The terms "paid-in capital" and "capital contributions" can have identical meanings or different meanings, depending on how they are used. Capital generally refers to the assets of a business used to produce goods or services. A new business obtains capital from two sources: investors and loans.
IRS Definition of Capital Contributions
Capital contributions are "Contributions to the capital of a corporation, whether or not by shareholders, [and] are paid-in capital," according to the Internal Revenue Service. If you start a business with a $10,000 personal investment from your savings account, it's a capital contribution or paid-in capital. If you borrow $10,000 to go with your initial $10,000 investment, that also is paid-in capital.
Capital Contributions and Owner's Equity
Paid-in capital and capital contributions are frequently associated with the owner's equity in a business. Owner's equity is the amount of money you personally have at risk in the business. When used in reference to owner's equity, paid-in capital or capital contributions are the same as owner's equity.
If you invested $10,000 in the business and borrowed another $10,000, however, your owner's equity or capital contribution, is only $10,000. When the $10,000 debt is paid, it becomes part of considered owner's equity.
Additional Paid-In Capital
Additional paid-in capital is another source of confusion. For example, you invested $10,000 in the business, and issued yourself 1,000 shares, each share has a par value of $10.00. The following year, you invest an additional $10,000 without issuing new shares.
In this scenario, you still own 1,000 shares having a par value of $10.00 each. The new $10,000 is recorded in the owner's equity section of your balance sheet as "additional paid-in capital." While the par value of your 1,000 shares remains at $10.00, the "market value" of your shares increases to $20.00 each.
Your owner's equity increases to $20,000. This assumes no changes in other key items on the business's balance sheet.
Capital Contributions and New Investors
Suppose your friend invests $10,000 in your business. The owners' equity increases to $30,000. If you issued your friend 1,000 shares at a par value of $10.00 each, the business would have 2,000 total shares outstanding. Each share has a market value of $15.00.
In this scenario, you diluted your owner's equity by $5,000 to $15,000. The better strategy is to issue 2,000 new shares to keep the par value and the market value equal. Your friend would get 1,000 new shares, while you keep 1,000 new shares for yourself. Your owner's equity remains at $20,000 while your friend has an owner's equity of $10,000.
Capital Contributions of Noncash Assets
Capital contributions to a business by investors can include noncash assets, such as buildings and machinery. The IRS allows tax-free investments of noncash assets as long as the basis (computed value) of the assets is the same for the investor and the business.
If an investor uses a building with an appraised value of $100,000 to acquire a $100,000 interest in a business, this would be a tax-free investment. If the investor acquired a $150,000 interest in the business with the same $100,000 building, this would be a $50,000 taxable gain to the investor.
- Shareholder vs. Equity Holder
- Difference Between Shareholders Vs. Investors
- What Is Unlevered Equity?
- How to Calculate Return on Investment in Real Estate
- Difference Between Liquid Capital vs. Investment Capital
- Unlevered Return on Equity Vs. Levered Return on Equity
- How Can Smaller Investors Obtain Access to Private Equity Investment?
- The Difference Between Stocks, Bonds & Mutual Funds