Dividend distributions are a common way to withdraw funds from the business and minimize vulnerable assets within the corporation. This withdrawal method is often restricted to the earned surplus.
Delaware and Nevada (among other states) apply a less restrictive earned surplus test in determining the legality of distributions of earnings and stock redemptions. The less restrictive test allows the corporation to pay dividends and stock redemptions out of earned surplus or the net income of the current or prior year (i.e., capital surplus).
Closely held corporations typically issue no-par stock and make no allocation from the amount received to capital surplus. Thus, in this case, the entire proceeds received for the stock are minimum (legal) capital. In this case, the entire amount received for the stock is minimum or stated capital, and there is no capital surplus (see our discussion of different classes of ownership interests with par value and no par stock).
The ability to pay a dividend or a stock redemption out of the current and prior year's net income is a significant improvement over the standard earned surplus test. When the corporation has no earned surplus, or a negative balance in earned surplus, the expanded test may allow the corporation to pay dividends or redeem stock.
The earned surplus account represents the corporation's cumulative earnings (or loss), less distributions of earnings (i.e., dividends). Thus, a corporation that has generated losses or that has paid out significant dividends in past years may have no earned surplus or a negative earned surplus. Under the standard earned surplus test, no dividends may be distributed or stock redemptions paid in this situation. However, under the more liberal test, if the corporation has net income in the current or prior year, dividends may be distributed or stock redemptions paid, even though the net income for these periods is not sufficient to erase the deficit in earned surplus.
Clearly, this more liberal test is especially important to startup companies, which may generate large losses for several years before turning a profit.
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Let's say the financial structure of a corporation, after two years of operation, is depicted by the following accounting equation:
assets = liabilities + owner's equity.
$30,000 = $20,000 + $10,000
Originally, the owners contributed $25,000 of owner's equity through the purchase of common stock. This $25,000 is the corporation's total contributed capital, and the minimum or stated capital, as the stock is no par and no allocation was made to capital surplus.
Now the owner's equity is $10,000 because the corporation has a negative balance of -$15,000 in earned surplus or retained earnings. Contributed capital of $25,000, net of the negative balance of -$15,000 in earned surplus or retained earnings, yields the total owner's equity of $10,000.
Finally, the corporation earns net income of $4,000 in year three, and another $4,000 in year four. Under the standard earned surplus test, no dividend (or stock redemption) may be paid in any of the years, because even after the net income for years three and four is added to earned surplus, the earned surplus is still -$7,000 (-$15,000 deficit after year two, offset by $8,000 of total earnings for years three and four).
However, under the more liberal test applied in Delaware, Nevada and some other states, the corporation may pay dividends (or stock redemptions) of $8,000 out of the year three and four earnings.
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The cash flow test will still apply, as a separate constructive fraud test, even in states that apply more liberal versions of the earned surplus version of the balance sheet test. Thus, in the last example, if the corporation were unable to pay its debts as they came due, the corporation would not be able to pay dividends or stock redemptions, despite the earnings in years three and four.
In addition, while the specific constructive fraud tests in state corporation statutes and limited liability company (LLC) statutes replace the Uniform Fraudulent Transfers Act's constructive fraud test, the UFTA's actual fraud provisions apply to all transfers. Thus, the UFTA's actual fraud provisions will apply as a separate limitation to distributions on account of an ownership interest (i.e., distributions of earnings and redemptions of ownership interests).
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As for the LLC, state statutes usually apply the standard cash flow test and the standard balance sheet test in the same way that these two tests apply under the UFTA's constructive fraud provisions. The LLC statutes also apply only with respect to distributions to owners on account of their ownership interests.
However, in Nevada, an LLC can waive application of the balance sheet test. A waiver of the balance sheet test leaves only the cash flow test as a constructive fraud restriction, and thus allows the LLC a greater opportunity to make distribution of earnings and for ownership redemptions. This waiver, which is recommended, must be accomplished in the articles of organization for the LLC.
More liberal restrictions on distributions of earnings by corporations help explain why Delaware and Nevada are popular choices for business formation, and why small business owners should consider forming the business entity in one of these states (see our discussion of choice of state issues).
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