Earned surplus owner's equity can restrict dividends
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. Thus, it 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).
What constitutes owner's equity?
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 and
- 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 piercing of the veil of limited liability, based on the under-capitalization theory.
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.
Example
The RayCo 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.
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.
More liberal dividend tests may be used
Dividend distributions are a common way to withdraw funds from the business and minimize vulnerable assets within the corporation. This withdrawal method is often restricted to the earned surplus.
Delaware and Nevada (among other states) apply a less restrictive earned surplus test in determining the legality of distributions of earnings and stock redemptions. The less restrictive test allows the corporation to pay dividends and stock redemptions out of earned surplus or the net income of the current or prior year (i.e., capital surplus).
Closely held corporations typically issue no-par stock and make no allocation from the amount received to capital surplus. Thus, in this case, the entire proceeds received for the stock are minimum (legal) capital. In this case, the entire amount received for the stock is minimum or stated capital, and there is no capital surplus.
The ability to pay a dividend or a stock redemption out of the current and prior year's net income is a significant improvement over the standard earned surplus test. When the corporation has no earned surplus, or a negative balance in earned surplus, the expanded test may allow the corporation to pay dividends or redeem stock.
The earned surplus account represents the corporation's cumulative earnings (or loss), less distributions of earnings (i.e., dividends). Thus, a corporation that has generated losses or that has paid out significant dividends in past years may have no earned surplus or a negative earned surplus. Under the standard earned surplus test, no dividends may be distributed or stock redemptions paid in this situation. However, under the more liberal test, if the corporation has net income in the current or prior year, dividends may be distributed or stock redemptions paid, even though the net income for these periods is not sufficient to erase the deficit in earned surplus.
Clearly, this more liberal test is especially important to startup companies, which may generate large losses for several years before turning a profit.
Example
The financial structure of AMS Corporation, after two years of operation, is depicted by the following accounting equation:
assets = liabilities + owner's equity.
$30,000 = $20,000 + $10,000
Originally, the owners contributed $25,000 of owner's equity through the purchase of common stock. This $25,000 is the corporation's total contributed capital, and the minimum or stated capital, as the stock is no par and no allocation was made to capital surplus.
Now the owner's equity is $10,000 because the corporation has a negative balance of -$15,000 in earned surplus or retained earnings. Contributed capital of $25,000, net of the negative balance of -$15,000 in earned surplus or retained earnings, yields the total owner's equity of $10,000.
Finally, the corporation earns net income of $4,000 in year three, and another $4,000 in year four. Under the standard earned surplus test, no dividend (or stock redemption) may be paid in any of the years, because even after the net income for years three and four is added to earned surplus, the earned surplus is still -$7,000 (-$15,000 deficit after year two, offset by $8,000 of total earnings for years three and four).
However, under the more liberal test applied in Delaware, Nevada and some other states, the corporation may pay dividends (or stock redemptions) of $8,000 out of the year three and four earnings.
The cash flow test will still apply, as a separate constructive fraud test, even in states that apply more liberal versions of the earned surplus version of the balance sheet test. Thus, in the last example, if the corporation were unable to pay its debts as they came due, the corporation would not be able to pay dividends or stock redemptions, despite the earnings in years three and four.
In addition, while the specific constructive fraud tests in state corporation statutes and limited liability company (LLC) statutes replace the Uniform Fraudulent Transfers Act's constructive fraud test, the UFTA's actual fraud provisions apply to all transfers. Thus, the UFTA's actual fraud provisions will apply as a separate limitation to distributions on account of an ownership interest (i.e., distributions of earnings and redemptions of ownership interests).
Think ahead
State LLC statutes usually apply the standard cash flow test and the standard balance sheet test in the same way that these two tests apply under the UFTA's constructive fraud provisions. The LLC statutes also apply only with respect to distributions to owners on account of their ownership interests.
However, in Nevada, an LLC can waive application of the balance sheet test. A waiver of the balance sheet test leaves only the cash flow test as a constructive fraud restriction, and thus allows the LLC a greater opportunity to make distribution of earnings and for ownership redemptions. This waiver, which is recommended, must be accomplished in the articles of organization for the LLC.
More liberal restrictions on distributions of earnings by corporations help explain why Delaware and Nevada are popular choices for business formation, and why small business owners should consider forming the business entity in one of these states (see our discussion of choice of state issues).
