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5. FINANCIAL MATTERS

b. Books and Records

Overview

Your company should maintain financial books and records that are complete and accurate. To accomplish this goal, consider hiring a bookkeeper or using financial software such as QuickBooks. You should also consult with a certified public accountant (CPA) during the formation phase, and the CPA can help set up the books and records.

Establish the “fiscal” year for your company. Most companies use the calendar year as the fiscal year. Also determine the accounting method for your company. The most common methods are “cash basis” and “accrual basis”. Note that tax laws may limit your options in these matters.

Consider purchasing a company binder from a vendor at a cost of approximately $80. The binder would hold your company records, company seal (optional), ownership certificates (optional), owner registers, meeting minutes and related forms, and perhaps other items.

Financial Statements

Arrange for someone to prepare financial statements on an annual basis and perhaps more often (quarterly or monthly). “Financial statements” usually include a balance sheet, income statement, and cash flow statement. The balance sheet is a snapshot of assets, liabilities, and owners' equity at year-end. The income statement shows profits and losses for the entire year. The cash flow statement shows the cash flowing in and out of the company throughout the year.

Mandatory Records

Applicable law may require the business managers to maintain certain records. For example, federal tax law requires companies to keep their tax returns and receipts for specified periods. The law of California requires LLC's to maintain the following records at an office within the state:

• current list of the name, address, capital contribution, and profit/loss share of each member, "economic interest holder", and manager
• copies of the articles, operating agreement, amendments, and any “powers of attorney” used to execute the documents
• copies of the LLC's federal, state, and local income tax or information returns and reports for the six most recent taxable years
• copies of the LLC's financial statements for the past six fiscal years
• books and records related to internal affairs for past five fiscal years

Delaware imposes similar but less extensive requirements on Delaware LLC's. However, if California residents own at least 25% of the voting interests of a Delaware LLC, then California law requires the company to comply with the above requirements applicable to California LLC's.

Capital Accounts

Tax law requires “S corporations”, LLC's, and LP's taxed as partnerships to maintain “capital accounts” for their shareholders, members, and partners (respectively). Capital accounts are not bank accounts, but merely records of the ownership interests of the owners. In the typical private equity fund, the investors have capital interests and the fund manager has a profits interest. Each capital interest is a proportional share of the capital assets, including paid-in capital. The fund manager does not have the right to any distributions from the liquidation of the capital assets.

Your company must allocate every item of income, gain, credit, loss, or deduction among the capital accounts. Usually, such allocations correspond to the ownership percentages. However, federal tax law may allow LLC's and LP's (but not “S corporations”) to make “special allocations” not in accordance with ownership percentages, if the company has legitimate business reasons.

Capital accounts are usually prepared by the CPA at the end of each fiscal year.

Expenses

Once you successfully file the articles for your new entity, contact the IRS for a taxpayer ID number (TID). The TID is also known as an “employer” ID number or “EID”. You may obtain the TID immediately by telephone or Internet. For more information, see the IRS website.

Once you have the TID, you should open new bank accounts in the name of the entity. At a minimum, get a checking account with company checks and debit cards. If your company has employees, also open a payroll account. Additional options are a savings account, money market account, and credit cards. You may also hold investor capital in an escrow account until deployment to portfolio companies.

Going forward, pay all business expenses with checks, credit cards, and debit cards of the entity incurring the expense. If you pay expenses from your personal accounts, you create tax, accounting, and legal problems. From a tax perspective, the entity may lose the ability to deduct the expenses from its taxable income. From an accounting perspective, the expense might avoid detection when your bookkeeper creates financial statements. From a legal perspective, you create the risk of personal liability under an “alter ego” theory.

Delivery of Records

State law may require your entity to deliver certain records to the owners and other persons. For example, if the entity is a California LLC, it must provide its members and “economic interest holders” with the following:

• information for their personal income tax returns within 90 days after the end of each taxable year
• copies of the company income tax returns, if the LLC has 35 or fewer members
• annual reports and maybe quarterly reports, if the LLC has more than 35 members
• copies of amendments to the governing documents, if executed pursuant to “powers of attorney”

In addition, every member, economic interest holder, and manager of a California LLC has the right to inspect and copy the mandatory records of an LLC. The inspection must be “reasonable” -- meaning, among other things, that it must place during normal business hours and for purposes reasonably related to the interest of the person making the request. If your California LLC has more than 35 members, additional inspection rights apply.

Delaware grants similar rights to members of Delaware LLC's. In addition, if your company is a Delaware LLC in which California residents own at least 25% of the voting interests, then your company must comply with the record requirements of California as well as Delaware.