Each Tuesday, our new series, "Accounting Tips Tuesday," brought to you by Zoho Books, presents articles that fit into one of two categories.
First, we look at the theory behind basic, and not so basic, accounting concepts with practical applications, including the old "debits and credits" appropriate to the situation.
Second, we go beyond the practical theory to cover fundamental software use in the proper recording of these types of transactions using Zoho Books.
This week, we are taking a look back at portions of an earlier article, written by my co-author, Rob Shaff titled Capital, Equity, or Retained Earnings? – Nomenclature Matters. Our return to this topic arises out of a readers’ question.
Equity Revisited - fig 1
A few weeks back Insightful Accountant published an article we titled, Capital, Equity or Retained Earnings? – Nomenclature Matters. That article started with an illustration of an actual situation.
The following excerpt was taken from the equity section of a client’s LLC balance sheet prepared by their in-house controller (Note: This company is taxed as a partnership):
Capital article - figure 1
Out of that illustration, the article posed a couple of vital questions. First, "do LLCs have retained earnings?" Second,"is a limited liability company’s equity referred to as “Capital” or “Equity”?"
Well, one reader wrote in not only thanking us for that article, but at the same time asking “how should the equity section of an LLC taxed as an S-corporation read?” We both believe that this is such an important topic, and one which is fundamental to the very purpose of this series, that it warrants this look back, so that we can actually elaborate on the particulars of our reader's question.
An LLC taxed as an S-corporation
When an LLC makes the election to be taxed as an S-corporation, one of the most important things to remember is that the entity is still, legally, an LLC. As a result, it has members, not shareholders, and issues units, not common stock.
Accordingly, for financial statement purposes, the equity section becomes more of a hybrid presentation.
As no stock is issued, and all issued LLC units are part of Members’ equity, the presentation takes the following format:
Equity Revisited - fig 2
All contributions to the entity, whether new unit purchases or cash calls to existing members, are credited to Members’ equity, and like always, Distributions and Net income (loss) are rolled into Members’ equity at year end close.
Yes, you’ll probably receive some sideways glances, but remember what we said above – just because you’ve converted for tax purposes, doesn’t mean the entity ceases being an LLC.
On the tax return, all unit purchases and member contributions are credited to Paid in Capital, while all Distributions and Net income (loss) are rolled into Retained Earnings. The rationale here is that you must prep an 1120-S, but you’re still dealing with the LLC equity structure on an S-corporation balance sheet form (square peg-round hole).
Remember, the presentation of your financial statements is very important. While certain in-house financial documents and schedules may have nuances, your published financials need to always reflect the proper terminology. If the accounting nomenclature is inappropriate, you are likely to find that those reviewing your financial statements will soon be questioning the overall accuracy of your financial presentation.