Table of Contents
Retained Earnings Tax: What It Is & How It Affects Your Business
Every business owner wants to grow their company, and one of the ways to do that is by saving profits instead of paying them out. These saved profits are called retained earnings, and they’re crucial for long-term success. But holding on to too much money can attract the attention of the Internal Revenue Service (IRS). That’s where the retained earnings tax comes in—also known as the accumulated earnings tax.
In this blog, we’ll break down what retained earnings are, explain the retained earnings tax, when it applies, how it affects your company, and what steps you can take to avoid or reduce it. Whether you run a small company or a large corporation, knowing the rules around this tax can help you avoid costly mistakes and keep your business moving forward.
Understanding Retained Earnings
Retained earnings are profits that your company keeps instead of giving out as dividends to shareholders. These funds stay in the business to support things like buying equipment, hiring staff, or paying off debt.
Here’s a simple formula:
Retained Earnings = Beginning Retained Earnings + Net Income – Dividends Paid
Retained earnings are found on the balance sheet, under shareholder equity. Unlike net income, which is part of the income statement, retained earnings show how much profit your business has kept over time.
These earnings are important because they provide working capital—cash you can use for daily operations or investment in future growth. Instead of borrowing from a bank or issuing stock, retained earnings help you fund your company from the inside. This boosts your company’s financial stability, especially during tough economic times.
How Retained Earnings Work
On a company’s balance sheet, retained earnings are listed under the equity section. They grow over time when profits are saved and shrink when money is paid out or lost.
Unlike dividends, which are paid to owners or shareholders, retained earnings stay in the company. For example:
- A company might use its retained earnings for research and development (R&D).
- It might pay off old loans or reduce unsecured debt.
- Or it could buy another company, which is part of mergers and acquisitions.
All of these help the company grow without needing outside help or raising external financing.
What Is Retained Earnings Tax?
The retained earnings tax, or accumulated earnings tax, is a corporate tax applied by the IRS when a C corporation keeps too much profit without a valid reason. This rule is part of corporate tax in the United States and is meant to stop businesses from holding money just to help owners avoid paying dividend tax or income tax.
The tax usually doesn’t apply to S corporations, sole proprietorships, or limited liability companies (LLCs) because they are flow-through entities, meaning profits are taxed on the owner’s return.
When Does the Tax Apply?
The IRS sets a limit of:
- $250,000 for most C-corporations
- $150,000 for professional service firms
If your retained earnings go over this amount and you can’t show a reasonable business need, the IRS might see it as tax avoidance.
Examples of acceptable business needs include:
- Saving money for a new location
- Keeping a reserve for emergencies
- Paying off large business expenses or inventory costs
If you don’t have proper records, the IRS may label the extra savings as “unreasonable,” which can lead to an audit and penalties.
Tax Rate & Calculation
If your company fails to explain its retained earnings, the IRS will charge a flat 20% tax on the extra amount. You report this tax using IRS Form 1120, Schedule PH.
For example:
If your company has $400,000 in retained earnings, but only $250,000 is allowed, the IRS may tax the extra $150,000 at 20%, which equals $30,000 in taxes.
How Retained Earnings Tax Affects Your Business
Here is how retained earnings tax affects your business:
Financial Implications
The biggest issue is losing cash to extra taxes. This reduces the money you have for growth, hiring, or buying capital like equipment.
It also impacts your business valuation and how your shareholders view the company. Some owners may prefer getting dividends, especially since C-corporations face double taxation—they pay corporate tax, and then owners pay income tax again when dividends are received.
Legal & Compliance Risks
If your records don’t back up why you’re holding the money, the IRS could audit your company. You might need to show:
- Business plans
- Budgets
- Contracts
- Evidence of upcoming large expenses
Failing to do so could bring not just taxes, but penalties, interest, or even legal issues under business law or taxation in the United States. There are many real-world cases where businesses faced heavy fines for poor documentation.
Strategic Considerations
To avoid this, companies must think smart. You should balance between reinvesting in the company and paying out dividends. Smart strategies include:
- Giving employee bonuses
- Paying more compensation and benefits
- Making tax-deductible investments like advertising or training
Sometimes, it’s better to keep the money in the company. Other times, it makes sense to distribute it.
How to Avoid or Minimize Retained Earnings Tax
The following are the tips to avoid retained earnings tax:
Proving Reasonable Business Needs
The key is having a valid reason to keep profits. This could include:
- Buying new equipment
- Expanding to a new market
- Saving for unexpected costs
You must document this with detailed budgets, financial statements, and plans reviewed by your board of directors.
Alternative Strategies
Other ways to avoid this tax include:
- Increasing dividends or salaries
- Spending on deductible business expenses like marketing, technology, or new hires
- Considering changing to an S-corp or LLC, which avoids double taxation
These strategies also improve your company’s image, performance, and financial management.
Working with Tax Professionals
Navigating these rules isn’t easy. A licensed CPA or tax professional can help you build smart plans, keep proper records, and avoid trouble. They understand corporate finance, tax policy, and the details of public economics, making it easier for your company to grow safely.
Conclusion
The retained earnings tax is something every C-corporation should understand. If your company holds on to too much profit without a clear reason, you could face extra taxes and legal trouble. But with smart planning, strong documentation, and the right guidance, you can use your profits to build a stronger future.
Need help managing your taxes and making sure your business stays on track? BIT Accounting is here to help. Our team of experts is ready to guide you through smart tax planning, accurate recordkeeping, and financial growth strategies that support your goals. Let us make your numbers work for you!
FAQs
1: Is retained earnings tax the same as corporate income tax?
No. Corporate income tax is on profits made during the year, while retained earnings tax is charged when too much of that profit is kept without a valid reason.
2: Do small businesses have to pay retained earnings tax?
Most small businesses are not affected because they are not C-corporations. The tax mostly applies to larger C-corps.
3: How does the IRS determine if retained earnings are excessive?
The IRS looks at your records, business needs, and any plans you have. If you can’t prove why you’re saving money, it might be taxed.
4: Can retained earnings tax be appealed or disputed?
Yes, but you’ll need strong documentation and might have to go through the United States Tax Court.
5: What’s the difference between retained earnings and profits?
Profits are what’s left after paying all expenses. Retained earnings are profits you decide to keep in the company instead of paying them out.
GET FREE QUOTE FOR ALL OF OUR SERVICES
Black Ink will send you a free analysis of your current state and what would be the cost of managing either a separate accounting and bookkeeping services or a complete solution across New York, USA. Do get in touch and we will be happy to consult you with our bookkeeping services in NY, New York, USA.
