S Corp Equity Section
By Jason Watson, CPA
Posted February 28, 2020
Massaging of the equity section of your balance sheet is required when being taxed as an S corporation. But what if the underlying entity is an LLC? Good question. We believe, for elegance sake, that an LLC being taxed as an S corporation should walk, talk and smell like a corporation on the tax return. Ultimately this does not alter the ownership; the IRS calls you a shareholder since that is what the K-1 reads, but if you are an LLC you truly remain a member and your ownership is called an interest (not a share or a stock).
So, you are living two worlds. You have the governance of your entity (LLC – Operating Agreement versus Corporation – Bylaws / Shareholder Agreement) in one world, and the tax election in another. Ok, upward and onward…
Here is some nauseating accountant jargon. On January 1st, or the effective date of the S corporation election, the equity section would have five accounts-
- Capital Stock
- Additional Paid-In Capital (for each shareholder)
- Shareholder Distributions (for each shareholder)
- Retained Earnings, and
- Net Income
Unlike a C corporation, an entity being taxed as an S corporation can only have one class of stock, so preferred stock is not allowed, yet common stock within an S corporation structure can still have voting and non-voting rights. This section of our book is regarding an LLC but if a C corporation elected to be taxed as an S corporation (for example), Dividends Paid would still be tracked within the equity section purely for legacy purposes. However, S corporations do not pay dividends. Rather shareholders receive distributions.
The challenge becomes how to “fund” the Capital Stock and Additional Paid-In Capital accounts. Typically an LLC will be initially funded with the owner injecting cash and perhaps some equipment to start the business. This would have been a debit to Cash and Equipment separately, and a Credit to the owner’s Capital account. Upon S corporation election, the Capital account would be closed out to Capital Stock using a pre-determined par value such as $10 per stock and a nominal number of shares such as 100, or $1,000 in Capital Stock.
We recommend keeping the Capital Stock account as small as possible because it provides the most flexibility in taking future Shareholder Distributions without affecting Capital Stock. The remainder would be a credit to the Additional Paid-In Capital account(s). Yup we are geeking out.
Typically when taking a C corporation and electing S Corp status, existing Retained Earnings needs to be recorded separately. Why? Theoretically these earnings would have been subjected to dividends taxes paid by the shareholders if distributed. Therefore, the IRS is wise and doesn’t want you to enjoy a 21% corporate tax rate as a C Corp, elect S Corp status and then distribute the prior earnings tax-free. There are some devils in the details and there are some things like Built-In Gains taxes and stuff, but that is rare for most small businesses converting to an S corporation.
Since it is common for small businesses to operate as LLCs for several years and to have incomplete records (shocking), the “funding” of the equity accounts might have to wait until the end of the first year of S corporation election to maintain sanity. For example, on December 31st Capital Stock and Additional Paid-In Capital are zero, including Retained Earnings.
The following three journal entries would be made-
- Net Income would be closed out with a credit to Retained Earnings, and
- Shareholder Distributions throughout the year would be closed out with a debit to Retained Earnings, and
- A correcting entry would be made with credits to both Capital Stock and Additional Paid-In Capital using the same guidelines of keeping Capital Stock a nominal value such as $1,000, and a debit to Retained Earnings.
You really don’t care about this, do you? No worries, we provide these journal entries during tax preparation.
Another technique where historical records are incomplete would be using the amount of cash in the business checking account on January 1 of the first year of S corporation election as the initial capital injection. The entry would be a debit to Cash, and credit to Capital Stock and Additional Paid-In Capital. While these techniques are not as elegant as tracing the capital structure from the beginning, it does create efficiencies and simplicity within a small business. Shareholder basis would also be the beginning cash, unless there are some other issues at hand (like transfer of depreciated assets, etc.).
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