Illinois limited liability companies that elect to be taxed as a sole proprietorship (single member) or partnership (multi member) maintain balance sheets that are distinct from Illinois corporations in one important respect: they require a separate equity account, or capital account, for each member – a member is an individual or entity that holds a membership interest in the LLC (similar to a shareholder in a corporation). Capital accounts guide how distributions are made to the members on an interim basis or in the event of a liquidation or acquisition of the LLC. Further, if a capital account is negative, this negative amount would reflect debts owed to the business.
LLC Operating Agreement
A corporate attorney drafting a limited liability company agreement (or operating agreement) for any business will provision for the basic economic understandings between the members. These provisions will consist of the contributions (e.g., capital, property or services) each member will make, how much credit the member will be given for those contributions, how the members will share in profits, how the members will share in losses, how the member will share in operating distributions, how the fair market value will be determined in an acquisition of the business, each member’s right to liquidating distributions, how much each member will need to contribute towards a capital call, among other items.
LLC’s Balance Sheet and Capital Accounts
In practice, the LLC’s business account will apply basic accounting principles to represent the basic economic understanding of the members of the business. The application of these basic accounting principles will produce two things: an income and expense statement and a balance sheet. The balance sheet will reflect the following simplified equation: Assets equals liabilities plus Equity. Each member of the LLC has a specifically designated share of the equity portion of the balance sheet. The member’s share of equity in the business is referred to that member’s capital account. As noted above, this is distinct from the accounting principles applied to corporations whereby the shareholders are not given individual capital accounts.
For purposes of examples, let’s say members A and B form an Illinois LLC and contribute sixty dollars and forty dollars respectively. The LLC now has cash assets valued at one hundred dollars. Assume that the LLC takes out a loan from a lending institution for nine hundred dollars and uses the total one thousand dollars in cash to buy a piece of real estate. The balance sheet will show a real property assets at its one thousand dollars cost and nine hundred dollars in liabilities and one hundred dollars in capital accounts, with member A’s capital account reflecting sixty dollars and B’s capital account reflecting forty dollars. In short, each members capital account reflects how much the owner has a right to receive from the equity of the LLC. Thus, if the real estate asset was sold for one thousand dollars, member A would receive sixty dollars, member B would receive forty dollars, and the lending institution would be paid back nine hundred dollars. Stated another way, each member has an individual capital account that reflects the member share of the LLC’s assets minus that members share of the LLC’s liabilities. It should be noted that capital accounts are often described as bank accounts in the LLC, although this description is inaccurate and misleading because there is not an actual bank account per se.
Capital Account Maintenance Simplified
To simplify the basic rules of capital account maintenance, consider the following. On the positive side, a member’s capital account is increased by the cash or value of property or services contributed to the LLC. Each member’s capital account is also increased by the member’s share of any LLC profits. On the negative side, a member’s capital account is decreased by the amount of cash or property the member receives as a distribution. It is also decreased by any depreciation charged to the member and by the member’s share of any LLC liabilities or losses.
Members of an LLC may not pay too much attention to their respective capital accounts until he or she (or it) dissociates from the LLC or the LLC is acquired or liquidated. In any of these events, the member’s will look to the operating agreement which may provide that the capital account will determine the distributions each member will receive in a dissociation, buyout or liquidation. The most difficult situations for a corporate attorney, and the LLC’s accounting professionals, is where the operating agreement is ambiguous, vague, silent on how the equity pie or distributions is to be carved out. This is why close attention should be made by the members of an LLC to clearly spell out these points when developing and drafting the operating agreement. On a final note, member’s of new startup LLC’s in Illinois should know that, at least in our law office, the most popular disputes between members on an LLC arise out of disagreements with how distributions are to be made due to ineffective operating agreements that do not address the points made above.