| Legal capital serves to protect the interests of creditors, and represents the amount of owners equity that cannot be distributed to shareholders. |
Legal capital refers to the portion of owners equity and assets that cannot be distributed, and is therefore permanent in nature. States require companies to maintain legal capital in order to protect creditor’ claims to assets.
Legal Capital and Par Value
Traditionally legal capital referred to the par value or the stated value of a company’s common and preferred stock shares issued. Any stock shares issued over par value was considered additional paid-in capital over par value, also sometimes referred to as capital surplus.
For example, if Sunny incorporates Sunny Sunglasses Shop and issues 25,000 common stock shares at $1 par value, the common stock issued at par equals $25,000.
Any additional amount that the company receives for issuing the stock is recorded as additional paid-in capital in excess over par. If Sunny receives $2 per share, additional paid-in capital equals $25,000 as recorded below:
Par Value and Additional Paid-In Capital
| Account | Debits | Credits |
| Cash | $50,000 | - |
| Common Stock @ Par, $1, 25,000 Shares | - | $25,000 |
| Additional paid-in capital | - | $25,000 |
Par value does not represent the actual value of the stock, but rather is an arbitrary or nominal amount determined in the corporate charter. Most state laws prevent companies from issuing stock shares below the par value to protect future investors. For this reason, par value is often set at a minimal price.
When stock shares do not have a par value, the company Board of Directors may assign a stated value to the stock to determine legal capital, or the amount of owners equity that the company must maintain after issuing dividends and buying back its stock.
When the stock shares are issued, the excess over the stated value is also recorded as additional paid-in capital account similar to the example above, except that the company records the issuance of stock shares at the determined stated value.
In the example above, Sunny could not declare a dividend in excess of $25,000 legal capital determined by the par or stated value of the stock shares.
Legal Capital and Total Contributed Capital
In recent years, many states no longer require a corporation to have a par value assigned to the stock. States that have adopted these provisions have eliminated the distinction between par value and the amount contributed in excess of par.
Therefore, many states require legal capital in the amount of the total proceeds received from the issuance of stock. In this example, legal capital would equal $50,000. In other words, these states only allow the payment of dividends and stock buybacks from retained earnings and not from contributed capital.
Actions taken by a corporation that could affect legal capital should be considered in light of the state laws where the company was incorporated.
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