Capital introduced versus drawings - The Book-keepers Forum (UK)

Rhianrach · Expert

Capital introduced versus drawings

Marclanders · Member

I have a friend who owns his own business operating as a sole trader. He introduces £1200 capital, from his personal account, into his business on the first of the month. At the end of the month he withdraws £1200 as his "salary". My understanding is, he has gotten his capital introduced back, in the form of drawings, and the business owes him no more. He feels that since the withdrawal was compensation for his work, ie salary, the business still owes him £1200, the capital introduced, and wants it back. Can anyone advise on the correct state of affairs?

Marclanders · Member

Thanks for replying, Rhianrach. Perhaps, accounting can be confusing. Anyone else have any ideas?

Marclanders · Member

There's been 55 views and one reply. Do I take then, that all agree with Rhianrach?

Don Tax · Expert

If he bought equipment or stock with some of the £1200 introduced then it's not very accurate to say he got his capital back. It will remain there until the capital balance is carried forward to the next period.

Its not compensation for his work as that is just another way of saying salary.

Hopefully, the so-called salary was drawings from profits. Is the bank is overdrawn at all?

best regards

Marclanders · Member

Thanks, Don. It's a service business, so no equipment or stock bought. Only expenses are, petrol, insurance, phone, wages etc. Yes the bank is in overdraft.

Don Tax · Expert

Try suggesting that after reserving for tax, nic, depreciation and his pension pot, he should only really have taken £120 sa.. erm drawings :o)

Marclanders · Member

Thanks Don. I'm doing all that! LOL the problem I'm having is, they are putting thousands into keeping the company afloat while taking thousands in drawings out, and believing the business owes them the capital introduced. Basically, they put 2000 in a month and take 1650 out in "salary" and pension. Yet, still fell the business owes them the 2000 back.

Don Tax · Expert

Hi I'm sure we're discussing this in the simplest of terms but if they don't listen to you, I hope they don't have to hear it from the bank manager. All you can do is up to date P&L, cash-flow etc and tell them the bottom line is available (or not) for personal drawings.

In the example you give, they've simply introduced £350 and even if it were a company, its only worth keeping afloat for so long.

I still see "wage" on client records who have been self-employed for 30 years, but it seems, in this case, that they are genuinely confused.

Shamus · Forum Moderator & Expert

Howdi Digga,

Now why is it never this sort of client who treats the business as a totally seperate legal entity that incorporates rather than those who treat their companies as personal piggy banks!

I think that everyone above right back to Steve's post has hit the nail on the head in that due to the legal form of the business it's not working the way that the owner expects it to.

Espechially impressed with Robs analysis that I may paraphrase myself in future discussions with clients.

-- Edited by Shamus on Monday 7th of May 2012 04:37:47 PM

Rob-f58049 · Senior Member

Being a sole trader, he is entirely liable for the trading losses. So if the overall state of the business is that it has negative capital (i.e. losses from all those expenses and a bank overdraft, with not enough income to cover them, and including all those drawings), then the business doesn't owe him money, but rather *he owes the business money*!

In other words, if he thinks he can wind up the business and get his capital back while letting the business absorb all the losses, he'll have to think again.

Wella · Expert

You get the gist with this, that you are basically right.

I have had clients who think that they can pay themselves a wage, as an expense against the business. They also don't realise that they liable for the tax on the profit, not what they draw out

It can be difficult sometimes to make them understand but you do need to tell him that he does not get a wage, it is just drawing on capital, which will be his original capital plus any profit made. As Rob has said, if he makes a loss, he could be in debt to the business, if the assets, are less than the liabilities

Marclanders · Member

Thanks folks. I really appreciate the comments. I had a four hour meeting with him and his wife this morning. Not much progress I'm afraid. I tried.

Don Tax · Expert

Try this. You know the self service check-outs at a supermarket and pay by cash. Tell him to imagine he feeds in the fivers and tenners and his wife is crouched in the machine slipping them into her purse, except every now and again she lets a couple of notes go through so they can leg it out of the shop. In this case he fed in £2000 and reached the getaway car with £1650.

Shaun, can I nick that classic too you've also just come out with. Never seen the juxtaposition before of the sole trader who owns a separate entity against the company who own a piggy bank lol

kind regards,
Tim

Marclanders · Member

Thanks Don, I tried something similar. I had her take a fiver out of her purse and think of it as introducing capital into the business. I told them to think of me as the business and had her hand me the fiver - introducing capital. I had her ask for the fiver back and to think of it as drawings. I handed the fiver back. I then asked her where was the capital introduced that she wanted "back"? She looked truly shocked, shrieked, threw the fiver on the table and said "oh, no, no, that's not right". So, I altered it slightly. Repeated the example, but this time had the husband ask for the money and i gave it to him. She was the person physically removing cash from their savings and introducing the capital. He was the one drawing it out. I repeated the question. An argument ensued between the two over what the money was spent on. I think they finally grasped the concept but, she said she didn't care, she wanted the money she was "due". Normally, I'd just tell her to take it "back" from future profits and be done with it. The problem is we're talking £14,000, they've taken on a partner as of 1 May and they don't think he would be entitled to a similar £14k drawings from future profits. At that point, I needed a drink and it was only 2pm. LOL. Clearly, she is just upset at the loss of savings and wants it back. Don't we all, don't we all.

Marclanders · Member

New problem with them but related. The new partner agreed to a "salary" of 1200 per month - same as the current owner. He's further agreed to let it accrue for three months. The business is comming into season and has always done well in the summer. The owners introduced 2k into the business 1 May and will draw it out by months end to pay the current owners salary. They did not require a similar cash introduction from the new partner. Their position is, as they did not require a matching cash introduction, the new partner is only entitled to 1200 in three months and not 3600 (3600 - 2000 capital not introduced).

Don Tax · Expert

Hi, I've got to nip out for a few hours but the crux would appear to be what the new partner has to say about this ?

Speak later.

MarkS · Expert

Hi There

At the end of the day it wont come down to what any of the partners "think" is the situation. The situation will be governed to what has been agreed in the signed partnership agreement (assuming they have one). If they dont then the Partnership Act 1890 will kick in and decide the agreement.

Re the original point. Being an unincorporated entity the sole trader/partner cant pay themselves as "salary" and get tax relief on it. All they are doing is drawing money out of the business which is a pure balance sheet movement. It is the same when the introduced money into the business. It was a pure balance sheet movement and had no effect on the profit. They are perfectly entitled to withdraw as much as they want from the business provided cash flow permits it. Though at the end of the day they will need to still satisfy all business debts as well as personal tax debts as the business and themselves are treated as the one person.

Regards

MarkS

Marclanders · Member

Thanks Marks. Don, the new partner has agreed to postpone his "salary" for 3 months but feels he is owed the full 3600. As for the £14k the owners want "back", the two sides havr agreed that the amount the new partner will introduce (for buying into the business), will be reduced by an equal £14k. There is no signed partnership as yet.

MarkS · Expert

Well if there is no signed partnership agreement in place putting in writing what everyone agrees then regardless of what they think they agree then the law will refer to Partnership Act 1890 if there is a later disagreement by any of the partners.

My advice to them would be to get a partnership agreement in place putting in writing exactly what has been agreed and get it them each to get separate legal representatives to review the agreeement with them.

Have seen it many times in the past when the apparent "agreement" turns out at some point later to be different when there is a fall out and unless there is something agreed in writing there will be someone left out of pocket.

Regards

MarkS

Marclanders · Member

Thanks Marks. But which position, with respect to the amount of "salary" each feels the partner is entitled to in three months, is correct?
Is it 3600 or 1200? Bearing in mind the above capital injection by the owners.

Wella · Expert

Are the entity has changed slightly from soletrader to partnership, which does put a slight tilt on it, and I can almost undrstand the wifes concern as to where "her" money has gone. The problem is if one partner racks up debt for the partnership, her capital goes to cover it.

As Mark has said point them in the direction of the Partnership Act 1890 (you can get pdf copy of the internet

http://www.legislation.gov.uk/ukpga/1890/39/pdfs/ukpga_18900039_en.pdf

Partners salary is still only a distribution of profit.

The new partner is paying for goodwill, which can either be left on the balance sheet, or withdrawn by the original partners.

It does sound like they all need to sit down with a legal advisor, who can draw up a proper agreement, and explain their individual, and joint responsibilies.

Bill

Don Tax · Expert

Marclanders wrote:
Thanks Marks. But which position, with respect to the amount of "salary" each feels the partner is entitled to in three months, is correct?
Is it 3600 or 1200? Bearing in mind the above capital injection by the owners.

They seem to have verbally agreed on something entirely dependent on something else - eg. the worth of the business and especially bank balance. The worth depends on profits, and the new partner is probably cognisant of the good season coming up, but will he want to stay around through the winter? I guess not because he wants a fixed salary and his cash introduced returned long before winter.

I would suggest what the new guy wants is a temporary contract and/or loan agreement; either way he should have proof of what he's paid for, as verbal agreements are not worth the paper they're written on.

Re. £3600 or £1200 the parties have a differing understanding of the answer to that but I'm not sure what you mean by ".......two sides have agreed that the amount the new partner will introduce (for buying into the business), will be reduced by an equal £14k."

Regards,

Tim

Marclanders · Member

Sorry for confusion Tim. The latest issue is in regards to the two partners "salary". The new partner is willing to let his accrue on paper for 3 months, resulting in £3600 (3 x £1200) due him. The current owners will continue to draw their salary, £1200 per month, as normal. They want to take additional drawings this month, resulting in total drawings for May of £2000. As the business is in overdraft, the current owners have introduced £2000 capital to cover the £2000 they plan to draw out. I know, why introduce it and take it right back out? Don't ask LOL The owners feel that as the new partner did not introduce a matching £2000, the new partners salary in 3 months time should be reduced by £2000. Resulting in £1200 due to him in 3 months and not £3600 (£3600 - £2000 capital not introduced). Thanks for all your help.

Don Tax · Expert

Marclanders wrote:
Sorry for confusion Tim. The latest issue is in regards to the two partners "salary". The new partner is willing to let his accrue on paper for 3 months, resulting in £3600 (3 x £1200) due him. The current owners will continue to draw their salary, £1200 per month, as normal. They want to take additional drawings this month, resulting in total drawings for May of £2000. As the business is in overdraft, the current owners have introduced £2000 capital to cover the £2000 they plan to draw out. I know, why introduce it and take it right back out? Don't ask LOL The owners feel that as the new partner did not introduce a matching £2000, the new partners salary in 3 months time should be reduced by £2000. Resulting in £1200 due to him in 3 months and not £3600 (£3600 - £2000 capital not introduced). Thanks for all your help.

Sorry to be pedantic Marc but resulting in £1,600 shirley?

So, they disagree? I would suggest they pay him for whatever work he's carried out and start again with a written agreement. You know what? to save you becoming a referee, it is probably best for the new partner to have a separate adviser.

Marclanders · Member

LOL Yes, Tim, 1600. I'm beat. lol. Which do you say is he correct state of affairs? Is the new partner entitled to 1600 or 3600? I don't mind helping out. Sometimes they drive me to drink, but I love them. LOL

Don Tax · Expert

Marc, as they're at loggerheads and the verbal agreement will be near-impossible to prove either way, and the answer will therefore be somewhere in the Partnership Act as pointed out by Mark and linked by Digger Barnes. Maybe someone will be good enough to point out which section(s) are pertinent. I did start to read it but you said you didn't mind helping out lol - pass the vino.

It might not be best for you to represent both sides even though you love 'em.

kind regards
Tim

Don Tax · Expert

Each already has a differing understanding of what the agreement was so how can we answer whether £1600 or £3600? Only by referring to the higher arbiter of law.

It's striking the couple asking him to forego salary when they will jump through non-existant hoops to do the opposite.

kind regards,

Tim

Rob-f58049 · Senior Member

Is this just me?

Someone (ok, two people) puts some money in a business and later want to take their money out again. Meanwhile, the money is not there to take out.

A third person comes along and puts some money in the business and by forgoing their right to take money out again, this allows the original investors to get their money out. There's some additional cash put in by the original investors but it's just going to be taken out again. In three months time, presumably the "I want my money back but can't" issue will have transferred from the original people to the new person, plus the original investors get their "salary" share of any money left over. The original investors say that they are owed money, but in reality they have got more than their original money back, via the taking of "salary", which has now been funded by the third person.

Suppose a fourth person came along and did the same thing. Presumably the third person would be able to get their money back, the first two people would get some more salary, and the fourth person would then have the problem.

This business is going to have to do really well in the summer to settle up everyone's claims. Doesn't sound like something I'd like to join.

gillyfleur · Senior Member

You know when you read something that you just know is going to end in tears....... ???? Or in court ?