Business owners can easily create legal structures for themselves using services like legal zoom. However, what these business owners don’t understand are the accounting or tax ramifications of choosing one structure over the other. A business owner may hear from a friend that a certain structure is good and then they adopt that structure without understanding what it means for their business.

Depending on what structure you choose, the way you represent the capital contributions in your books is different. This article discusses the way capital contributions is treated by the sole proprietor, partnership and corporation (this also applies to s corporations).

Sole proprietorship

A sole proprietorship is the simplest entity to run when it comes to accounting for equity. In a sole proprietorship owners contribution and retained earnings (money you have earned in your business over time) are all looked at as one thing. The total is attributed to the owner’s capital account. For example, if a sole proprietor makes $2,000 and contributes $500 in his/ her business, the owner’s capital will be $2,500 and is represented on the equity session of the balance sheet as follows

Owners capital $2,500 (alternatively you can choose to use the owners last name)

Partnership

The partnership is similar to the sole proprietorship when it comes to reporting equity in the balance sheet. The difference is each partner has a different capital account. For example if James Doe ($2,500 equity) and Julie Moe ($5,000 equity) are partners, the capital structure will be represented as follows:

Moe, capital $5,000

Doe, capital $2,500

Corporation

The corporate structure is the most complicated and regulated entity when it comes to equity transactions. To understand how contributions are represented first I will need to explain some terms.

Par value

Most states require corporations to assign a par value to stock. Par value was initially created to represent the maximum liability of the investors. The par value multiplied by the number of shares issued should equal the minimum capital requirement intended to protect creditors. This is also known as legal capital. To ensure every corporation has legal capital, most states require that corporations have par value. Any initial shareholder, would have to pay at least the par value to acquire the stock/ ownership of the business.

However, corporations found a way around this rule by minimizing the par value: In other words, most corporations do not issue par value that exceed $1. Due to the popularity of this practice, par value has very little relevance in today’s society.

Stated Value

In lieu of par value, a corporation might have stated value for each share of stock. This is another random number decided by the board of directors. Like par value, stated value also has very little meaning.

Stock Authorized

Stock authorized is the maximum number of shares a corporation is legally permitted to issue. This is established when the articles of incorporation are filed. Amendments can be made to change the authorized shares

Issued stock

Issued stock is authorized stock that has been purchased by shareholders. For example, if a corporation is approved to issue 1,000 shares, but its shareholders only buys 500 of those shares, then the corporation has 1,000 authorized shares and 500 issued shares.

Outstanding stock

Outstanding stock is stock owned by investors less the amount held in treasury (this is stock bought back by the corporation). For example, if a corporation issues 500 shares and then buys back 100 shares then the outstanding shares are 400.

Capital stock and the financial statement

Issuing stock with no par value is different from issuing stock with par value. If a stock has par value, the total amount received from the purchase of the stock is split between two equity accounts. The amount of the par value is recorded is recorded in the common stock account and the amount paid over par value is recorded in the paid-in-capital account. For example, Joe Inc. is authorized to issue 1,000 shares at $1 par. During the year, Joe Inc., issued 500 shares at $3 per share. To record this transaction in its book, Joe Inc. would have to record the amount received at par value which is $1* 500 and the $2 excess is recorded in paid in capital as follows:

Now let’s take a look at what the equity session of a corporation will look like:

Note: As an S corporation you can only have one class of shares, this means all shares have to have the same treatment. Treating a share differently, creates another class which means you lose your s corporation status.

This article should not be considered tax advice, please consult your CPA for more personable advice.