In an LLC, capital contributions are what each member puts into the business — cash, property, or services — and capital accounts are the internal ledger that tracks every member’s equity in the company, moving up with contributions and allocated income and down with allocated losses and distributions. For an LLC taxed as a partnership (the default when there is more than one member), those numbers control who can deduct losses, whether a distribution is tax-free, and who gets what if the business is sold or wound down. Getting them wrong can also cost members the liability protection they formed the LLC to obtain.
What Counts as a Capital Contribution
Members can fund an LLC three ways. Cash is the clean case: money moves into the LLC’s account, and the contributing member’s capital account goes up by that same amount.
Property
Property contributions include real estate, equipment, patents, software, and other tangible or intangible assets. When you contribute property in exchange for a membership interest, you don’t recognize gain or loss on the transfer, and the LLC takes the property at your existing tax basis rather than its current market value.1Office of the Law Revision Counsel. 26 USC 721 – Nonrecognition of Gain or Loss on Contribution Your capital account, though, is credited at the property’s fair market value on the date of transfer. The gap between fair market value and carryover tax basis is the built-in gain, and when the LLC later sells the asset, that gain gets allocated back to the contributing member under special allocation rules.
Intangibles need documented valuations. The IRS expects an appraisal that identifies the property, states the valuation method (income approach, comparable sales, or cost approach), and explains the basis for the value assigned.2Internal Revenue Service. Publication 561 – Determining the Value of Donated Property For patents, the appraisal should address remaining patent life, whether the technology has been superseded, and any restrictions on transferability.
Services
Services are not “property,” so the nonrecognition rule doesn’t apply. If you receive a capital interest in exchange for work already done or promised, you owe ordinary income tax on the fair market value of that interest, less anything you paid for it. The tax hits in the first year the interest is either transferable or no longer subject to a substantial risk of forfeiture, whichever comes first.3Office of the Law Revision Counsel. 26 U.S. Code 83 – Property Transferred in Connection With Performance of Services
Because of that immediate bill, most operating agreements give a service provider a profits interest rather than a capital interest. A profits interest entitles the holder to a share of future gains but would pay out nothing if the LLC’s assets were sold at current fair market value and the proceeds distributed. Under Revenue Procedure 93-27, receiving a profits interest for services is generally not a taxable event, provided the interest isn’t disposed of within two years, doesn’t relate to a publicly traded partnership, and the underlying partnership income isn’t substantially certain and predictable.
How a Capital Account Works
Each member’s capital account is a running balance of their economic stake. It goes up when the member contributes capital or when income or gain is allocated to them. It goes down when losses or deductions are allocated to them, or when they take a distribution. At any moment, the account represents what the member would receive if the LLC sold all its assets at book value, paid its debts, and distributed the remainder.
The IRS requires LLCs taxed as partnerships to maintain these accounts under specific Treasury Regulations. To satisfy the “substantial economic effect” test, the operating agreement must do three things: maintain capital accounts under the regulatory rules, pay liquidating distributions in proportion to positive capital account balances, and require any member with a negative capital account to restore that deficit on liquidation.4eCFR. 26 CFR 1.704-1 – Partners Distributive Share If allocations don’t have substantial economic effect, the IRS can disregard them and reallocate income or loss based on the members’ actual economic interests, which can move a real tax bill onto members who weren’t expecting one.
Since the 2020 tax year, partnerships have had to report each member’s capital account on Item L of Schedule K-1 using the tax basis method. The reported balance reflects contributions, the member’s share of income or loss for tax purposes, and any withdrawals or distributions during the year.5Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065) (2025) Sloppy accounts are much harder to hide now than they were before that change.
Outside Basis Is a Different Number
A member’s capital account and their outside tax basis in the LLC are related but not the same. Outside basis starts with the cash contributed and the adjusted basis of any property contributed. It goes up with allocated income and additional contributions, and down with losses, deductions, and distributions. It also includes the member’s share of the LLC’s liabilities, and this is where the two numbers can diverge significantly. An increase in a member’s share of partnership liabilities is treated the same as a cash contribution for basis purposes.6Internal Revenue Service. Recourse vs Nonrecourse Liabilities
How debt gets allocated depends on whether it is recourse (a specific member bears the economic risk of loss) or nonrecourse (no member is personally liable). Recourse debt is allocated to the member who would bear the loss if the LLC couldn’t pay. Nonrecourse debt is allocated among all members, generally in proportion to their profit-sharing ratios.
Outside basis matters for two things members care about: how much loss they can deduct, and whether a distribution is tax-free.
Losses You Can and Can’t Deduct
Members who plan to use LLC losses against other income face two separate limits, and many only know about one.
First is the basis limit. Your share of losses in a given year is deductible only up to your adjusted basis in your LLC interest at year end. Losses above that aren’t lost; they carry forward and become deductible when your basis rises through additional contributions, income allocations, or a larger share of debt.7Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share
Second is the at-risk limit. Even with enough basis, you can only deduct losses up to the amount you have “at risk” in the activity. That amount includes cash and property contributed plus amounts borrowed for which you’re personally liable or have pledged non-activity property as security. Nonrecourse debt where you’re protected against loss generally doesn’t count toward at-risk.8Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk Losses disallowed under the at-risk rules also carry forward until the at-risk amount is sufficient.
Members who fund contributions with nonrecourse loans sometimes find they have a large basis but a much smaller at-risk amount, and the loss deduction they expected isn’t available.
Distributions and Draws
A distribution is a formal payment of cash or property from the LLC to a member, either a share of profits or a return of capital. A draw is an advance against a member’s expected share of current-year profits, taken as needed rather than on a set schedule. The operating agreement should say how and when distributions happen; without clear rules, disputes over timing and amounts are almost guaranteed.
Tax Treatment
Distributions are generally tax-free. A member doesn’t recognize gain unless cash distributed exceeds their adjusted basis in the LLC interest immediately before the distribution.9Office of the Law Revision Counsel. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution Each dollar distributed reduces basis dollar for dollar, and only the excess over basis is taxed, typically as capital gain from the sale of the partnership interest. Loss is never recognized on a current (non-liquidating) distribution.
This is why tracking basis matters. A member who has lost the thread might take a distribution they think is tax-free, then find at filing time that prior loss allocations had already pulled their basis close to zero.
Solvency Limits
State law limits when an LLC can pay out, protecting creditors. Most states follow a two-part solvency test based on the Uniform Limited Liability Company Act: the LLC can’t distribute if doing so would leave it unable to pay debts as they come due, or if the distribution would cause total liabilities to exceed total assets. Members who approve a distribution that fails either test can face personal liability to creditors for the improper amount.
Foreign Members
If any member is a foreign person or entity, the LLC has to withhold tax on that member’s share of effectively connected taxable income and report it on Forms 8804 and 8805.10Internal Revenue Service. Instructions for Forms 8804, 8805, and 8813 Withholding is based on allocable income, not actual cash paid out, so the LLC can owe withholding in a year when it hasn’t distributed anything to the foreign member. Missing this creates penalties against the LLC itself.
Self-Employment Tax on a Member’s Share
How LLC income reaches a member changes the self-employment tax answer. Guaranteed payments for services (fixed amounts paid to a member whether or not the LLC is profitable) are subject to self-employment tax.11Internal Revenue Service. Self-Employment Tax and Partners
A member’s distributive share of ordinary business income is also generally subject to self-employment tax if the member actively participates. A member who functions as a limited partner (contributing capital but not managing) can exclude their distributive share from self-employment income. The statutory exclusion covers “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments.”11Internal Revenue Service. Self-Employment Tax and Partners An LLC with both active managers and passive investors should structure its payments and allocations to reflect who is actually providing services and who is only providing capital.
Capital Calls and Member Defaults
A capital call is a demand for additional contributions beyond the initial investment, usually triggered by an operational shortfall, a new opportunity, or a major expense. The operating agreement should specify whether calls are mandatory or voluntary, how they are issued, and how much notice members receive. Mandatory calls backed by clear language are enforceable under contract law.12U.S. Small Business Administration. Basic Information About Operating Agreements
The agreement should also say what happens when a member fails to fund a call. Common remedies include dilution of the defaulting member’s ownership percentage, a penalty interest rate on the unpaid amount, or forfeiture of the interest. Some agreements let non-defaulting members cover the shortfall and take a proportionally larger share in return. These remedies need to be in writing before a dispute arises; courts are reluctant to impose consequences the members never agreed to.
Keeping the Liability Shield Intact
The LLC’s liability shield depends on the company being treated as a legitimate entity separate from its owners. Sloppy capital accounting is one of the fastest ways to undermine that separation. Courts deciding whether to “pierce the veil” look at several factors, but two show up over and over: commingling of personal and business finances, and inadequate capitalization (starting the LLC with too little funding to reasonably operate). Smaller LLCs and single-member LLCs face closer scrutiny, because the line between owner and entity is already thinner.
Every contribution should be documented with a resolution or ledger entry showing the amount, date, and business purpose. Every distribution should follow the same discipline. Members who treat these formalities as optional are the ones who find out their limited liability wasn’t.
Winding Down
When an LLC dissolves, payments follow a set order. Creditors are paid first, including any members who hold creditor status (for unpaid guaranteed payments or approved but unpaid distributions). After creditors, members receive their capital back, and any remainder is distributed according to the operating agreement or, if it is silent, in proportion to capital account balances.
Liquidating Distributions
The tax rules for a final distribution mirror those for current distributions, with one addition: a member can recognize a loss on a liquidating distribution, but only when nothing other than cash, unrealized receivables, and inventory is distributed. The loss equals the excess of the member’s adjusted basis over the sum of cash and the basis of those specific assets received.9Office of the Law Revision Counsel. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution If the member receives any other kind of property (equipment, real estate, intangibles), loss recognition is deferred until that property is sold.
Deficit Restoration and Final Filings
In the LLC’s last tax year, each member’s capital account should reach zero after all final allocations and distributions. The LLC files a final Form 1065 and issues a final Schedule K-1 to each member, both marked as “final” returns.5Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065) (2025) Any member with a negative capital account balance who agreed to restore that deficit has to contribute the shortfall, typically within 90 days of liquidation. Failure to restore a deficit can create unexpected taxable gain for other members who effectively absorb it.