The purchaser of an equity interest in
a business expects to be compensated for the investment in any of the three
Income from earnings distribution
of the business, either as dividends paid to corporate shareholders or as
drawings in a partnership.
Capital gain realized upon sale of
Capital gain realized from selling
his or her interest to other partners.
Capital gain is the term used to
describe any excess of the selling price of an investment over the initial
purchase price. For example, if you purchased an equity interest in a business
for $5,000 and later sold it for $8,000, you would realize a capital gain of
The equity investor in a partnership is
entitled to a share of all drawings paid out to partners at a percentage
established when the interest was purchased. For example, assume an investor
acquired a 20% interest in a partnership. The distribution of earnings to all
partners in a given year is $20,000. The holder of the 20% interest would
The dividends received by the equity
investor in a corporation depend upon the number of shares held. For example, if
a corporation voted a dividend of $1.50 per share in a given year, the owner of
1,000 shares would receive a dividend of $1,500 (1,000 x $1.50).
Sale (or Liquidation) of Business
If a business is sold or liquidated,
the equity investor shares in the distribution of the proceeds. As with an
earnings distribution, the share of the proceeds in a corporation sale depends
upon the number of shares held. In a partnership, each partner's share of the
proceeds is based upon the percentages specified in the partnership agreement.
If the proceeds received by the equity
investor exceed the original purchase price, this excess is considered a capital
gain and taxed accordingly.
If the business were liquidated, the
assets would be sold and the proceeds would first be used to discharge any
outstanding obligations to creditors. The balance of the proceeds, after these
obligations had been fulfilled, would be distributed to the equity investors in
accordance with their share-holdings or percentages of interest.
Sale of Equity Interest
As a business prospers and grows, the
of an equity interest grows with it. Therefore, the equity investor may be
able to sell his or her interest at a price higher than the initial acquisition
For example, an equity investor in a
corporation may have purchased his or her interest at $10.00 per share. As the
business grows, he or she is able to sell the shares at $15.00 per share,
realizing a capital gain of $5.00 on each share sold.
Capital Gains vs. Dividends
In many cases, the
equity investor in a small business
is primarily interested in capital gains. Aside from the tax advantages, the
equity investor usually realizes that the earnings of the small business are
better retained in the business than distributed as dividends or drawings.
Retention of earnings permits the business to grow so that the value of the
equity interest increases. The investor can realize a return on the investment
through a capital gain derived from selling his or her shares or upon sale of