When a company earns enough money to pay its bills, invest in promising projects and put something aside for a rainy day, that rainy-day fund is retained earnings, or the accumulation of profits that have yet to be spent. Retained earnings accumulate every year in the portion of a company’s balance sheet known as stockholders’ equity. While a hefty pile of retained earnings may give stakeholders a warm and fuzzy feeling, the Internal Revenue Service has other ideas.
Accumulated retained earnings, which are represented on a company's balance sheet as stockholders' equity, are company profits that are held instead of distributing to shareholders.
What are Accumulated Retained Earnings?
Every quarter, corporations issue an Income Statement detailing revenue and costs over the period, including interest expenses and taxes. The final balance is the quarterly net income. Accountants accumulate the net income in the retained earnings account — that’s why they call it “accumulated“ retained earnings.
Although there are many uses for retained earnings, it is the one and only source of dividend payments. A corporation is under no obligation to pay dividends and can devote retained earnings to buying assets, starting projects, paying down debt or collecting dust.
Reporting Retained Earnings
The annual corporate financial reports will show the year-end balance in the retained earnings account. The corporation will also issue an Accumulated Retained Earnings Statement, which shows the changes in retained earnings over the reporting period. Starting with the previous balance, the report will show the effects of net income or net loss, possibly the transfer of some retained earnings to other capital accounts, and the payment of any dividends. The final figure should match the balance sheet figure for retained earnings.
Accumulated Earnings Tax
A normal "C" Corporation — one that is taxed separately from its owners — with retained earnings exceeding a $250,000 threshold might receive a visit from an IRS auditor. The reason: The corporation might have triggered the accumulated earnings tax, or AET, meant to keep corporations from letting their retained earnings remain idle. In the words of the IRS, the accumulation of $250,000 or less generally falls within the "reasonable needs of most businesses." A $150,000 exception applies to other types of businesses.
The IRS recognizes legitimate reasons for accumulating earnings such as business expansion. But there are also red flags that indicate an untoward reason for retaining earnings such as classifying shareholder withdrawals as personal loans.
So if a corporation doesn’t have a good explanation why it hasn’t paid out dividends or otherwise purposed retained earnings, it might be subject to a 20 percent tax on the excess retained earnings above the threshold.
Legitimately Bypassing AET
Corporations have many legitimate ways to escape AET. Most involve keeping explicit minutes from board meetings during which uses for the retained earnings are planned. Reasonable uses for retained earnings include paying accrued income tax, business expansion, litigation costs, debt retirement and several others. The IRS is pretty wise about these things and will want to see some proof beyond idle chit-chat.
The federal agents will also look at working capital levels, essentially assets minus debt, to see whether the company will need to tap retained earnings to operate. The corporation does have an ace up its sleeve: It can become an "S" Corporation and escape the AET altogether. An "S" Corporation passes tax obligations through to its shareholders.
- How to Read a Financial Report: Wringing Vital Signs Out of the Numbers; John Tracy
- Intermediate Accounting; Donald Kieso et al
- Sound Investing, Chapter 13: Retained Earnings Evidence; Kate Mooney
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