Different Entities Mean Different Equity – The Corporate Equity Section
Corporations have the most complex equity sections of any business entity, and for C corporations it can get much trickier than for S corporations. Owner’s equity for corporations has more components than other business forms. It starts with the two basic divisions that all companies have: contributed capital and earnings. That’s where the first difference occurs; rather than folding earnings into contributed capital accounts, they get their own permanent account, called retained earnings.
The next big difference comes with the two different contributed capital categories; other entities have only one. With corporations, the amount you put into the company will be split up into two separate accounts, one for stock at par value and one for any excess over that par value. Par value sim- ply means the dollar value assigned to a single share of stock in the corporation, which may have absolutely no relationship to its actual value; it’s just a number you pick so the stock has a dollar value on the books. You can’t pay in less than that amount for a share of stock, which is why small corporations often set their par value very low, sometimes even at zero (in states that allow that). If you gave your corporation’s stock a par value of $2 per share, but you paid in $10 per share for 100 shares (a total of $1,000), your journal entry would look like this:
General Journal Entry
Cash: $1,000.00
Capital Stock: $200.00
Additional Paid-in-capital: $800.00
To record $1,000 capital contribution for 100 shares of $2 par value stock.
Even the stock category can be subdivided, but only for C corporations. S corporations are allowed to have only one class of stock, but C corporations are under no such restrictions and can have as many different classes of stock as they like. Every share within a certain class of stock has the exact same rights, such as those for voting and dividends. Different classes can have different rights; for example, you can have one class with no voting rights but a higher dividend payout, or two classes with the same voting rights but different dividend payouts.
Retained earnings are self-explanatory: earnings that you keep in the business instead of paying them out to the owners. Every time your corporation has profits, they initially increase that retained earnings account.
These retained earnings can be used to expand your business or to purchase major assets, among other things, or to pay out dividends to the shareholders. When you do decide to pay dividends to the shareholders, those dividends decrease retained earnings rather than any contributed capital accounts. Should the corporation sustain losses (instead of profits), the balance of retained earnings would decrease, and might even go negative. For many new and small corporations, it’s not unusual for the retained earnings account to be negative for the first year or two.
Why Have Different Classes of Stock?
It may seem cumbersome to have more than one class of stock for a small corporation, but there are times when this strategy makes a lot of sense. For example, if you’ve raised money from friends and family to build your corporation, you may want to pay them regular dividends without letting them have voting rights (which can equate to control over business decisions).
You may also want to pay dividends to shareholders who don’t work for the company without paying dividends to those of you who are drawing a salary. You can also pay different dividends to different shareholder classes; for example, Class A could get $0.25 for each share, and Class B could get $2.00 per share. When there’s only one class of stock, each share counts exactly the same, has the same voting rights, and gets the same dividend.
ALERT!
S corporations cannot have more than one class of stock; it’s strictly forbidden by the IRS. However, they can split that one class into two pools of voting and nonvoting shares. If you want the flexibility to make different dividend payouts to different shareholders, though, use a C corporation for your entity instead.
Retained Earnings Is Not an Asset
Retained earnings is an equity account, a separate spot to keep track of any profits not paid out as dividends. Like all other equity accounts, retained earnings has a claim against assets, because it represents ownership interests. However, retained earnings is not linked to a specific asset account— not even the cash account. You can have retained earnings without having any cash, which is one reason why some corporations do not pay out cash dividends. For example, your corporate balance sheet could show $25,000 in retained earnings when the company has only $2,000 in cash.