than as a permanent addition to capital. 
  • Alternative two:  Treat owner contributions of cash that are expected to be paid back in an Other current liability account commonly named “Notes payable to owner”.  Repayments would be posted as reductions of this account.  However, many tax preparers prefer not to use liability accounts for owner contributions and distributions. 
  • Discuss this issue with your tax preparer to determine which method to use. 

Order of accounts in the equity section:  Typical order is first Common stock (initial or subsequent owner cash contributions for which stock is issued), then Additional paid in capital (APIC)(additional cash contributions for which no stock is issued), then Beginning retained earnings, then Current year distributions, and finally the QuickBooks Current year net income account.

In the above example, when we close Dec 31, 07 Current year distributions of $(20,028) and Net income of $13,507, with Beginning retained earnings of $67,011, we arrive at the 2008 Beginning retained earnings balance of $60,490.  Note also that Additional paid in capital of $16,488 is not closed into Beginning retained earnings. 

Posting direct to retained earnings:  It is important to differentiate posting distributions or contributions directly to Beginning retained earnings, which should NEVER be done. While owner distributions ultimately roll into retained earnings after the year is closed, they must be separately accounted for each year.

Solution Two – Track in an Asset or Liability Account

Notes payable to / from owner:  If there are numerous ins and outs with the owner, you can net these transactions in a Due from Owner other current asset account, or Due to Owner other current liability account, which would commonly be posted at the end of the year as either a net distribution or net additional paid in capital in the Equity accounts as discussed above.  It is not a good idea to leave due to / from balances from year to year in the balance sheet unless there is a specific plan to pay off the balances, and a note receivable or payable is written in support.

Owner expense reimbursements:  Use a Due to Owner other current liability account to accrue expenses when the owner is to be reimbursed for expenses paid or incurred on behalf of the company.  The payment of these expenses will be posted as reductions of this account when ultimately paid.  Be sure to treat these payments separately from the owner distributions discussed above. 

Similarly, you may choose to use a Due from Owner other current asset account when money is spent by the company on behalf of the owner and the owner intends to reimburse the company for the specific transactions.    

Solution Three – Track in an Expense Account

Owner distributions expense:  Some owners prefer to consider distributions as an expense in the Profit & Loss Statement.  Post the distributions into a separate account that is clearly labeled such as Owner distribution expense.  Be sure to differentiate these distribution payments from Owner payroll expense, the account which is used to record regular owner compensation recorded in the W-2.  Also be sure that no other owner payments are recorded in this account.  For example, mileage or other expense reimbursements should be recorded in separate owner reimbursed expense accounts. 

Note that this treatment for owner distributions is not in accordance with tax laws.  At tax time, the tax preparer will reclassify the “expense” as an equity distribution as discussed above. 

Owner contributions income:  Similarly, owners may desire to post contributions of cash to the company in an income account.  This is also not in accordance with tax laws and should be avoided. 

Conclusion

There is a wide variety of transactions with owners, and each requires separate treatment.  Therefore, consultants should familiarize themselves with the types of transactions they will encounter for each business, and coordinate QuickBooks accounting with the tax preparer to ensure owner transactions will be easily identified for proper classification in the tax return.  

In Part 2, we will look at further examples and special case studies for recording owner distributions and contributions.

5 Comments

  • Joleen S says:
    April 26, 2009 10:13

    I'm wondering why you recommend that the client clear out the Distribution account (contra-equity account) to Retained Earnings every year in case I'm missing something important.

    I recommend clients use the contra-equity account for Distributions but let it accumulate (don't clear it out to RE) for two reasons:
    1. The owner can see very clearly how much money he/she has taken out of the business current year by using a comparative balance sheet and over the life of the business which is an important figure especially if the owner is subsidizing a personal lifestyle instead of keeping the business and personal life separate.
    2. In a potential future sale of the business or in bank discussions, the owner clearly shows the cumulative gross amounts for distributions and retained earnings instead of the net retained earnings to illustrate a truer picture of profit production/retention and owner return over the life of the business than netting the figures.

    Am I missing something important by doing it this way?

    Thanks,
    Joleen

  • Donald L says:
    May 22, 2009 11:25

    Excellent point Joleen. Cumulative distributions can be an informative number. A similar point would be to track cumulative profits. Here is a way you can close these accounts, and still retain the details (see example following). Create a header account for Retained Earnings Cumulative (410). Then create accounts for Net Income and Distributions for both Beginning and Current Year (412/.1 and 413/.1). These accounts will be subtotaled, allowing you to show the details of cumulative net income and distributions, as well as the total of cumulative combined retained earnings. Note that QuickBooks will always generate Net Income as a separate line at the bottom of the Equity section, along with Retained Earnings (3900). Each year end, it is necessary to zero out the QB Net Income account by posting a debit to the QB Retained Earnings account (3900), with the credit posted to Net Income Current Year (412.1). This is repeated each year end. When QB "closes" Net Income automatically on 1-1-xx, it will leave a zero balance in account 3900. It is a little confusing until you get used to the flow of entries, but it works quite well. On 1-1 of each subsequent year, you will need to post your own entry to "close" current year net income (412.1), and current year distributions (413.1), into the respective Beginning balance accounts (412 / 413). We get the best of both worlds. If you desire even more detail, you could individually subtotal both the net income (412 and 412.1) and distribution accounts (413 and 413.1). I actually use this method in the financial statements for my company. While this is not the most common method, it does work well when the owner is interested is seeing the cumulative components of retained earnings.

    Take a look at the chart: http://pastehtml.com/view/090610aEWPqXoy.html

    Distributions and net income are closed to retained earnings for a few practical reasons; 1) This is how the numbers flow in the tax return, 2) "Retained" earnings implies just that - retained, meaning, the cumulative earnings that have been retained after distributions. For the typical GAAP based statement of equity, retained earnings is closed in this fashion, 3) When printing a balance sheet that has columns for more than two years, it is much easier to see the net income and distributions for any given year when both are closed annually. Best wishes! Don Leininger

  • says:
    May 10, 2010 06:42

    If I wanted to show that some profit for this financial year was being distributed for a previous financial year ( either because there was not enoguh distributed or none distributed at all for the prevous year) how would that be represented as an entry?

  • Donald L says:
    May 10, 2010 18:26

    I usually see only one distributions general ledger account, since the reader of the F/S can compare the distributions for the current year against both the net income for the year and the beginning retained earnings balance. However, if you want to be more specific you can set up more than one distributions account, with a separate account for each year's distributions. You can be as flexible as you desire here. If you do set up more than one distributions account I recommend you subtotal the accounts so that the reader of the F/S can easily see the total of distributions

  • Jan B says:
    June 25, 2012 12:12

    I have an entry to post on a new LLC and I'm not sure how to handle it according to GAAP. Before the company was fully operational, the owners of the company had to loan $600K to the company for development funds. Now the development steps have been taken and a revenue amount (this is an oil and gas company) has been sent to us. The revenue amount includes enough to repay the owners, who are expecting these funds.

    According to GAAP, should the loan and repayment be posted to owner conributions and distributions? Or can we show a liablity (loan payable) and then relieve the liabiltiy upon payment?

Please log in to add a comment!

QuickBooks & Beyond Blog