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