Your business needs capital to operate. Capital is not borrowed money, but comes from investors and is considered the initial value of the company. You use capital to establish and development your business with the hope of being able to pay back investors the original investment plus a profit. Understanding the differences between paid-in capital and capital contributions is necessary for tax and business operation purposes.
You can raise capital in the start-up stage of the business by selling stock to investors. This is referred to as paid-in capital. You have to establish a per-share value for that stock so that investors will own part of the company in proportion to how much money they put in. For example, an investor who puts in 30 percent of the necessary start-up money receives 30 percent of the shares. This paid-in capital is not considered company income by the IRS because it is used to establish the company as a viable business and offers a return on the money to investors, though that return is not guaranteed. The IRS will accept that part of the paid-in capital may be used to pay initial operating expenses.
Investors may provide a capital infusion after shares have already been sold. This is considered a capital contribution. This investment does not go for the purchase of additional shares; it is put into the business to help it grow by purchasing assets. This contribution should not be used to pay operating expenses.
Capital contributions can have tax implications under IRS rules. You must be able to show that the capital contributions were not made as a payment to the company for services. You must also prove that the contributions went to assets that would produce income. If your business uses capital contributions to pay bills, the IRS will count those contributions as income and tax them. If you satisfy the IRS requirements for capital contributions, you do not have to pay tax on them.
If you continue to need additional capital contributions as you grow, your business is not paying for itself and you should accumulate retained earnings. This is money kept in an account and not paid out to investors so that you can invest it in the business. Your goal should be to have retained earnings in excess of the amount of money investors put into your company.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.