Balance Sheet and Earned Surplus Tests for Dividends
Small business owners have a variety of withdrawal methods available to them when attempting to minimize the amount of vulnerable assets within a business.
Most states restrict distributions to the owners in the form of dividends or stock redemptions to the corporation's "earned surplus." This account will always be less than the corporation's assets minus its liabilities, and thus is a more restrictive test than the balance sheet version imposed by the Uniform Fraudulent Transfers Act (UFTA).
The laws vary from state to state. Corporation statutes on fraud in some states may apply the standard balance sheet test (liabilities exceed assets) rather than the more restrictive earned surplus version of this test, along with the cash flow test.
Even limited liability company (LLC) statutes on fraud, which usually apply the standard balance sheet test, as well as the standard cash flow test, can vary from state to state.
To determine the exact restrictions that will apply to these distributions, it always is wise to check the statute in the particular state in which the business entity was formed and consult a legal advisor regarding the interpretation of this statute.
Finally, some state corporation statutes apply a less restrictive version of the earned surplus test. This test, in terms of restrictions, is somewhere between the standard balance sheet test and the earned surplus test. This version underscores the variability among the states with respect to these restrictions. This less restrictive test applies in Delaware and Nevada (among other states).
Corporate structure and terminology. Because of the nature of the earned surplus test, it is important that small business owners have a basic understanding of a corporation's financial structure and the terminology used to describe the elements that comprise this structure.
A corporation's financial structure can be represented by what accountants term the accounting equation: assets = liability + owner's equity. The liabilities (i.e., debts) and the owner's equity (i.e., the owner's investment) represent the two ways that the owners of the corporation can finance the corporation's acquisition of assets.
The owner's equity is subdivided into two categories, which represent the two ways that owners can make contributions to the corporation:
- Contributed capital, which includes the contributions to the corporation in return for common stock
- Earned surplus (also called retained earnings), which is comprised of the corporation's cumulative earnings, less distributions of those earnings (i.e., dividends)
The concept that an owner can make an investment to a corporation in two ways can be understood by an analogy to a savings account. Let's say an individual deposits $100 into a new savings account that earns 4 percent interest. At the end of the first year, the account has earned $4 of interest, which the depositor leaves in the account. His initial investment, or contributed capital, is $100. At the end of the year, the retained earnings or earned surplus in the account amounts to $4. At the end of the year, the total investment, or the owner's equity, in the account is $104. Really, the $4 contribution, in the form of earned surplus (retained earnings), is no different than a withdrawal of the $4 of interest, which is then followed by a deposit of $4.
The contributed capital (common stock) is further divided into the minimum or stated capital (amount paid in for par value or, absent a special allocation, the total amount paid in for no par stock) and the capital surplus (amount paid in above minimum, or stated capital).
When par value common stock is issued, the minimum or stated capital will be equal to the amount paid in for the par value. The amount paid in above par value is the capital surplus.
When no par value common stock is issued, the entire amount paid in will be minimum or stated capital, unless within a fixed period (e.g., 60 days) the corporation makes a special allocation of a portion of these proceeds to capital surplus (see our discussion of different classes of ownership interests with par value and no par stock). Usually, no allocation is made, as an allocation could possibly open the corporation to a piercing of the veil of limited liability argument, based on the undercapitalization theory.
As noted above, the owner's equity component of the accounting equation can be divided into these basic constituents:
Owner's Equity:
- Contributed Capital (Common Stock):
- Minimum or Stated Capital (amount paid in for par value or, absent a special allocation, total amount paid in for no par stock)
- Capital Surplus (amount paid in above minimum or stated capital)
- Earned Surplus or Retained Earnings (cumulative income minus dividends paid)
The common state corporate earned surplus version of the balance sheet test, as applied to dividends, is illustrated in the following example.
 |
Let's say a corporation's financial structure is depicted by the following equation:
assets = liabilities + owner's equity
$100,000 = $60,000 + $40,000
Let's say the owner contributed $25,000 of owner's equity, through the purchase of common stock, that the common stock has no par value, and that the corporation has not allocated any portion of the $25,000 to capital surplus. Thus, the corporation's minimum or stated capital is $25,000. This also is the total amount of the corporation's contributed capital.
The remaining balance of owner's equity, $15,000, is the corporation's earned surplus or retained earnings. This amount represents the corporation's cumulative earnings, less any distributions of these earnings to the owners (i.e., dividends).
Under the constructive fraud balance sheet test applied in most states, distributions of dividends and for stock redemptions must be limited to the amount of earned surplus. Thus, the corporation can distribute a maximum of $15,000 to the owners on account of their ownership interests.
|
|
Because dividends, by definition, are a distribution of earnings, limiting dividends to available earned surplus or retained earnings is logical.
However, the earned surplus version of the balance sheet test usually applies to both distributions of earnings (i.e., dividends) and to stock redemptions. Application of this restriction to stock redemptions really doesn't seem to make sense, because stock redemptions are not paid out of earned surplus, but instead come out of capital stock.
This extension came about as states broadened the definition of the term "distribution" beyond dividends, so as to include all distributions on account of an ownership interest, including stock redemptions. Logical or not, the earned surplus restriction applies to stock redemptions as well as dividends in most states.
 |
Work Smart
Stock redemptions and redemptions of LLC interests can qualify for favorable capital gains treatment. Before redeeming or selling an interest in a corporation or an LLC, small business owners should consult a tax advisor.
|
|
|
