S Corp retained earnings are the profits made by the business that are retained and not distributed to the shareholders after they have paid taxes on such profits of the business.

When a C Corporation makes a profit, it must pay corporate income tax on those profits. Thereafter, the profits can either be distributed to the shareholders in the form of dividends or reinvested into the business as retained earnings. If the profits are distributed as dividends, then the shareholders must pay taxes on that money.

However, a business that elects to be taxed as an S Corp by the Internal Revenue Service (IRS) doesn’t have to pay taxes on the profits of the business; rather, the profits and losses pass through to the shareholders who then report it on their personal income tax returns.

For that reason, the S Corp must distribute all pre-tax profits to the shareholders for tax purposes. While the S Corp is in fact a corporation, it generally uses the tax rules of a partnership.

Retained Earnings: An Overview

As previously noted, an S Corp must allocate the profits of the business to the shareholders for tax purposes. However, the S Corp can do what it wants with such profits. Therefore, the business can allocate profits to the shareholders, keep it as retained earnings, or do both.

If the funds are distributed to the shareholders, then they will not be required to pay taxes on such wages as they already paid taxes on them. But if the company retains the earnings, then the shareholders still have to report the profits on their tax returns per the S Corp guidelines established by the IRS.

Retained earnings are determined by looking at the following:

  • Overall revenue
  • Expenses
  • Net income distribution

If your S Corp has significant retained earnings, then the S Corp could lose its status. Keep in mind that the previous year’s closing balance in the retained earnings account is used as the opening balance the following year. In order to calculate the new retained earnings, you will take that opening balance and then do the following:

  • Add net income.
  • Subtract net loss.
  • Subtract the portion of the income distributed to shareholders to identify the closing balance for the retained earnings account.

Problems on Retained Earnings

Some of the problems regarding retained earnings include the following:

  • Shareholders are taxed on a percentage of the profits whether or not they end up receiving the money thereafter.
  • If the S Corp has a silent partner investor, this individual might not be happy with paying taxes on profits that she may not actually receive, particularly if she doesn’t have authority in how the earnings will be handled after taxes are paid.

Cash Basis Accounting

Cash basis accounting is a method whereby an S Corp recognizes revenue when the cash from sales transactions are received and subsequently pays any expenses when the payments are actually made.

This type of accounting system also assumes that all sales are paid for in cash.

Furthermore, an S Corp that has this type of accounting system shouldn’t have any retained earnings. But the retained earnings account allows the S Corp to keep track of the amount of any undistributed income.

There are some instances when an S Corp could receive cash payments for goods or services that are to be delivered at some point in the future. The company might also receive money that is due for past transactions. All of the receipts for such transactions should be considered revenue for the current accounting period, even if the products or goods were distributed or made at that time.

If the S Corp is utilizing the cash basis method, then the S Corp recognizes all cash payments as incurred expenses. This means that advance cash payments, i.e. prepaid rent, is recognized as an incurred expense for the accounting period before the cash is actually paid out.

You will then determine the income and/or loss at the end of that particular accounting period, which occurs after you have finished preparing the appropriate financial statements for that period. The net income or net loss would simply be calculated by subtracting the revenues and expenses that were incurred during that period.

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