Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation. In the forums we always see both new and experienced investors inquiring about entity structuring. Should they use LLCs, and if so, should they use multiple LLCs? The end goal is usually liability protection and anonymity, the latter of course being difficult to achieve. I tend to find it somewhat disturbing that investors will go through the hassle of setting up an LLC to legitimize their business and protect their personal assets, yet they fail to invest time in learning how to operate the LLC. A lawyer that I refer my clients to told me that, “A key reason LLCs’ asset protection veils are pierced is because the owner doesn’t treat the LLC like a business entity.” There are several important aspects of treating an LLC like a business entity; however, today I am going to address only one: accounting. What new (and sometimes experienced) investors don’t realize is that there are specific sets of journal entries that must be recorded when you move an asset into an LLC or purchase an asset via your LLC. There are also journal entries that deal with moving cash in and out of your LLC that are critical to maintain that entity’s status. If you do not have the discipline to learn these accounting entries (or hire it out), then please do not waste the time and money in setting an LLC up. Without the proper accounting, your LLC is nothing more than an extension of your personal finances, which is always in reach of litigation. Accounting 101 Before we jump into the specific transactions, I need to provide you with a high level “Accounting 101” course. The golden equation is: Assets (A) = Liabilities (L) + Equity (E) When this equation rings true, you have effectively “balanced your books.” A journal entry is how transactions are recorded in accounting. A journal entry consists of an equal debit and credit. You will book assets and transactions and will even make adjusting entries with journal entries. Journal entries are the lifeblood of accounting and the backbone to your understanding of how transactions are accounted for on your books. Why am I teaching you about journal entries? Technically, every transaction ever has been recorded with a journal entry. Software programs make it easy to do, and all the journal entries occur behind the scenes. So, two reasons for teaching you this are: (1) it’s important to have a basic understand of what happens when you have a transaction, and (2) sometimes software programs will mess up, and you need to ensure the journal entries the program records are accurate. Debits increase asset and expense accounts. Debits decrease liability and revenue accounts. On the other hand, credits increase liability and revenue accounts and decrease asset and expense accounts. Have you ever wondered why your cards are called “debit” and “credit” cards? When you use a debit card, you will immediately debit an expense account and credit a cash account, which is fancy talk for increasing your expenses and decreasing your cash. When you use a credit card, you debit an expense account, but credit a liability account. By purchasing something on credit, you have increased your liabilities (a credit), and your cash remains untouched. Accounting is all around us folks; it makes the world turn! For future reference, Dr = debit and Cr = credit. Let’s look at examples below. A typical journal entry for a sales transaction in which you receive cash may look like this: Dr: Cash $20,000 Cr: Sales $20,000 The transaction above increases your cash account and increases your sales (revenue) account. Cash is considered an asset, while revenue is part of your equity accounts. Because both accounts are increasing (revenue increases equity), our golden equation A = L + E remains true because both A and E are increasing. Notice that a debit is increasing our asset account and a credit is increasing our equity account. A typical journal entry for a purchase transaction in which you paid cash may look like this: Dr: Supplies Expense $1,000 Cr: Cash $1,000 The transaction above will be seen when we book expenses. Expense accounts are part of equity accounts, while cash is an asset account. Because our expense account is being debited, it is increasing. When an expense account is increasing, our overall equity account is decreasing. So, for our golden equation to remain true, we must see a similar decrease in an asset account OR an increase in a liability account. In this case, our equity and our assets are decreasing at the same rate. Pro Tip: Equity can be tough to wrap your head around. Just remember that a debit increases expenses, and a credit increases revenues. Expenses decrease your overall equity, while revenues increase it. When we decrease equity, we need to see a decrease in assets or increase in liabilities. When we increase revenue, we need to see an increase in assets or a decrease in liabilities. A typical journal entry for a purchase transaction in which you pay with a credit card may look like this: Dr: Supplies Expense $1,000 Cr: Payables $1,000 In this transaction, we’ve purchased supplies “on account,” meaning we were extended credit to purchase the supplies. This journal entry occurs every time you use a credit card. Again, our golden equation is still intact because our equity account is decreasing and our liability account is increasing (credits increase liabilities), so A = L + E remains true. Whew, hopefully you don’t have a headache. Let’s move on to the cool stuff. Purchasing an Asset and Transferring It to the LLC Alright, so you’ve purchased an asset in your personal name, whether it be a property, vehicle, equipment, etc. and you want that asset to be transferred into your LLC. How will you account for such a transaction? Related: A CPA Answers: “Do I Need an LLC for My Real Estate, and How Will That Impact Taxes?” Well, first we need to understand that we are going to be updating the entity’s books, not your personal books. So in the eyes of the entity, we need to record the asset coming in and also how the asset was contributed to the LLC (owner contribution vs. mortgage or notes). If transferring property into an LLC, the LLC will increase (debit) asset accounts called “Buildings” and “Land.” At the same time, in order to keep our golden formula in balance, the LLC will need to increase (credit) liabilities and/or an equity account. The liability and equity accounts most commonly used are “Notes Payable” and “Owner Contributions,” respectively. Here’s an example of transferring a $100,000 property with a $70,000 note to your LLC: Dr: Building $80,000 Dr: Land $20,000 Cr: Notes Payable $70,000 Cr: Owner Contributions $30,000 If nothing else were on the LLC’s books, assets would be $100K, liabilities $70K, and equity $30K. Therefore, our golden equation balances: $100K = $70K + $30K. Purchasing an Asset Through the LLC This becomes a bit trickier from an accounting perspective, mainly because the LLC will likely pay some amount of cash at closing. The question is, how much cash and where did the cash come from? Assuming this LLC was formed a day before closing, we need to first transfer cash into the LLC, then purchase the building through the LLC. Funding the LLC with cash: Dr: Cash $30,000 Cr: Owner Contributions $30,000 We now have assets of $30,000 and equity of $30,000. We are balanced. Now let’s buy the asset: Dr: Building $80,000 Dr: Land $20,000 Cr: Notes Payable $70,000 Cr: Cash $30,000 It’s essentially the same as transferring a building into the LLC; however, when purchasing through the LLC, we just need to account for the cash movement. Notice though that our golden equation still balances. Our assets are $100K since we’ve increased our building and land accounts but decreased our cash, our liabilities are now $70K, and our equity remains at $30K, as it was unchanged during the actual purchase transaction since we credited cash instead. So, $100K = $70K + $30K. Pretty cool, huh? Moving Cash to Other Entities This can cause accounting nightmares, so prior to moving cash between entities, make 100 percent sure you understand journal entries or hire an accountant. Poor accounting in this area exposes liability risk in the event of litigation. Proceed with caution. Let’s say LLC B needs cash and LLC A has the cash available. LLCs A and B are not related, meaning one does not have any ownership stake in the other. To account for a cash transaction, we will use “Due To/From” accounts. The “Due To” account is a liability account, as it basically means the entity owes another entity or person. The “Due From” account is an asset account, as it means that the entity is owed money from some other entity or person. So, LLC A sends over (does NOT loan) money to LLC B. The transaction looks like this on LLC A's books: Dr: Due From LLC B $20,000 Cr: Cash $20,000 On LLC B’s books, the journal entry looks like this: Dr: Cash $20,000 Cr: Due To LLC A $20,000 As the cash extension is paid back, you simply reverse the transactions on each of the entity’s books. What if you want to move cash from a parent LLC to a sub LLC? Assuming LLC B still needs money from LLC A, here’s what the journal entry looks like on LLC A’s books: Dr: Investment in Sub – LLC B $20,000 Cr: Cash $20,000 And on LLC B’s books: Dr: Cash $20,000 Cr: Owner Contribution – LLC A $20,000 Owner Contributions and Distributions Every entity needs to be appropriately capitalized; otherwise, you are exposing your personal assets to undue risk. What business the entity engages in determines how it should be capitalized. As a general rule, as yourself, “How much money will my entity need in its bank account to fund transactions?” Whatever the answer, that’s how much you need to initially deposit into your entity’s bank account. Related: 5 Reasons I Do NOT Invest in Real Estate Using An LLC You don’t want to transfer money from your personal bank account into the entity’s bank account every other day, or it will look as if you have not appropriately capitalized the entity, which exposes your personal assets to liability in the event the corporate veil is pierced. What the journal entry looks like: Dr: Cash $5,000 Cr: Owner Contribution $5,000 Now the entity has cash (asset) and has increased its equity account to account for that inflow of cash. Everyone also always asks, “How do I pay myself?” I’m about to show you the journal entry that describes how to book an owner distribution. But before I do, I need to insert a caveat: Do not take owner distributions more than once every two weeks while you are growing. Once you’ve stabilized, reduce the distributions to once a month. Once you’ve transitioned out of growth and into a maintenance phase, take owner distributions once a quarter. The reason for the above caveat is to reduce the risk of your owner distributions being classified as “co-mingling personal and business expenses.” Co-mingling is a great way to involve all of your personal assets in a lawsuit caused by your LLC. Don’t do it! What the journal entry looks like: Dr: Owner Distributions $5,000 Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free Cr: Cash $5,000 Now the entity has paid its owner cash, resulting in a decrease of assets and a decrease in equity. Summary Phew. That was a long article. There’s a ton of good information in there, and it may be tough to digest. Recognize the importance of your entity’s accounting, though. It’s imperative that it’s done correctly; otherwise, all that hard work and expense that went into setting up your entity is all for naught. This stuff can be confusing, so either read back over it a few times, take a training or two, or talk to your accountant. It needs to be done, and it needs to be done correctly. Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation. Do you invest using an LLC? Any questions about the accounting practices involved? Leave all your comments and questions below!