Understanding Negative Capital Accounts
Introduction to Capital Accounts
A member’s capital account cannot begin with a negative balance. However, a member can have a negative capital account after accounting for losses and distributions. The goal is to ensure the business has resources to meet obligations and operate smoothly.
Negative capital accounts arise when the member receives distributions exceeding the capital account, and/or is allocated deductions beyond the capital account. If a member doesn’t have an obligation to make a contribution when its capital account is negative, the IRS can require allocations preventing or eliminating negative capital accounts.
Capital Account Management
Can an LLC capital account be negative? A negative capital account balance is permissible if supported by proper allocation of partnership debt or an obligation to restore a deficit. Certain operating agreements actually require the LLC members to keep their capital accounts positive. This could cause members to add to their accounts out of their own pockets to bring a negative balance up to zero. Such additions are viewed as member contributions.
Capital accounts represent the total investment made by business owners or partners. In a Limited Liability Company (LLC), a capital account refers to the individual member’s ownership interest. It tracks the contributions and distributions made by each member.
Negative Capital Account Implications
What happens when a partner has a negative capital account? Upon termination of the partnership, the partner with a negative capital account must pay back or restore the amount owed to the partnership.
Can a partner have a negative capital account? A partner’s capital account cannot begin with a negative balance. Partners and members of an LLC taxed as a partnership will often have negative or deficit capital account balances at the end of a taxable year.
Capital Accounts in Tax Filings
When can a capital account be negative? A partner’s tax basis capital account can be negative if a partnership allocates tax losses or deductions or make distributions to the partner in excess of the partner’s tax basis equity in the partnership, or when a partner contributes property subject to debt in excess of its adjusted tax basis to a partnership.
Under certain conditions, the IRS allows a capital account to be negative at the end of each fiscal year. This can occur when the cumulative distributed cash and allocated losses exceed a partner’s capital contributions plus allocated income to date.
Settlement of Negative Capital Accounts
What happens when a partner’s capital account is negative? If any members of a partnership have a negative capital account, that partner is legally obligated to restore their deficit, also known as a DRO (deficit restoration obligation).
How do you close partners capital account? The entry is to debit Cash Account or Bank and credit the partner’s capital account.